Professor Bernanke vs Central Banker Bernanke

This evolution of Bernanke from a Professor to a Central Banker is very interesting. It is as interesting as tracking developments in ongoing debates on monetary policy and all other economic topics.

Broadly, Professor Bernanke has worked on following key areas:

  • Uncertainty in business investment scenario (his PhD theses was on this)
  • Great Depression (he is truly a great depression scholar. His main contribution to this great depression debate was role of financial sector in making the depression so severe and prolonged. Great depression debate goes broadly like this:
    • Keynes said depression happened as overall demand collapsed;
    • Friedman said it happened as Fed tightened policy when is should have eased;
    • Eichengreen et  al said it turned into a global depression because of role of gold standard; New research shows France was a leading contributor to the great depression;
    • Bernanke said via this paper that closure of so many banks led to sharp curtailment of credit. This affected other business firms and overall business environment slumped
    • Then there are many other variants as well. I am not getting into details
  • Inflation targeting as a framework for central banks (see this speech as well)
  • Japan – Apart from Great Depression scholar, he became a Japan scholar as well. He lectured Japanese central bank/policymakers on where they have gone wrong. And how could this crisis be averted. (see this speech, this paper)
  • Asset market bubbles – As Princeton Economics Dept CEO, he set up Bendheim centre to understand asset market bubbles (see this superb article- Bernanke’ Bubble Lab). He also wrote a landmark paper on central banks targeting asset prices (though landmark till this crisis)
  • Financial accelerator – This follows from his work on great depression and business uncertainty. An increase in productivity that improves the cash flows and balance sheet positions of firms leads in turn to lower external finance premiums in subsequent periods, which extends the expansion as firms are induced to continue investing even after the initial productivity shock has dissipated  (see this speech)

Interestingly, all his above works are happening now in real time with US and other economies.

  • Business environment is highly uncertain
  • We don’t know this for sure, but most research/policymakers show we averted a second depression. Just like great depression was a severe double dip-recession, we face the same situation now
  • US is facing Japan like situation. As per James Bullard, St Louis Fed president US is closest to Japan than it ever was. Just like Japan, US faces debt-deflation trap kind of a situation. With very low inflation and persistent high unemployment. demand is likely to be low. This could further put downwards pressure on US inflation. With deflation come all other set of problems. Even setting of deflationary expectations is dangerous
  • Financial accelerator has become  Financial decelerator….
  • There are debates on whether central banks should remain as pure inflation targeters and how should asset bubbles be managed?

So, it isn’t just the case of repeating/rhyming of history. The man who has spent much of his academic life studying these issues is one of the main persons responsible to get US out of this mess.  It is such an interesting coincidence!! YOu could not have a better person leading the Fed  at this point of time.

As the Fed CEO now, the question that comes to mind is how did he fare as a central banker? Or how does he see his academic lessons in real-time policymaking?

Reams have been written on how Bernanke and other have averted the second depression. So, in the first phase may be the lessons were kind of carried forward. We will only know more via research in future but some preliminary evidence shows world avoided a second slump because of forceful policies followed by central banks and treasuries/finance ministries.

What I would like to focus on is the current situation. How does US manage to get itself out of Japan like situation? As explained by Bernanke and others even expectations of Japan like economy are dangerous. So, the US economy may not be Japan now but looks like Japan in making. Both are equally dangerous (read this another landmark speech).

In this aspect Bernanke does not seem to be taking the academic lessons forward in policymaking. There are two interesting articles on this. One by BW columnist Frank Aquila and two by Gulzar.

Bernanke’s main idea for Japan was that it adopt an inflation target and a higher one at that. Around 3-4%. Aquila writes:

So, if the U.S. economy today is in a state similar to Japan’s a decade ago, what would the professor recommend? Inflation! In his scholarly view, the Bernanke of 1999 concluded that the Bank of Japan should have announced “a target in the 3-4 percent range for inflation, to be maintained for a number of years.”

The normal reaction to inflation is that it should be kept contained, held to a low level. The destructive effects of a sustained rise in prices are well-documented. But is it possible that higher inflation would actually strengthen the economy? Inflation increases the nominal dollar value of assets while the nominal dollar value of debt remains the same. As wages and prices increase, the debt burden is effectively eased. Clearly the holders of that debt are losing out as rising prices erode the “real” value of their holdings—but that might be preferable to a long-term economic malaise. Individuals and companies would be reluctant to sit on their cash during a period of sustained inflation. Instead, they would spend or invest it. Igniting inflation is risky business and it is understandable that few central bankers would have the resolve to promote such an approach.

A decade after Professor Bernanke delivered his paper, Bank of Japan Governor Masaaki Shirakawa, speaking in New York in April 2009, acknowledged the striking similarities between Japan in the 1990s and the U.S. since 2007. Shirakawa warned that “the U.S. might be entering its own version of the ‘lost … not necessarily decade but something else.’ ” With the benefit of hindsight, Governor Shirakawa acknowledged that his BOJ predecessors had not acted as quickly and decisively as was required to avoid the economic stagnation that comes with low growth and deflation.

In Professor Bernanke’s 1999 paper he rebuts the argument made by the Bank of Japan at the time that simply maintaining low interest rates for an extended period represented monetary policy necessary to provide economic growth. As he noted then, “low nominal interest rates may just as well be a sign of expected deflation and monetary tightness as of monetary ease.”

Sage advice from Professor Bernanke to Chairman Bernanke.

He says being a central banker is different from being a professor:

The role of an academic is far different than that of a central banker. While an academic can propose policies based on theories, a central banker must take actions that could have enormous consequences, sometimes very negative consequences. Professor Bernanke clearly understood that challenge and urged Japan to have “Rooseveltian Resolve” in dealing with its stagnating economy. Although Professor Bernanke accepted that many of Franklin D. Roosevelt’s programs did not work as expected, he praised FDR’s resolve and willingness “to do whatever was necessary to get the country moving again.”

Governor Shirakawa challenged Americans, and possibly Chairman Bernanke, to remember “that ‘bold actions’ are [not always] judged to be bold afterward.” Hopefully Chairman Bernanke will take the advice of both Governor Shirakawa and Professor Bernanke. It is clear that we need a moment of “Rooseveltian Resolve” in order to re­ignite the U.S. economy.

Gulzar points to Bernanke’s Jackson Hole 2010 speech where he says:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed’s hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets–including inflation risk premiums–would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy.

Fascinating twist of words. If US adopts an inflation target and a higher one, it could lead to higher inflation expectations in US. But if Bank of Japan adopts it would be fine and if not it would be self-inducted paralysis!!

Perhaps time has come for BoJ/Japan officials to coem and lecture US and Bernanke. It isn’t as easy as it was made out to be.

I also recall what Krugman said when Bernanke was named Time person of the year:

So Time magazine has named Ben Bernanke Person of the Year. Be afraid, be very afraid.

The magazine cover curse is a well-known phenomenon: you should always short the stock of a company whose CEO is the subject of a glowing cover story in a major magazine.

He also points to an old Time Magazine cover which had picture of Greenspan, Summers and Rubin. The cover story was  the committee to save the world. :-) Krugman at his very best.

Though, I don’t think (more than think hope) things will go so bad. But Bernanke and his team need to understand the risks properly.

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