Bernanke, Not Borg

Krugman has a good NYT Magazine article on Bernanke. They have an interesting personal history -- as Chair of the Econ department at Princeton, Bernanke hired Krugman (over some opposition I believe) -- and also an interesting intellectual history -- they were both working on the Japan deflation in the late-1990s, with Krugman concluding that Old Keynesianism was still relevant because of its emphasis on the liquidity trap, while Bernanke concluded that the Bank of Japan was merely timid, not impotent.

In the article Krugman argues that Chairman Bernanke has not followed the advice of Professor Bernanke. He offers three possible explanations for this.

The Bernanke Conundrum — the divergence between what Professor Bernanke advocated and what Chairman Bernanke has actually done — can be reconciled in a few possible ways. Maybe Professor Bernanke was wrong, and there’s nothing more a policy maker in this situation can do. Maybe politics are the impediment, and Chairman Bernanke has been forced to hide his inner professor. Or maybe the onetime academic has been assimilated by the Fed Borg and turned into a conventional central banker.

The Ludlum-esque title is unnecessary, as the addition to the pile of "Krugman's Mystical Creatures" (confidence fairy, bond market vigilantes, etc.), but I believe Krugman's framing is correct and I think the second explanation makes the most sense: Bernanke is politically constrained (see here). So naturally Krugman concludes that Bernanke's been assimilated into the Borg, thus continuing our long-running streak of disagreeing on almost everything.

Today Krugman finds support for the Borg view in these words from Bernanke:

We have, uh, we, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable, in that we’ve been able to take strong accommodative actions in the last four or five years to support the economy without leading to a, [indiscernible] expectations or destabilization of inflation. To risk that asset, for, what I think would be quite tentative and, uh, perhaps doubtful gains, on the real side would be an unwise thing to do.

In some ways Krugman's selection of Bernanke's comments are a bit disingenuous -- Bernanke starts by pointing out that the U.S. in 2010-12 is very different from Japan in the late-1990s, particularly since one was suffering from deflation and a recession while the other just has unemployment a few percentage points higher than it would like -- but more problematic is his interpretation of them. When Bernanke starts talking about the "credibility" of the Fed there is no a priori reason to think that he's only talking about credibility with markets. He's also talking about credibility with Congress, and in particular a Congress that is incredibly hawkish on inflation lately* and routinely threatens Bernanke in a number of ways.

The Fed likes its authority. It wants to keep it. It likes it's "independence". Ironically, it will only keep it if it does what Congress wants it to do (i.e. "There is no technocracy" + "There is no central bank independence"... common themes around here). That means not throwing away its credibility for inflation-control in pursuit of dropping the unemployment rate by a point or two. Note that this is also why Bernanke would like to see more fiscal stimulus: that would effectively prevent Bernanke from having to make a difficult choice. But if he's forced to make that choice, he'll the choose the path that doesn't jeopardize his authority.

Note: after I wrote the above, but before publishing it, I came across this excellent post by Greg Ip. Highlights:

This means, judging from the projections, that 13 of the FOMC’s 17 members want to tighten sooner than he does, and none want to tighten later. ...

The second problem is that even if Mr Bernanke’s views prevail while he remains chairman, the odds are that he no longer will be after January, 2014. He is unlikely to be reappointed even if Barack Obama is re-elected (even if wanted the job, a big if, he probably couldn’t be confirmed), and certain not to be if Mitt Romney wins.

But all that's irrelevant. Instead, Bernanke's been captured by the Borg.

*Some of the reasons for that may be found in this excellent post by Steve Randy Waldman. I hope to have more to say about it soon, but for now it's worth reading that one in its entirety. The takeaway is that the coalition of political interests that would be harmed by higher inflation is much larger (and much more politically active) than the coalition that would benefit from it.

Financialization and Inflation Rates

While looking for something else I came across this paper by Gerald Epstein from 2002. Here's the abstract:

"Financialization" refers to the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operations of the economy and its governing institutions, both at the national and international levels. This paper considers one aspect of financialization: the increased use by central banks of "inflation targeting". An extensive review of the literature shows that there is little evidence that inflation targeting reduces the costs of fighting inflation. Moreover, I present new evidence that, with respect to moderate rates of inflation – under 20% -- there are few macroeconomic costs of inflation. Hence, central banks' focus on inflation targeting cannot be explained by a "rational" social cost/benefit calculation and therefore, political economy analysis must be employed to explain its widespread use. The paper explores a "contested terrain" approach to understanding central banks' preoccupation with inflation fighting, an approach which concentrates on the relative interests of finance, industry and labor with respect to macroeconomic policy. I suggest that, in the case of the United States, financialization during the 1990's led to a closer alignment of large industrial and financial firms in the U.S., leading to a greater emphasis by Alan Greenspan and the U.S. Federal Reserve on financial asset appreciation as a goal of monetary policy. In the conclusion, I explore the contradictions and limits of this as a basis for sustained, expansionary monetary policy for the U.S.

We've discussed this sort of thing regularly on this blog, so some readers may find it of interest.

Fighting Grade Inflation at UNC

UNC will institute a new policy to combat grade inflation, beginning in 2012. The plan hinges on qualifying grades based on contextual factors, so transcripts will now contain summary course statistics alongside grades, and a "scheduled point average" will replace the traditional GPA. In other words, an 'A' in a class where 50% of students receive 'A's will now be worth less than an 'A' in a class where 15% of students receive 'A's.

This plan has been in discussion for quite some time. See, for example, this December NY Times article about a UNC sociology professor Andrew Perrin's push for such a system. And Michael Bérubé wrote an op-ed back in 2004 proposing something similar. I am in full support of this plan, and I hope more colleges and universities adopt a comparable scheme.

But there is one thing that I disagree with. Perrin says:

“I don’t think it’s fair to say it punishes or undermines students,” he said.

“For every student that it seems to harm because it shows their high GPA was earned in relatively easy classes, it helps another student whose low GPA was earned in relatively difficult classes.”

This isn't really true. Some students will benefit from this, yes, but if the problem is grade inflation rather than grade inconsistency, more students will suffer than will benefit. That's because the new "contextual" grades will send a clearer signal of a student's ability (or, at least, her performance in classes). This will help strong students, but it is unlikely that they needed the help: they likely had high GPAs under the traditional grade-inflated system. It will hurt mediocre students, who previously benefitted from the extra noise. A clear signal reveals their mediocrity, where the previous noisy signal masked it. A low GPA in difficult classes will become a mediocre GPA, but will still sort those students into a lower tier than the strongest students.

As I understand it, that's the whole point: rewarding good students for their good work. Like Perrin, I don't think of this as "punishing" mediocre students, but as removing rents. In other words, if the system works the way it's intended, it should hurt some students on the job market*. Which means parents are going to complain. Which means the system might not stay intact for very long. Of course, if this sort of practice becomes widely-adopted, then that pressure will go away. So I hope that's what happens. But there are reasons for schools to not participate: a noisy signal is better for the majority of their students than a clear signal would be.

*Unless it raises the status of a UNC degree at any GPA sufficiently high that a "contextual B" at UNC is equivalent to a "likely-inflated A" at UVA, or wherever. But because the 'A' is a noisy signal while the 'B' is a clear signal, I doubt that will happen.

UPDATE: See Phil's thoughts on how he, as a professor at a different university, would respond to this type of system. He likes it, and would change teaching strategies, but the students are likely to be angry.

Politics Everywhere or Markets in Everything? Fake Brazilian Currency Edition

An interesting Planet Money podcast on Brazil's economic turnaround. How did they reverse decades of economic stagnation, excessive inflation, and severely-underdeveloped markets? Four grad school drinking buddies invented a fake currency. The summary:

For a while, inflation was so high that grocery stores were raising their prices every day. Shoppers would run ahead of the guy changing the price tags, so they could pay the previous day's price.

A series of leaders tried and failed to stop inflation. One guy instituted a price freeze. Another froze peoples' bank accounts. None of it worked.

Then, the government brought in in four economists who had been talking to each other for years about how to fix Brazil's inflation problem. Their solution: Create a currency that doesn't exist. No coins, no bills.

Brazil is now the Western hemisphere's second largest economy (take that, Canada), the world's 8th largest, and is growing at 7% a year.

ht: Modeled Behavior's Twitter.

The IMF Doesn't Like Inflation Any More than the Finance Ministers Who Run It

Some IPE bloggers seem to be reading a lot into a recently-released IMF Staff Position Note. In this note, IMF chief economist Oliver Blanchard and his co-authors consider the lessons we might draw from the recent crisis about the pre-crisis consensus on macroeconomic policy. One lesson he suggests is that a slightly higher inflation target (4 rather than 2 percent) might make it easier to cut rates in the face of large negative shocks. Let me quote the relevant section at length:

The crisis has shown that large adverse shocks can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future—the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center. Should policymakers therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?

Achieving low inflation through central bank independence has been a historic accomplishment, especially in several emerging markets. Thus, answering this question implies carefully revisiting the list of benefits and costs of inflation (page 11).

Maybe I am missing subtlety (subtlety has never been my strong suit), but I don't see how one gets from these paragraphs to Erik Voeten's assertion that the IMF's "Chief Economist calls for countries to raise their inflation target to 4 percent."

Nor do I see how James Vreeland (welcome to the blogosphere, James) can assert that Blanchard has called for monetary authorities to raise their inflation target and cite (I can only infer approvingly) the Financial Times' claim that this "represents a dramatic shift away from the standard policy advice of the IMF." (Though I highly recommend the rest of Vreeland's post on the evolution of IMF conditionality).

Nor, even if this interpretation is correct, do I see why this is hypocritical. What I see is exactly what one hopes to see. Reflective people drawing lessons from major historical events. Lord Keynes' ideas for the IMF emerged from his reflections on the lessons of the Great Depression. In that context, it made sense to prioritize the fight against deflation. Central bankers embraced a two-percent inflation target based on lessons of the Great Inflation. In this context, it made sense to prioritize the fight against inflation. The world throws new challenges at us, and we reflect and adapt. And then the world throws new challenges at us. Shouldn't we welcome indications that policymakers are reflecting and possibly adapting?

Why We Shouldn't Be Worried About Inflation... Yet

Munger disagrees with my optimistic take on the Fed's profit:

Here's the thing: if inflation cranks up, the Fed is going to have to unload a buttload of debt, really fast. The only way to sell that much debt, and take excess cash out of the economy, is to sell at fire sale prices.

So, if there is inflation, the Fed is going to take truly ginormous capital losses on the debt it will have to sell. But this is exactly Bernanke's plan, the one he is so sure will work to prevent inflation. Big Ben's talk at the AEA meetings made much of this policy. But who in the world is going to buy CDOs in this market?

The lagniappe: Lots of the CDOs are based on fixed interest rate mortgages. If there is inflation, the capital value of those gets hammered. All the rest are based on ARMs of some kind. And for those the PAYMENTS skyrocket with nominal interest rates, and defaults go up, and AGAIN the CDOs' capital value takes it right up the ol' gazoch, with a red hot poker.

This is not really a good policy.

All of this is true... if inflation cranks up in the short-run. What do the markets think about inflation? Here is the most recent TIPS spread (the difference between nominal T-bills and inflation-protected T-bills, which represents the market's expectations about inflation):



This indicates that the market does not anticipate inflation to "crank up" any time soon. In fact, it means that we are at a much greater risk of deflation than inflation. Which means that the Fed policy is actually a very good policy, given the circumstances.

Of course, Munger is free to disagree with the markets if he pleases, but a libertarian should do so at his own risk.

As Krugman says, the danger that we'll end up in a Japan-style situation is much greater than the danger that we have rampant inflation in the short-run. In the medium-run, sure. But by then the Fed will have had plenty of time to off-load its risky assets at acceptable prices.

China's Choice: How to Adjust

The United States wants China to allow the value of its currency to appreciate. This would make Chinese exports to the United States relatively more expensive, which would reduce the quantity demanded. It would also make U.S. exports to China less expensive, which should increase the quantity demanded and thus create more jobs in exporting sectors. If the reduction in the quantity demanded of Chinese exports and in the increase in the quantity demanded of U.S. exports is large enough, the current account deficit in the U.S. will narrow, the capital outflows from China will shrink, the global economy will be brought into greater balance, and the risk of a future financial crisis caused by the inflation of asset bubbles by the influx of foreign capital will be lessened.

China does not want this. China wants to keep its currency weak in order to keep the quantity of its exports demanded very high. This, in turn, boosts domestic employment in the exporting sectors. Given the still-very-large numbers of unemployed or underemployed Chinese with very poor standards of living, this is an understandable goal.

But one by-product of keeping the exchange rate low in the face of a trade imbalance is that it puts upward-pressure on domestic prices. Krugman explains:

Consider the real exchange rate, defined as RX = EP*/P, where E is the exchange rate measured as the domestic currency price of foreign currency (so an appreciation of the renminbi is a fall in E), P* is the foreign price level, and P the domestic price level. Basic international macro says that there is a “natural” level of the real exchange rate, determined by trade competitiveness and international capital flows. And the economy “wants” to get to that real exchange rate.

If you have a floating exchange rate, you get there via a rise or fall in E. But if you have a pegged rate, there’s pressure on prices instead. By deliberately keeping E higher than it would be under floating, China is creating pressures for P to rise; the inflationary pressures are directly related to the exchange rate policy.

This is exactly right. Now that inflation in China may be well over 10%, Chinese officials are growing concerned. The savings rate in China is very high -- around 40% -- and many Chinese investors are hedging against inflation by buying tangible assets like housing. This may be leading to a property bubble in China. Moreover, high inflation hurts poorer Chinese (i.e. those who consume most of their income) by reducing their standard of living. Add to that the fact that China's currency is pegged to the dollar, so it has actually depreciated with the dollar relative to the yen and euro in the past year, and pressure is mounting for the Chinese leadership to adjust upwards the RMB's peg to the dollar.

What would be the effect of this? So long as China doesn't couple a currency appreciation with trade protection, it would increase the purchasing power of Chinese consumers and improve standards of living. Some employment in exporting sectors might be lost, but gains in employment in importing and nontraded sectors would offset some or all of that effect. Also, a stronger currency would likely attract more foreign direct investment, which could lead to domestic employment. If China also took steps to strengthen the social safety net it could reduce national savings rates, which would lead to more domestic consumption and thus more domestic employment. Moving towards currency convertibility could give China more influence in international financial markets, especially regionally.

This is the path that China will have to take eventually. The tradeoff between growing inflation + asset bubbles on the one hand and competitiveness in traded goods will only be resolved by either moving away from an open trading system or from an undervalued currency. China has been able to have it both ways for more than a decade now, but all good things (from their perspective) must come to an end.

The OECD in Nominal Spending Perspective

The above picture, from David Beckworth, is shocking. It shows that nominal spending (total demand in an economy) among OECD countries had a jarring drop last year, and that this is the proximate cause of the economic slowdown. (For a short post on why nominal spending matters, see this post). Beckworth is arguing that the Fed screwed up majorly by targeting inflation rather than spending, and is still making the same mistake.

Krugman hates this, although he admits it' power with this parenthetical: "monetary policy doesn’t matter (unless it can affect expected future inflation, but that’s another story)". BUT THAT IS THE STORY! As Beckworth writes:

If an economy is running at full employment, then any sudden increase or decrease in nominal spending will give rise to changes in real economic activity that are not sustainable. This is because there are numerous rigidities that prevent prices from adjusting instantly. There is simply no way to suddenly jar nominal spending (i.e. create a nominal spending shock) and not have real economic activity move as well.

Note that the key here is not to aim for inflation stability, but to aim for nominal spending stability. This is because inflation is merely a symptom of nominal spending shocks.

Krugman tries to trump this as he always does, by saying that in a liquidity trap monetary policy cannot get any traction. But it can if it commits to a certain nominal target over time. This is what Scott Sumner has been saying since his first post (and he does not disappoint in his response to Krugman). And as the Free Exchange blog argues, Krugman cannot possibly prove that the central bank is powerless when they haven't even tried to affect inflation expectations. Instead, the Fed has repeatedly sounded hawkish when it comes to inflation. If Bernanke came out tomorrow and said "inflation is soon going to spiral upwards, and there's nothing we can do about it" then present spending would almost certainly jump. Instead, the Fed is committing to holding inflation down when if anything it should be committing to holding it up. Given the Fed's anti-inflationary history, this commitment is viewed as credible. Faced with that reality, spenders are quite rationally holding on to cash, and this has depressed the economy.

In other words, Krugman is arguing that something that hasn't been tried cannot succeed. But there are very good reasons for thinking it can: if the Fed were to make a commitment to future nominal spending (or even explicit inflation targets), it would move money in the present. If money moves in the present, then nominal GDP goes up. If nominal GDP goes up, then the economy grows back into full employment.

Hawks vs. Doves in the Fed

Remember last month when Ryan Grim wrote a terrible article arguing that the Fed had taken over the entire economics profession and didn't allow dissent? I went ballistic on him at the time, but it now appears that his timing couldn't've been worse. First was the "saltwater" vs. "freshwater" argument started by Krugman that showed that economic theory is not as unified as Grim makes out. But now we see deep divisions within the Fed, even at the top levels:

Fissures are developing among policy makers at the Federal Reserve as they debate how and when to start raising the benchmark interest rate from its current level just above zero. ...

But Fed officials have hinted at new disagreement in recent weeks. The arguments go beyond the traditional split between hawks, who worry that easy money will stoke inflation, and doves, who contend that unemployment is the top problem.

Indeed, the Board of Governors looks to be very divided and it is unclear where Bernanke stands. Then again, maybe they're just being cagey:

RBS Securities (the firm formerly known as Greenwich Capital) mentioned an interesting article by well respected research firm Wrightson in which Wrightson posits that some of the recent hawkish comments by Federal Reserve officials are a shot across the bow of leveraged speculators. Wrightson makes the salient point that if the trajectory of rates is unclear then leveraged positions are not such safe bets.

Perhaps. But I don't believe it. Fed officials are very aware that it takes a very long time for Fed actions to trickle through the system: one quarter to two years for output, and one to three years (or more) for inflation. So they are shooting at a moving target that is in the future. There is plenty of uncertainty, and thus plenty of room for debate. The Fed doesn't want to stifle employment in the short- to medium-run, but they also don't want to spike inflation and re-inflate another bubble. It's a tightrope act, made difficult by the Fed's dual mandate.

This is a historical division: the hawks are concerned about inflation and the doves are concerned about unemployment. FWIW, in this case I'm with the doves. I think the medium-run unemployment worries are much more concerning than the possibility that inflation goes up to 4 or 5% for a year or so.

Why We Shouldn't Try to Inflate Our Way out of Debt

Chris Hayes has a policy paper out advocating moderately high inflation over the next few years to reduce the debt burden. Yglesias loves it:

The idea is basically that if we could sustain a five or six percent inflation rate for a period of years, that would make it much easier to work off the debt overhangs—both in the public and private sectors—that otherwise threaten to hobble the economy for years. You would need, of course, to try to be sure that this doesn’t spiral into accelerating inflation. But the point is to move beyond the kind of anti-inflation hyper-vigilance that came into vogue after the Great Inflation of the 1970s. That mentality was an understandable reaction to what had happened, but the fact that an out-of-control wage-price cycle is a bad thing doesn’t mean that inflation should always be kept as low as possible. A moderate amount of inflation could do a great deal to help us.

There's only one problem: you can't inflate your way out of debt:

The bad news for central bankers is that creating currency isn't like, say, diluting shareholders in a company. You're always rolling your debt, and the market's response to an inflationary strategy is (not surprisingly) higher interest rates. It's a treadmill, and it's extremely hard to get ahead.

So why do we have this mythology, as Donovan calls it, of inflating our way out of debt? It's probably because on the surface there's some simple logic to it, though more importantly it's a myth borne out of necessity. The opposite idea, that we'd actually have to cut spending and raise taxes (which is to say, actually pay off our debts) is just too painful to contemplate.

Even worse, if a country tries to sneak out of debt by inflating it away not only will investors demand higher interest rates, investors may demand a risk premium on top of higher interest rates, or even refuse to lend at all. Even if that doesn't happen it's nearly impossible to stay ahead of lenders when you have to roll over the debt.

And of course, inflation also carries many significant downsides. In short, trying to inflate the debt away is a very bad idea.