Core Inflation and Inflation Targeting

As I mentioned recently, inflation doesn't look nearly as scary if one focuses - as the Fed does - on "core" inflation, which excludes food and energy prices. Some Fed critics - e.g., Willem Buiter - seem to see core inflation as an excuse for going soft. Here is a counter-argument from NYU's Mark Gertler - a co-author of Bernanke's back in his academic days - defending the Fed's focus on "core" inflation in the FT:

Why care about headline inflation versus core inflation? Simply put, a sustained move of headline inflation to the levels of the 1970s is unlikely without an accompanying increase in the core component. The reason is simple: although they can be highly persistent, rapid increases in the relative prices of energy and food cannot go on indefinitely. Once this process dies down, as long as core inflation remains anchored, headline inflation must converge to it.

One criticism of using a core measure is that higher overall (or "headline") inflation feeds into inflationary expectations, which, in turn, influence wage and price setting behavior. Gertler addressed this issue:

Could it be that high headline inflation is unmooring inflation expectations, leading us back to the 1970s through this painful route? Some measures of inflation expectations are edging upwards. This needs to be taken seriously. However, where we should expect the impact of increasing expectations to show up is exactly in the behaviour of core prices and wages.

So far this is not happening. Not only has core inflation remained stable but the growth in nominal unit labour costs, on which most pricing of core items is based, also remains benign. It may very well be that the Fed’s reputation for keeping core inflation stable has kept the expectations relevant for price- and wage-setting in line. Also relevant is that, at least to date, wage- setters appear to understand that, however unfortunate, the relative increase in energy and food prices is something beyond the central bank’s control that they must live with.

Fed governor Frederic Mishkin (also a Bernanke co-author), who is leaving for Columbia University, seems a little more concerned about the expectations issue. In his last speech as a Fed official, Mishkin argued that explicit inflation targets - such as that of the European Central Bank - help stabilize, or "anchor" expectations:

[T]here is substantially greater disagreement in long-run inflation forecasts for the United States than for the euro area. As shown in figure 2, the standard deviation of U.S. inflation forecasts at each survey date is higher than the standard deviation of corresponding euro area inflation forecasts. Moreover, the degree of dispersion in the views of individual forecasters has gradually declined towards negligible levels for the euro area but not for the United States. One obvious interpretation of these patterns is that professional forecasters in the United States are less certain about the Federal Reserve's longer-term inflation goal.

That uncertainty may also explain differences in the behavior of inflation compensation as implied by the gap between nominal and real yields on long-term bonds. Figure 3 depicts far-forward inflation compensation (that is, the one-year-forward rate nine years ahead) for the United States and the euro area. Inflation compensation, sometimes referred to as "breakeven inflation," reflects not only inflation expectations but also a premium that compensates for uncertainty about inflation outcomes at the specified horizon. Evidently, far-forward inflation compensation for the euro area displays much smaller fluctuations than for the United States, consistent with greater stability of inflation expectations and a lower degree of uncertainty about longer-run inflation outcomes. Moreover, regression analysis confirms that U.S. far-ahead forward inflation compensation exhibits statistically significant responses to surprises in macroeconomic data releases--consistent with the view that market participants are continuously revising their views about the longer-run outlook for U.S. inflation. In contrast, euro-area inflation compensation does not respond significantly to economic news.

Mishkin goes on to suggest that inflation targeting does not result in worse performance in terms of stabilizing output:

One concern might be that these benefits in anchoring inflation expectations could come at the expense of the performance of output growth. However, the empirical evidence suggests that central banks with explicit inflation goals do not have worse output performances than central banks, such as the Federal Reserve, that have not specified an explicit numerical goal for inflation.

So far, this is true, but inflation targeting is relatively new, so I think it is too soon to tell (perhaps a good research topic a few years from now...).

Mishkin did not address the issue of which inflation measure to use, though all of the current inflation targeters use headline inflation. His strategy for implementation is for the Fed to incorporate a target into its long-run forecast:

In light of these considerations, I would like to suggest several specific modifications to the Federal Reserve's current communication strategy.

• First, the horizon for the projections on output growth, unemployment, and inflation should be lengthened. This change might involve simply an announcement of FOMC participants' assessment of where inflation, output growth, and unemployment would converge under appropriate monetary policy in the long run. Alternatively, the horizon for the projections could be extended out further, say to five or more years.
• Second, FOMC participants should work toward reaching a consensus on the specific numerical value of the mandate-consistent inflation rate, and this consensus value should be reflected in their longer-run projections for inflation.
• Third, the FOMC should emphasize its intention that this consensus value of the mandate-consistent inflation rate would only be modified for sound economic reasons, such as substantial improvements in the measurement of inflation or marked changes in the structure of the economy.

If the deviations between core and non-core inflation induced by oil price fluctuations, etc., are indeed transitory (i.e. they die out in a shorter time period than the forecast horizon) there is no tension between tolerating headline inflation spikes in the short run and stabilizing it in the long run. However, a commitment to "long run" inflation targeting which allows substantial "short run" deviations seems rather squishy, and I wonder if it really would earn the Fed the additional credibility that true inflation targeters have.

There Will Be Subsidies

An interesting report from the Times' Keith Bradsher on oil subsidies in developing countries:

From Mexico to India to China, governments fearful of inflation and street protests are heavily subsidizing energy prices, particularly for diesel fuel. But the subsidies — estimated at $40 billion this year in China alone — are also removing much of the incentive to conserve fuel.

The oil company BP, known for thorough statistical analysis of energy markets, estimates that countries with subsidies accounted for 96 percent of the world’s increase in oil use last year — growth that has helped drive prices to record levels.

The subsidies prevent the price mechanism from working in a significant part of what is a global market, therefore the adjustments of price and quantity demanded must be larger elsewhere.

I would suspect that policymakers in these countries realize these subsidies are bad policies - indeed, the article describes how many countries are raising prices, but their price increases are falling short of the increase in world prices, so the costs to the governments are nonetheless increasing, even as citizens protest higher prices.

Is Preferential Trade Freer Trade?

Not everything with the word "free trade" in it really represents genuine trade liberalization. In particular, regional (or "preferential") trade agreements among pairs or small groups of countries, like NAFTA or the pending deals between the US and Colombia and Korea are criticized by some true free traders.

Some see these deals as distractions from the multilateral WTO negotiations (which currently continue to be very much bogged down), and, in theory, they can reduce economic efficiency through trade diversion (e.g. if Taiwan is a more efficient producer of monitors than Korea, if our tariff treatment of the two countries is the same, we will import monitors from Taiwan, but if we lower trade barriers preferentially with Korea, they may end up producing our monitors). One of the leading critics of preferential trade agreements from a free trade perspective is Jagdish Bhagwati - see this Economists' View post about his book "Termites in the Trading System." On the other hand, Richard Baldwin has argued that the WTO needs to embrace the "spaghetti bowl" of regional trade agreements (see also, this Economist article).

Perhaps free traders should not worry too much. At VoxEU, Antoni Estevadeoral, Caroline Freund and Emanuel Ornelas summarize their recent research on preferential trade agreements. They find that:

Our results imply that regionalism is a building bloc to free trade. There is no clear evidence that trade preferences lead to higher tariffs or smaller tariff cuts. There is strong evidence that preferences induce a faster decline in external tariffs in free trade areas. For example, if a country that follows a strict policy of non-discrimination offers free access to another country in a sector where it applies a 15% multilateral tariff, the country would tend to subsequently reduce that external tariff by over 3 percentage points. This complementarity effect is stronger in sectors where trade bloc partners are more important suppliers, precisely where trade discrimination would be more disrupting.

Exchange Rates Are Predictable

in the long run, but not in the short run (so reading this won't help you make any money...). That's one of the points made by this useful recent Dallas Fed Economic Letter surveying exchange rate economics, "Why Are Exchange Rates So Difficult to Predict," by Jian Wang.

One relationship that works well in the long run is purchasing power parity (PPP), which says when one currency is exchanged for another, the ability to purchase goods and services forgone in one country should be equal to the purchasing power gained in the other. A well-known example is The Economist's Big Mac index. According to this measure, the British pound is overvalued (i.e. too expensive) relative to the dollar because a Big Mac costs, on average, $3.57 in the US, and £2.29 in Britain, but $3.57 (i.e., enough to by a Big Mac in the US) exchanged into pounds at the exchange rate of $2 per £ would only give £1.79, not enough to buy a Big Mac in Britain.

The Economist has a chart of the latest update of the index (alongside a very distressed-looking - Grimace-ing? - Ronald McDonald). The Norwegian Kroner is the most over-valued currency, with the Euro, Swiss Franc and Argentine Peso (!) also among the dear ones. On the other side, the currencies that are cheaper than their Big Mac parity values include the Yen, Rouble and Yuan.

Of course, "purchasing power" is more than Big Macs (hopefully!), but since national price indexes are made up of many different goods with different weights, etc, making a similar calculation with a complete bundle of goods and services is highly impractical, so we turn to the "relative" form of PPP, which links changes in exchange rates to changes in price levels (i.e. inflation rates). If the exchange rate, e, is the "home" price of "foreign" currency, and ph and pf denote the home and foreign price levels, respectively, relative PPP says %Δe = %Δph - %Δpf.

A bit of my own research helps illustrate that this works well in the long run:


The real exchange rate is q = e x pf/ph, so if relative PPP holds, %Δq = %Δe + %Δpf - %Δph = 0, which means the graph should be a straight line if it holds constantly. Clearly it doesn't: there are substantial and persistent deviations from PPP, but they do tend to die out, and, remarkably, the total change from January, 1794 to December, 2005 is about 3%.

PPP is one of the tools used by Agnes Benassy-Quere, Sophie Bereau and Valerie Mignon to ponder the Euro-Dollar rate at VoxEU. They write:

In the “very long run”, the real exchange rate (the relative price of the same basket of goods across two countries) is expected to come back to a constant level, due to the convergence of the prices of both traded goods (due to international arbitrage) and non-traded goods (due to productivity equalisation all over the world). In the jargon, this is called purchasing power parity, and it acts as a very long run attractor.

They believe this implies "in the long and very-long run, the equilibrium value of the euro [currently $1.57] is found much lower – around 1.10. Thus, our work suggests that the euro may have peaked and be due to fall."

A Beacon of Insane Deals

The sale of domestic assets to foreign owners is one manifestation of the US current account deficit (and the declining dollar is making those assets cheaper). On the Daily Show, Lewis Black considered the implications:

A Defense of Greenspan-ism

from Brad DeLong:

But so far--look: In the dot-com boom of the 1990s we were the winners. The rich investors of America built out a huge amount of fiber-optic cables and conducted an enormous amount of experimentation in business models from which we all benefit. In the real-estate boom of 2000s the rich investors of America and the world built an extra four million houses and loaned the rest of us money at remarkably low interest rates for five years. Those who moved into newly-built houses with teaser-rate mortgages wish those teaser rates would continue--but they won't, and in the meantime they got to live in a nice house for quite a low rent. Those of us who took out big home equity loans wish the low interest rates would continue--but they won't. And those of us who felt rich because our house values have appreciated wish we still could think of ourselves as sleeping on a pile of gold--but we can't.

The dot-com bubble and the real-estate bubble were bad news for the investors in Webvan, WorldCom, Countrywide, FNMA, and securitized subprime mortgages. But they were, by and large, good news for the rest of us. And investors are supposed to take care of themselves.

Now we are not yet out of the woods. If the tide of financial distress sweeps the Fed and the Treasury away--if we find ourselves in a financial-meltdown world where unemployment or inflation kisses 10%--then I will unhappily concede, and say that Greenspanism was a mistake. But so far the real economy in which people make stuff and other people buy it has been remarkably well insulated from panic at 57th and Park and on Canary Wharf.

Or, as Keynes said (General Theory, ch. 22):

Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.

See also, more recently, The Onion.

At the risk of sounding Gramm-esque, it is worth bearing in mind that the main macro aggregates - GDP growth, unemployment and inflation - still aren't looking too bad by historical standards....

Bernanke Blast

A "word cloud" from Bernanke's testimony earlier this week:
(Hat tip: Big Picture)

The CPI is High (is Stagflation Nigh?)

The latest Consumer Price Index numbers (BLS report; NYT story) are not good: inflation was 1.1% for the month of June.

How alarmed depends you are by this depends, in part, on whether you are a believer in focusing on "core" inflation, which excludes food and energy prices. According to the BLS:

The index for energy rose sharply for the second straight month, increasing 6.6 percent in June following a 4.4 percent increase in May. The increase in the energy index accounted for around two-thirds of the overall increase in the all items index in June.

Core inflation still looks rather more tolerable:
Note: I represented core inflation with the core PCE deflator, since that seems to be the Fed's preferred measure (the core CPI would be a smidge higher).

The Fed is expecting the energy price increases to lead to higher core inflation, but they see this as transitory, according to the minutes of the last (June 24-25) FOMC meeting:

The staff's projection for price inflation in core personal consumption expenditures (PCE) for 2008 as a whole was unchanged; recent readings on core PCE inflation were better than anticipated and led the staff to lower its projection for the first half of the year. But some of the recent improvement was seen as reflecting transitory factors, and the forecast of core inflation for the second half of this year and next year was marked up to incorporate the likely pass-through of the recent jumps in the prices of energy and other commodities, and the reversal of these transitory factors. The further large increase in energy prices also prompted an upward revision of the forecast of headline PCE inflation in the second half of 2008, and headline inflation was expected to exceed core inflation by a considerable margin this year. However, in view of a projected leveling-out of energy prices and the anticipated slack in resource utilization, headline inflation was expected to decline considerably in 2009 from its pace in the second half of 2008, and core inflation was forecasted to edge lower.

The projections of the board members and regional presidents appear to be consistent with this.

Willem Buiter thinks they are too sanguine. He says the Fed, Bank of England and ECB "have looked inflation in the face, blinked and hoped for a better tomorrow." Tightening monetary policy when output is falling and unemployment is rising will not be popular, but Buiter believes they need to bite the bullet:

This is your time, guys & gals. This is why central banks were made operationally independent. If you don’t use the political space created by the laws that granted you operational independence to keep the lid on inflation when this is difficult - as it is today - there is no point in granting central banks operational independence. Only determined action by central banks can put the inflation genie back in the bottle. Praying for a miracle won’t do.

You Don't Mess With The Milton

The University of Chicago's plan to honor Milton Friedman by naming a new research institute for him has proven controversial. The Times reports that the university president is being petitioned to convene the faculty to discuss the issue:

More than 100 professors signed the petition, declaring that they were “disturbed by the ideological and disciplinary preference implied by the university’s massive support for the economic and political doctrines that have extended from Friedman’s work,” and the implication that Chicago’s faculty “lacks intellectual and ideological diversity.”

Outside the economics profession, Friedman is probably best known for his evangelism on behalf of free market ideology, so it is understandable why some might raise objections. To which professional economists - especially those of us who do not share Friedman's opinions - should respond: "yes, but... Milton Friedman really was a great economist who made some very important contributions that left a lasting impact and helped shape our understanding of how the economy works."

That was, in part, what I think Paul Krugman was trying to do in his essay "Who Was Milton Friedman?" which appeared in the New York Review of Books in Feburary, 2007 (Friedman died in November, 2006). Writing for an audience presumably aware of (and, likely, not fond of) Friedman as an anti-government public intellectual, but not trained in economics, Krugman explained some of Friedman's important theoretical insights, while also criticizing some of his ideas.

In assessing Friedman, Krugman tried to separate the good from the bad:

Milton Friedman played three roles in the intellectual life of the twentieth century. There was Friedman the economist's economist, who wrote technical, more or less apolitical analyses of consumer behavior and inflation. There was Friedman the policy entrepreneur, who spent decades campaigning on behalf of the policy known as monetarism—finally seeing the Federal Reserve and the Bank of England adopt his doctrine at the end of the 1970s, only to abandon it as unworkable a few years later. Finally, there was Friedman the ideologue, the great popularizer of free-market doctrine.

Did the same man play all these roles? Yes and no. All three roles were informed by Friedman's faith in the classical verities of free-market economics. Moreover, Friedman's effectiveness as a popularizer and propagandist rested in part on his well-deserved reputation as a profound economic theorist. But there's an important difference between the rigor of his work as a professional economist and the looser, sometimes questionable logic of his pronouncements as a public intellectual. While Friedman's theoretical work is universally admired by professional economists, there's much more ambivalence about his policy pronouncements and especially his popularizing. And it must be said that there were some serious questions about his intellectual honesty when he was speaking to the mass public.

Krugman explains the significance of Friedman's most enduring intellectual contributions on consumption theory and the relationship (or lack thereof) between inflation and unemployment. He is more critical on Friedman's "monetarist" doctrine that monetary policy should be on autopilot, following a rule of growing the money supply at a constant rate. The "questions about his intellectual honesty" come from Friedman's explanations of the Great Depression. There is little doubt that the Federal Reserve failed to act properly, but Krugman argues that Friedman was misleading in suggesting that the Fed caused the depression.

In the conclusion he wrote:

In the long run, great men are remembered for their strengths, not their weaknesses, and Milton Friedman was a very great man indeed—a man of intellectual courage who was one of the most important economic thinkers of all time, and possibly the most brilliant communicator of economic ideas to the general public that ever lived. But there's a good case for arguing that Friedmanism, in the end, went too far, both as a doctrine and in its practical applications.

Krugman made some sharp criticisms, but the essay is far from a hatchet job, and the appreciation for Friedman's brilliance and his contributions to economic theory is clearly genuine. Or so I thought...

Edward Nelson and Anna Schwartz apparently didn't think so, offering a letter to the editor criticizing Krugman's essay. The word limit of the NYRB's letters section evidently was too tight a constraint on their anger at Krugman, so they wrote a longer piece "The Impact of Milton Friedman on Modern Monetary Economics: Setting the Record Straight on Paul Krugman's 'Who Was Milton Friedman?'" I was taken aback by this when I first saw it, and quite surprised to see it again in the latest Journal of Monetary Economics, the top academic journal focused on macroeconomics (it is also posted here, if you don't have access to the JME).

Nelson and Schwartz write:

To some readers, Krugman's willingness to praise Friedman despite these accusations might indicate that his essay is balanced; but to us, it shows the degree to which the essay consists of doubletalk. Krugman's accusations constitute such fundamental criticisms that, if accurate, they should be sufficient to rule out a favourable conclusion about Friedman. Specifically: How can he say Friedman was a great economist and a great man, if he believes Friedman to have been intellectually dishonest? Or that Friedman was a man of courage, if he misled people?

So one must come to a "favorable" or "unfavorable" conclusion about Friedman - be a friend or an enemy - and any opinions that are nuanced, mixed or ambivalent can only be "doubletalk"?

The article goes on to enumerate what Nelson and Schwartz believe to be "misstatements" by Krugman and dig up some contradictions. Can you believe that Krugman, in 1993, referred to Friedman's 1953 paper on the case for floating exchange rates as "seminal" and yet did not mention it in the NYRB essay? Nelson and Schwartz also dredge up quotations from 1960's Keynesians James Tobin, Paul Samuelson, Arthur Okun, Walter Heller and Gardner Ackley which seem rather beside the point (although perhaps the point is Friedman was always and everywhere right, and his opponents were always and everywhere wrong). Much of the argument seems really to hang on semantics - whether the Fed's failure to take action in the depression are a "cause," and what, precisely, constitutes "monetarism."

They conclude:

Paul Krugman is a respected trade theorist. But he does not speak authoritatively on subjects on which he has no expertise. Monetary economics is not his field of expertise. Krugman's research background does not qualify him as an authority on Milton Friedman's work. Krugman's scholarly publications rarely mentioned Friedman and, when they did, they acknowledged the contributions of Friedman and monetarism in a way that contradicts his essay on Friedman. Friedman's reputation is intact despite Krugman's deplorable efforts to denigrate him and his contributions.

The JME published a short response by Krugman. I suspect what he was really thinking was: "jeez." But that - even for academic bigwigs like Krugman - won't get published in the JME. Instead, Krugman briefly addressed some of the points about the depression and about monetarism before concluding:

Professional economists rarely have a critical word for Milton Friedman's legacy. The current exchange explains why: Friedman's defenders make life very unpleasant for anyone who points out the great man's failings...

Its a tribute to the importance of Friedman's work that questions about his legacy bear so directly on contemporary policy issues. But for that reason it's also important not to engage in hagiography. Friedman was a great economist, but like every other great economist in history, he was also wrong about some important things.

The tone of Nelson and Schwartz's essay reflects, I think, an earlier era - well before my time - when macroeconomics was much more intensely political. In his short intellectual history, "The Macroeconomist as Scientist and Engineer," Greg Mankiw discusses some of the arguments of the 1970's and 1980's. Writing of an exchange between Robert Solow and Robert Lucas, Mankiw said: "Such vitriol among intellectual giants attracts attention, much in the way that the patrons in a bar gather around a fistfight, egging on the participants. But it was not healthy for the field of macroeconomics." Fortunately, "as the older generation of protagonists has retired or neared retirement, it has been replaced by a younger generation of macroeconomists who have adopted a culture of greater civility."

Update (7/24): Having pondered this a little more, I might add: I am not an expert on the ins and outs of all the internecine macro fights of the 1960's and 1970's, but I suspect a reasonable argument could be made that Krugman understated Friedman's importance. I believe that is, in part, what Nelson and Schwartz were trying to say, but their vituperation distracts from the substance of the argument (at least to this reader).

Some Economists are Republicans

John McCain's campaign released a statement signed by 300 economists endorsing his economic plan. Most of the big names are not surprising; many are people who have served in Republican administrations. Many are obscure, but a few I recognize and some I know - my graduate econometrics professor,* for one. Its like how Bob Frank felt when he got the news about Bernanke:

"When the news first came that he was a candidate to be named a Fed governor, I thought it was interesting that the Bush administration would nominate a Democrat," Mr. Frank said. "I was surprised. I worked with him and did not know he was a Republican."

So yes, some economists are Republicans (but most are not). Although the statement begins "we enthusiastically support John McCain's economic plan," I would venture that the signatories were motivated more by their general philosophical inclinations than by excitement over what he has been offering on the campaign trail.

On said trail, McCain descended further into incoherence today with the promise to balance the budget by 2013, despite his earlier promises for big tax cuts (which he promised despite opposing the Bush tax cuts as a Senator - he actually voted against them before he was for them...). The Times' Matthew Cooper writes:

As Senator John McCain kicked off a week of economic-themed campaigning here on Monday, it was apparent that some of the underlying tensions between the two schools that guide his economic thinking — the supply-siders who want to cut taxes and the deficit hawks who want to balance the budget — remain unresolved.

Mr. McCain has promised once again to balance the budget by the end of his first term in 2013, his advisers said Monday. They were reverting to an earlier pledge that Mr. McCain abandoned in April, when he proposed a series of costly tax cuts and, citing the ailing economy, said that it might take two terms to balance the budget.

See also Mark Thoma's comments.

McCain was also telling his Colorado audience about the inspiring entrepreneurs who gave us Crocs, which turns out to be a warmed-over example, and one about a company that's now going down the tubes; more croc-pot economic ideas from the Republicans! Besides, doesn't McCain know that sandals are for socialists? (see the sixth paragraph here).

*Perhaps when he heard McCain's plans would lead to an increase in inequality, he thought that meant more like Chebychev's.

Update: Underpants gnomery, says DeLong.

Update #2 (7/10): DeLong notes notable Republican economists absent from McCain's 300, while the Politico reports some signatories are not truly enthusiastic. See also EconomistMom and TPC's Howard Gleckman on the non-credibility of the balanced budget promise, and EconomistMom on the misleading press coverage.

A Trade Restriction Led Zeppelin

to switch from helium to hydrogen, causing, indirectly, the Hindenburg disaster:

Today’s airships fly with helium, as did the Hindenburg until the United States imposed an embargo on what was then a fairly valuable commodity. Hence, the Hindenburg had to start using inflammable hydrogen on its flights.

From a fascinating NY Times article about a revival of interest in airships.

Reverse Beast Starving

One argument sometimes made by Republicans, sotto voce, for tax cuts is that budget deficits will constrain Democrats from expanding government. That is, tax cuts will "starve the beast."

In an interesting project syndicate column, Brad DeLong makes the case that since the Republican party seems to have completely broken with what was once known as fiscal conservativism (i.e. the government should not run deficits except in recessions), the next Democratic administration may not want to trim the deficit too much. He writes:

Those of us who served in the Clinton administration and worked hard to put America’s finances in order and turn deficits into surpluses are keenly aware that, after eight years of the George W. Bush administration, things look worse than when we started back in 1993. All of our work was undone by our successors in their quest to win the class war by making America’s income distribution more unequal.

A chain is only as strong as its weakest link, and it seems pointless to work to strengthen the Democratic links of the chain of fiscal advice when the Republican links are not just weak but absent. Political advisers to future Democratic administrations may argue that the only way to tie the Republicans’ hands and keep them from launching another wealth-polarizing offensive is to widen the deficit enough that even they are scared of it.

They might be right. The surplus-creating fiscal policies established by Robert Rubin and company in the Clinton administration would have been very good for America had the Clinton administration been followed by a normal successor. But what is the right fiscal policy for a future Democratic administration to follow when there is no guarantee that any Republican successors will ever be “normal” again? That’s a hard question, and I don’t know the answer.

Sounds like "starve the beast" in reverse (hat tip: Economist's View).

On a related note, Greg Mankiw sees evidence for "starve the beast," but Romer and Romer do not.

Lessons of History or Mistakes of the Past?

A specter is haunting Europe, but we can't agree on which one...

The European Central Bank is raising interest rates in an effort to keep inflation in check, while the Fed has the fed funds rate target at 2% (so the real interest rate is actually negative). Real Time Economics excerpts an analysis from Deutsche Bank that argues the trans-Atlantic divergence in monetary policy is rooted in differing historical experiences:

In the United States: “The traumatic experience of the deflation and extreme levels of unemployment that occurred during the Great Depression in the 1930s – and the Fed’s mistakes during this period — play a prominent role in the discussion of monetary policy by both practitioners and academics. Accordingly, Fed policy makers have been very sensitive to the risk of asset price collapses and debt deflation (note, for example, the Fed’s reaction to the 1987 stock market crash, the [Long-Term Capital Management] crisis, and the burst of the dot-com bubble).”

In Europe: “Probably the most prominent economic trauma in Europe were Germany’s hyperinflation after World War I and currency reform after World War II. Throughout its existence the Bundesbank was extremely sensitive to inflation pressures, and willing to take significant risks with growth to keep inflation in check (note, for example, the Bundesbank’s reaction to the two oil shocks of the 1970s and its reluctance to follow the Fed in 1987). German sensitivity to inflation risks of course had a strong influence on the institutional design of the ECB and more recently on the implementation of the euro zone’s monetary policy.”

The Telegraph's Ambrose Evans-Pritchard thinks the ECB is repeating the mistakes of the 1930's, in an excessive zeal to avoid repeating the mistakes of the 1970's:

Sadly, we are witnessing the sort of strategic errors that turned the recession of 1930 into a global catastrophe.

The European Central Bank is now hell-bent on a course of action that will have a knock-on effect across the world and risk a dangerous implosion of the credit system...

The ECB mantra is that Europe and the world is on the cusp of a wage-price spiral along the lines of the 1970s. This directly contradicts Ben Bernanke at the Fed, who insists -- correctly -- that today's conditions are not remotely like the 1970s....

By taking this militant 1970s line, he is in effect kicking Bernanke in the teeth. Or put another way, the ECB is trying to pressure America into a tighter monetary stance. Regrettably, this has in part succeeded. The Fed badly needs to cut rates further -- probably to 1per cent. It cannot do so because the ECB keeps threatening to pull the plug on the dollar.

This is madness. It is the mirror image of the early 1930s, when the Federal Reserve (cowed by the Chicago liquidationists) precipitated the collapse of 4,000 banks, and transmitted their fervour to rest of the world through the Gold Standard. This time there is no Gold Standard. But the globalised capital and currency markets -- egged on by Trichet -- are playing much the same role.

That comes to my attention via Naked Capitalism. This is not the first time the choice of the correct historical analogy has been at issue (see, e.g., this earlier post).

"Blood and Guts" Volcker

The Economist's Free Exchange raises the interesting question of whether academic credentials - like those of Ben Bernanke - are valuable for central bankers. Paul Volcker (Fed chairman, 1979-87) apparently takes a rather Stephen Colbert-ian view of the issue:

A central bank governor's most essential trait was "guts" and some management abilities, said Mr Volcker.

Guts?! Hmm... by that logic, perhaps Curt Schilling should replace Bernanke when his term expires, or maybe Ponch from "CHiPs"...

Free Exchange notes that

Mr Volcker does not have an economics PhD; he has a Harvard MA in political economy and two years of study at the London School of Economics. Despite this, he is frequently called the best central banker ever.

Volcker is often lauded for his "toughness" in presiding over the disinflation of the early 1980's, when the Fed tightened monetary policy (the Federal Funds rate exceeded 19% in mid-1981) to bring inflation down. Undoubtedly, that episode was difficult for Volcker, who took some harsh criticism, but the truly severe consequences were suffered by the millions of workers who lost their jobs in the ensuing recession; the unemployment rate peaked at 10.8% in 1982.

The ardent praise sometimes lavished on Volcker for his "courage" in the "fight" against inflation reminds me of the scene from "Patton" when a soldier says: "There he goes, 'ol' blood 'n guts.'" His buddy replies: "Yeah, our blood, his guts."

Arguably, there was no painless way to put a stop to the inflation that had taken hold in the 1970's, but I sometimes like to think that a smart PhD economist might have found a way to do so with less damage.