Mark Carney had this to say in the FT:

Central banks are most effective when they operate with clear and stable objectives. The pursuit of temporarily higher inflation could only work if policy were anchored to a new target, such as nominal gross domestic product – total output at market prices, unadjusted for inflation.

However, the uncertain rewards of such a regime shift must be weighed against the risks of giving up what is arguably the most successful monetary policy idea in history: flexible inflation targeting.

This is wrong.  The Bretton Woods system was considerably more successful.  Here’s the flaw in Carney’s reasoning.  He’s thinking in terms of low and stable inflation as being the goal of monetary policy.  But it’s not.  There is no plausible macro model where fluctuations in inflation between -2% and 6% directly produce significant welfare losses.  The argument was always about aggregate demand.  Economists saw inflation instability leading to output instability (the famous expectations-augmented Phillips Curve) and decided stable inflation was the best way to stabilize AD, and hence output.  But by that criterion inflation targeting has been a disaster, as it lead to the greatest collapse in AD since the Great Depression, in both the US and Europe.  Admittedly Carney is a governor of the Bank of Canada, and Canada has done considerably better than the US and Europe during the current crisis.  But Carney’s piece isn’t just about Canada, he’s defending inflation targeting as the standard policy regime for developed economies.

I don’t favor a return to Bretton Woods, as we can do much better than either inflation targeting or fixed exchange rates.  Here’s Samuel Brittan, also in the FT:

At the other end of the spectrum some financial market types have taken fright at the trillions of dollars created by central banks for firewalls and in “quantitative easing”. I would not dismiss these fears out of hand. It is easy to imagine a long period of stagnation or recession followed by a breakout into rapid inflation.

Yet there is a way of sustaining an expansionary policy while minimising this threat. This is not through any financial market gimmick but by a different way of thinking. Long-time readers will not be surprised to learn that I have in mind something usually called a nominal GDP objective. One of the greatest obstacles is that its name is so off-putting. I seem to remember a former chancellor, Nigel Lawson, saying that it lacked sex appeal.

Yet the basic idea could hardly be simpler. The growth figures that dominate the headlines are of “real” gross domestic product, which means they are corrected for inflation. With nominal GDP they are uncorrected. The idea of targeting nominal GDP is to leave room for real growth, but damp any inflationary take-off.

That’s right.  There is an alternative to our current nightmare.

I hope to finish my grading today, and will then address the backlog of comments.

HT:  Bruce Bartlett and Nicolas Goetzmann

This post was triggered by a comment in a recent Tyler Cowen post:

Finally, Rajan is a case for testing Krugman’s oft-stated view that we should listen most seriously to those who have made good predictions in the past.  Rajan was probably the best, more accurate, most serious, most detailed, and most non-Chicken Little predictor of the financial crisis.  You might think that means he gets listened to today, or given the benefit of the doubt on interpretation, but apparently not.

That was a brilliant set of predictions by Rajan, and thus it can’t be compared to the sort of thing Krugman was talking about.  Both market monetarists and Krugmanites have been consistently right about the economy since late 2008.  We’ve pointed out that US interest rates are likely to stay low, despite the huge budget deficits.  We’ve pointed out that inflation is likely to stay low, despite predictions by Austrians and old-style monetarists that all the money printing was an inflationary time bomb.

In my view, these predictions were patently obvious, requiring no special insight.  The bond market told us interest rates would stay low.  The TIPS markets signaled that inflation would remain low.  Even a bright high school student could make these sorts of predictions.

In contrast, Rajan made a brilliant prediction, the sort of prediction that earned John Paulson billions of dollars.  That’s why everyone should take Krugman and we market monetarists seriously, and no one should pay attention the Rajan.

This should be obvious to my regular readers.  But just in case anyone is a bit slow, let me fill in the details:

1.  Brilliant predictions of major crises are just luck, according to the EMH.

2.  Even if they aren’t luck, they have no policy implications.  The government regulators responsible for controlling bubbles won’t have the skill of a Rajan or a Paulson, otherwise they’d be running a hedge fund or teaching at the UC Business School.  (And that’s assuming these guys didn’t just get lucky.  Given the investment record of Paulson, Roubini, et al, since the crisis, I’m inclined to believe the EMH, and attribute their 2008 success to luck.  But again, even if it was skill, it’s an incredibly rare skill with no policy implications.)

3.  In contrast we can and should expect policymakers to pay attention to problems that are patently obvious to the financial markets.  The markets said that the Rajan’s of the world were wrong about monetary policy in 2010.  So were the Austrians and the old-style monetarists.  And so were the Keynesians who believed in liquidity traps, who believed QE2 would not and could not boost asset values.  Who was right?  The market monetarists were the most right, with the Krugmanite Keynesians coming in second.  We saw the need for more monetary stimulus in 2009 and 2010, when others were skeptical.  Our predictions had important policy implications—they told policymakers that NGDP growth was likely to be suboptimal over the next few years.  And we were right.

In fairness to Rajan, I imagine he based his prediction on a sound model of what was wrong with the US financial system.  And he was probably right.  Let’s suppose he argued there was too much risk-taking.  That would be correct—our regulatory system biases banks toward taking excessive risks.  But he wouldn’t have been right because he correctly predicted an opportunity for John Paulson to make billions of dollars, that part was luck.  Rather he was right because sound economic principles point to our financial system being riddled with moral hazard.  He would have been just as right about excessive risk if there’d been no crisis.  In contrast, market monetarists made correct predictions based not on luck, but market forecasts.  This technique won’t always work, but on average we’ll continue to be right far more often than our opponents.

PS.  In 2000 a small increase in interest rates drove Japan right back into deflation.  In 2010 Rajan proposed a 200 basis point increase in the Fed’s target at a time when core inflation had fallen to 0.6%.  If his policy advice had been followed we would now be in Great Depression II.

PPS.  I certainly agree with Tyler that Rajan should be given the benefit of the doubt when being interpreted.  As I explained in my previous post, I have a much more nuanced take on his views than many of his critics.

Because Raghu Rajan’s posts on macroeconomics tend to drive me nuts, let me start off on a positive note, where I partly agree with him:

1.  It’s probably not a good idea to set a 4% inflation target.  (In my view targeting NGDP would be a much better idea.  If we must target prices, let’s level target the CPI on a 2% trend line from July 2008.   We are currently well below that trend line.)

2.  I don’t think Keynesians should be arguing that lower real interest rates are the key to recovery.  A bold and credible monetary stimulus that was expected to produce much faster NGDP growth might well raise long term risk-free interest rates.

3.  At times Keynesians overstate the extent to which all our problems are demand-side, and ignore the structural problems in the economy.

Having said all that, Rajan grossly underestimates the demand-side problem that we still face.  Here’s one example:

Second, household over-indebtedness in the US, as well as the fall in demand, is localized, as my colleague Amir Sufi and his co-author, Atif Mian, have shown.* Hairdressers in Las Vegas lost their jobs because households there have too much debt stemming from the housing boom. Even if we can coerce traditional debt-free savers to spend, it is unlikely that there are enough of them in Las Vegas.

If these debt-free savers are in New York City, which did not experience as much of a boom and a bust, cutting real interest rates will encourage spending on haircuts in New York City, which already has plenty of demand, but not in Las Vegas, which has too little. Put differently, real interest rates are too blunt a stimulus tool, even if they work.

This is the wrong way to think about macro issues.  Start from the fact that the Fed controls aggregate demand, or NGDP, whether they want to or not.  The least bad policy is one that provides macro stability and low inflation (NGDP targeting, in my view.)  When the least bad policy is in effect, policy will necessarily be a bit too expansionary for 50% of cities, and a bit too contractionary for the other half.  There’s no way of avoiding the one-size-fits-all problem in a common currency area.  Right now most cities have way too little demand.

And is it even true that NYC doesn’t face a demand shortfall?  How would Rajan know?  I don’t doubt that most of the people he knows are employed—the same is true for me.  But what does the data show?  It took me 15 seconds to Google this report.   The NYC unemployment rate is currently 9.7%, or 1.5% above the national rate.  Perhaps NYC has a very high natural rate of unemployment, then his argument about “plenty of demand” might be defensible.  But at a minimum Rajan should provide some evidence, as most economists would regard a 9.7% rate as well above the natural rate.

Rajan concludes with this observation:

With a savings rate of barely 4% of GDP, the average US household is unlikely to be over-saving. Sensible policy lies in improving the capabilities of the workforce across the country, so that they can get sustainable jobs with steady incomes. That takes time, but it might be the best option left.

Perhaps a Keynesian can chime in and correct me if I am wrong, but I don’t think the Keynesian argument (which he is attacking) is that the US saving rate is too high.  I had thought that the Keynesians made a distinction between planned saving and actual saving.  Thus when people become pessimistic and try to save more, they don’t actually succeed.  Instead income falls until macro equilibrium is restored.  Indeed the fall in income might well lead to lower investment, and in a closed economy model that means lower realized saving.  Conversely an expansionary policy that made Americans richer might actually lead to an increase in realized saving and investment, even though the initial stages of the expansion might involve an attempt by the public to save less.

My bigger problem with Rajan’s entire approach to macro is that he’s always talking about finance, credit, lending, saving, etc.  The problem is much more basic.  We have far too little NGDP to employ everyone who wants to work at the current salary levels.  We need either much more NGDP or the same NGDP and much lower salaries.  You know which one I favor.   (Hint: it’s the only solution that has a prayer of actually being implemented in the near term.)  If the Fed provides the right amount of NGDP, all those finance issues will take care of themselves.  Real interest rates will find their Wicksellian equilibrium.  Saving, lending, borrowing, etc, will be determined by the public.

The Fed shouldn’t be trying to encourage either consumption or saving.  They should encourage stable growth in NGDP, and let the market allocate that spending according to the preferences of the public.  Since mid-2008 NGDP has grown at the slowest rate since Herbert Hoover was President.  Rajan’s had all sorts of interesting things to say about all sorts of issues, but he doesn’t see the elephant in the room.  Not enough nominal spending for anything close to full employment.

HT:  Oli

I seem to recall Paul Krugman once arguing that when the central bank raises and lowers interest rates to keep inflation stable, then it controls aggregate demand.  If rates are stuck at zero then fiscal policy becomes important.  The ECB has recently been raising and lowering interest rates to keep inflation at 2%.  That means Europe has a growth policy, if by “growth policy” you mean aggregate demand policy.   The only fiscal stimulus that works under that sort of regime is supply-side initiatives.

The French just elected Leon Blum Francois Hollande, who is committed to fiscal policies aimed at boosting AD and reducing AS.  Good luck with that.

PS.  I have lots of grading this week, which is slowing down blogging.  I will eventually address the Hamilton and DeLong posts that people have asked me about.

Here’s the latest outrage from “The World’s Greatest Deliberative Body”:

Republican Senator David Vitter has demanded that the Senate hold a debate before any vote on the nominees, which would require Democratic leaders to muster a super majority to move forward – a hurdle that may be too high to clear.

As a result, the Senate may end up abandoning the nominees, Harvard economist Jeremy Stein and investment banker Jerome Powell, and leave a decision on filling out the normally seven-member Fed board until after this year’s presidential election.

“I refuse to provide Chairman Bernanke with two more rubber stamps who approve of the Fed’s activist policies,” Vitter said when asked if he planned to lift his hold on the nominations.

.   .   .

Democrats control 53 votes in the 100-member chamber, but under Senate rules, they would need to muster 60 votes just to bring the nominees up for a vote, given Vitter’s opposition.

The various votes and debate could take as long as two weeks. But with highway funding, government spending and cyber security legislation looming, Senate Democratic leaders are not likely to make the Fed nominees a priority.

In addition, Democrats would be loath to spend precious political capital defending an unpopular central bank in an election year. Senate Majority Leader Harry Reid will be thinking long and hard before calling on any Democrat in a tight race to support a controversial cause.

“We are still trying to find a way to get Senator Vitter to drop his obstruction,” said Reid spokesman Adam Jentleson.

Matt O’Brien points out what President Obama should do (and what President Roosevelt would have done.):

I’ve left out a fairly important detail. There are two unfilled seats on the FOMC. President Obama’s picks for those positions have been among the victims of the endless Republican obstruction in the world’s greatest deliberative body. There’s a simple solution. Obama could just bypass the Senate with recess appointments. That’s what he did for the Consumer Financial Protection Bureau (CFPB) and National Labor Relations Board (NLRB). Why not do the same for the Federal Reserve (or the Federal Housing Finance Agency)?

There’s no good reason not to. The administration’s rationale is that Republican obstruction over the CFPB and NLRB was particularly pernicious — that it amounted to de facto nullification. Hence, the extraordinary recess appointments for just those vacancies. But even if that’s true, who cares? It’s hard to run the government if it’s not staffed. So staff it! More importantly, there’s little Obama can do that might help the economy more than sending Bernanke a few more friendly faces on the FOMC.

Regrettably, the Obama administration has consistently underestimated the importance of the Fed. That there are still two empty FOMC seats proves as much. So do the administration’s (blocked) nominees. Consider Peter Diamond. He’s a phenomenal economist — a Nobel-prize winner — who’s clearly qualified to serve on the FOMC. But he’s said that he doesn’t think there’s much more the Fed can do now. Even if he’s right — and I clearly don’t think he is — wouldn’t you rather appoint someone who thinks otherwise and find out if the Fed really is powerless? Someone like … former Council of Economic Advisers Chair Christina Romer.

Let’s try pushing some more before we declare that we’re pushing on a string.

Isn’t it ironic that Vitter is a product of America’s most corrupt state?  Imagine if Greece had a veto over everything the EU wanted to do.  That’s the US Senate circa 2012.