Monday, February 1, 2010

Central bank incentives and deflation

To paraphrase Keynes: 
A sound central banker is not one who foresees danger and avoids it, but one who, when he fails to meet his stated goals, does so in a conventional way along with his fellows, so that no one can really blame him.

Central banks are strange creatures, and independent central banks are stranger still.  Central bank independence is intended to reflect the fact that elected governments will always choose growth over recession. If governments could control the central banks in fiat money countries, they will inevitably cause inflation. Central bankers are like trustees whose job it is to prevent a minor from spending his inheritance. 

But even though most central banks do not have growth or full employment mandates, clearly they owe a duty to their nations to prevent unnecessary recessions and deflation. And yet, if you look at the recent performance of the major cenbanks, they have all done a very poor job. The BoJ is a special case of incompetence and nonfeasance, which I have discussed previously. 

But looking at the Fed, the BofE and the ECB, they were all very late in recognizing that the financial system was having a coronary in the fall of 2007, and have consistently been behind the curve in responding in an adequate manner (i.e., with overwhelming force). Credit is still contracting after two years of monetary stimulus, unemployment is stuck at very high levels, and overall economic performance has been the worst since the Depression. 

The regional fed hawks on the FOMC (currently St. Louis, and Kansas City) are already worrying about inflation--remember 1937 and the second Depression? And in Europe, King & Trichet are ready to pounce at the first hint of recovery.

Why is it that central bankers will happily err on the side of deflation and recession? I think the answer is provided by Keynes above. Central bankers want to stay in the "center". They want the respect of their peers and of conventional economists and pundits. 

If you read Friedman, Eichengreen and Bernanke (and Krugman too), there is compelling evidence that if central banks are willing to engage in massive monetary stimulus, they can prevent deflation and can produce an increase in nominal GDP. Deflation is always and everywhere a monetary phenomenon, which is why it is infuriating to read the BoJ forecasting deflation for the next two years, as if deflation were an exogenous variable. 

As I have said before, Bernanke understands this better than anyone else. He has spent a considerable part of his career in advancing the view that monetary policy is capable of maintaining aggregate nominal demand, and that a decline in nominal GDP is prima facie evidence of a policy failure. 

This is Ben in 2002:
Under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero...

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

And here is Helicopter Ben in Japan in 2003:
I have advocated explicit inflation targets, or at least a quantitative definition of price stability, for other leading central banks, including the Federal Reserve. [But, in the case of Japan, I recommend that] the Bank of Japan announce a quantitative objective for prices. Rather than proposing the more familiar inflation target, I suggest that the BOJ consider adopting a price-level target, which would imply a period of reflation to offset the effects on prices of the recent period of deflation.

So if Ben totally gets it that central banks are on the hook for aggregate demand growth, why has he been so cautious about generating aggregate demand and inflation? The answer is that the FOMC is a committee that includes a number of hawks, and Bernanke does not want to run the money supply on a split FOMC vote. I think he should, but his incentive structure discourages such action.

No comments: