The definition of insanity is . . .

In a recent post I offered a half dozen arguments against Bernanke’s recent defense of Fed policy.  But I missed the most important one.  Here is Bill Woolsey commenting on Bernanke’s reply to DeLong:

For more than twenty years, making vague statements about high employment and price stability, while making monthly adjustments in short term interest rates with the apparent goal of having the CPI rise at a 2 percent rate from where ever it happens to be, appeared consistent with better macroeconomic performance than in the past. Unfortunately, this approach was not robust in the face of financial problems for a handful of large Wall Street investment banks.

Bernanke is just too focused on putting humpty dumpty back together. All during the crisis last fall, the focus was on jump starting securitization markets. Now, Bernanke appears willing to accept low production and high unemployment for years, because otherwise, they won’t be able to return to their traditional approach to monetary policy. And then there is this fantasy that they are going to get the regulations right this time so that there won’t be the sorts of financial disruptions that made their traditional approach to policy ineffective!

We’ve known for a long time that a low inflation target might be ineffective during a liquidity trap.  Woodford has argued that level targeting would be superior when rates fall to zero.  Now Bernanke has shown that those fears were well-founded.  And yet he wants to return to the failed policies that not only were unable to prevent this crisis, but were also the cause of NGDP falling 8% below trend in the 12 months after July 2008.

There are three approaches that would have helped us avoid this crisis:

1.  A higher inflation target.  Neither Bill nor I think this is necessary, but if given the choice between a 3% rate of inflation and a massive recession every few decades that caused the size of the government sector to balloon, I’d pick 3% percent inflation.

2.  Price level targeting.  This is Woodford’s solution, and it was Bernanke’s solution before he became captured by the institutional inertia of the Fed.  Under this plan we’d need slightly faster inflation until we caught up to the old trend line, and then we’d follow a plus 2% price level trajectory.

3.  NGDP (or final sales) targeting, level targeting.  This is the approach both Bill and I favor. BTW, I believe the 3% figure Bill mentions doesn’t necessarily mean we should shoot for 3% NGDP growth next year.  In past posts he has estimated a 1994-2008 trend-line and shown that right now we need to grow faster to catch up to a 3% line extended from mid-2008.  Obviously as time goes by it becomes a judgment call as to where to start the trend line.

PS.  For those who haven’t seen the famous Ben Franklin quotation in the post title, the ending is:

.  .  . doing the same thing over and over again and expecting different results.

Update: Recently there is so much good stuff on the internet that I can’t keep up.  Here is an very perceptive comment from Matt Yglesias:

Less vividly, you’ve no doubt heard a lot of talk about the importance of central bank independence. Ben Bernanke talks about the importance of central bank independence. Barack Obama and Larry Summers and Tim Geithner seem to believe in central bank independence so strongly that they won’t comment on this whole issue. Economists overwhelmingly believe in central bank independence. So do elite journalists. And the whole reason for central bank independence is supposed to be to provide a credible solution to this Pringle problem. Bernanke has a lot of power and a lot of independence and now is the time to put them to use.

When you have bloggers on both the left and the right making the same criticism, maybe it’s time for the elite mainstream media to take notice.  How about it WaPo?

Update 12/21/09:  Michael Belongia pointed out that my statement about inflation targeting being ineffective at zero interest rates wasn’t accurate.  The central bank can still use various techniques such as monetary targeting, exchange rates or targeting inflation forecasts.  I was thinking of a different issue.  Under a price level target it is much more likely that traditional monetary tools (ie. the fed funds target) will still be effective during a period of deflation.  This is because under a price level target deflation tends to raise inflation expectations.  In contrast, under an inflation target deflation does not tend to raise inflation expectations.



6 Responses to “The definition of insanity is . . .”

  1. Gravatar of pushmedia1 pushmedia1
    20. December 2009 at 10:05

    Professor, thanks for the post replying to my craziness. BTW, I agree with everything in this post. I just think NOW is a bad time to introduce a new policy. Switching to level targeting right now, which would look like an increase in the inflation target, would look an awful lot like discretionary policy just meant to kowtow to politicians. Bernanke could give a speech explaining what he’s doing, but I don’t think he would be credible.

  2. Gravatar of marcus nunes marcus nunes
    20. December 2009 at 12:08

    Bernanke´s credibility is already lost! If you read his 2003 speech in Japan addressed to japanese policymakers about what they should do and contrast that with what he is doing there is only one concluson: As an adviser or academic you can “speek your mind” (say what you really believe in) while as a policymaker you have to “bla bla bla” in order to keep people “happy”.

  3. Gravatar of marcus nunes marcus nunes
    20. December 2009 at 12:24

    This link to Bernanke et al, written almost exactly 10 years ago, long before he became Fed governor is testimony to a great “about face”!:

  4. Gravatar of ssumner ssumner
    20. December 2009 at 13:59

    Those are both good points, but I tend to side with marcus. If we have been targeting inflation all along, then a catch up period is appropriate. The key is to the do the right thing, and try to justify it by pointing out that you have been saying all along that in a liquidity trap it was important to do level targeting. There is no gain to doing the wrong thing for consistency reasons, their credibility is already shot. People assumed they would let NGDP fall at the fastest pace since 1938, and they did.

  5. Gravatar of Greg Ransom Greg Ransom
    21. December 2009 at 12:57

    35,000 construction jobs have been lost in Orange County, CA in 3 years. 15,000 Real Estate and finance jobs have been lost in 1 year.

    Spain had a housing bubble / housing finance fiasco on an Orange County scale.

    Watching “macroeconomists” work is like watching a Platonist trying to explain
    the origin of species — everything at the level of causation is assumed not to exist by conceptual fiat. “Species” and adaptations for the Platonist are natural kinds, and they can’t evolve — just like for you Macro guys “capital” is a natural kind and “labor” is a natural kind and “aggregate demand” is an undifferentiated natural kind interacting with other fixed and homogenous “enties”.

    It’s a bogus Platonic relm completely inconnected with the causal processes of the real word — but it’s your world and you are stikomg to it and barring entry to anyone who sees the world for the actual causal system it is.

  6. Gravatar of ssumner ssumner
    22. December 2009 at 17:32

    Greg, You said;

    “35,000 construction jobs have been lost in Orange County, CA in 3 years. 15,000 Real Estate and finance jobs have been lost in 1 year.”

    The art of macro is the art of learning what numbers matter. The US economy gains and loses over 30,000,000 million jobs a year. The numbers you cite have no cyclical impact. Real estate was in free fall for two years from mid-2006 to mid 2008. Plus we were being hammered by a massive oil shock. And despite all that the unemployment rate only rose by about 1% point. That’s small potatoes.

    BTW, I suppose the insanity line could also refer to making the same comment twice and expecting a different answer. 🙂

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