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.

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