Should a central bank address a broad agenda of economic growth, price stability, and full employment? Or should it focus single-mindedly on controlling inflation? Last autumn this debate mounted in Europe, where calls from social democratic governments for lower interest rates grew louder as the continent prepared for the European Central Bank. In the United States, where federal law stipulates full employment as a policy goal, Republican proposals to require that the Federal Reserve focus only on inflation surface regularly in Congress.
Ben S. Bernanke and his colleagues, each a veteran of the Federal Reserve Bank of New York research staff, make the case for inflation targeting in a book that has the intellectual rigidity of a manifesto. But their tone, worried rather than strident, will seem familiar to followers of the recurrent debates over competitiveness, which cater to national vanity in similar terms. In the authors' eyes, the United States is "lagging behind other industrial countries in considering monetary policy frameworks and institutions that might help ensure good economic performance in the long term."
Since the early 1980s, a handful of countries have formally declared that low and stable inflation should be the overriding objective of monetary policy. These countries, which include New Zealand, Canada, Great Britain, and Sweden, are the main focus of the book. After reviewing these cases, Inflation Targeting uses them as examples to argue that inflation targeting would also enhance American "economic performance in the long term." But the authors have a curious interpretation of this phrase. They do not use it to refer to rising living standards, full employment, declining inequality in pay, or similar recent improvements in American material well-being. Rather, they explicitly deny that monetary policy should be praised for these blessings, since the gains of an expansionary monetary policy are inherently temporary and unsustainable. Economists should therefore not count such gifts among the benefits of a sensible long-term monetary policy.
In other words, America's present affair with full employment is sure to end badly, with an acceleration of inflation leading finally to recession and unemployment. In contrast, the right strategy to fight inflation is to keep unemployment high enough all the time at its "natural" rate, or as low as joblessness can go without sparking inflation. A central bank distracted by the pursuit of economic growth and full employment is to be condemned, while a central bank that achieves price stability at the cost of chronic high unemployment -- as in Germany -- has done its duty. The European Central Bank, charter-bound to price stability whatever the cost, represents the pinnacle achievement for this school of thought. Meanwhile, the Federal Reserve -- unmentioned in the U.S. Constitution, obliged to report on unemployment -- must seem emasculated in comparison.
The case for inflation targeting, as Bernanke and his colleagues present it, rests on a theory -- the natural rate of unemployment mentioned above -- that links monetary policy exclusively to inflation control and denies central banks any important role in determining economic growth or employment. As disciples of the natural-rate doctrine, our authors favor inflation targeting not simply as the better strategy, but as the only strategy consistent with sound economics. But are these principles correct?
The authors do not bother to argue their case, but merely tell us that these truths were presented by Milton Friedman in 1967, refined by Robert Lucas in 1976, and consequently were accepted by most economists. Indeed, the theme of consensus crops up time and again. We read that "most macroeconomists agree" the inflation rate is the only variable that monetary policy can affect in the long run; that there is "by now something of a consensus that even moderate rates of inflation are harmful"; and that there "is a growing belief among economists and central bankers" that low inflation is good for both efficiency and growth. For the authors, the case is closed and consensus has settled the issue.
In fact, no such consensus exists or has ever existed. To take just a few examples, Robert Eisner, a former president of the American Economics Association and a renowned macroeconomist, has never accepted the Friedman/Lucas view. Neither has James Tobin, Paul Samuelson, Robert Solow, or the late William Vickrey -- all Nobel laureates. Neither did Ray Fair at Yale, James Medoff at Harvard, or William Dickens at the Brookings Institution. Bernanke and his colleagues maintain the illusion of consensus by ignoring the actual debate, which has grown more intense, not less, in recent years.
There are two basic reasons why this controversy persists. First, although the FriedmanffiLucas doctrine does enjoy some academic dominance, it rests on a peculiar philosophical position that regards the future as a sort of lottery drawing. For example, it would view the Asian financial crisis not as a policy failure but merely an unfortunate, random outcome. Not surprisingly, many thoughtful economists reject this approach. Second, the real world has been openly contradicting the theory for years. Three years ago, every advocate of the natural-rate doctrine firmly held that unemployment below six percent would spark inflation. Unemployment has since fallen, but contrary to theory it not only has remained below the supposed natural rate but has failed to touch off inflation. The Friedman/Lucas arguments have received a clear empirical rebuke.
Instead, deflation, not inflation, reared its head in much of the world last year as the financial crisis spun out of control. But adherents of the natural-rate theory were never able to see this threat. They were still arguing for an anti-inflation policy when the Asian crisis broke in 1997, and they were still clinging to it in the summer of 1998 when U.S. markets began to crack under the strain. As the case for urgent action grew evident to everyone else, including Federal Reserve Chairman Alan Greenspan, the diehard natural raters inside the Federal Reserve obstructed forceful action. The concrete result: interest rate cuts were at first too cautious to impress the financial markets and affect the economy, and so the crisis deepened.
Can a central bank pursue inflation targeting without adhering to the natural-rate doctrine? Although Bernanke and his coauthors make no effort to separate the two, it is possible to base inflation forecasts on something other than the unemployment rate. An inflation targeter could very well have argued at the Federal Reserve last August that the Asian crisis had eliminated inflation risk and that large cuts in interest rates were essential to ward off the threat of deflation.
This supply-side view may be an improvement over an employment-driven inflation obsession, but it is still less sensible than current Federal Reserve practice. Economists opposed to rate cuts could have countered, correctly, that deflation outside the United States will not depress prices inside the country because most wages and prices are unlikely to fall that quickly. However, the great danger of the Asian crisis is not falling price levels but rising unemployment, recession, and income inequality. A doctrine of inflation targeting, even if not tied to the natural-rate dogma, would have weakened the argument for the interest rate cuts needed to stabilize employment and output, not to mention the financial markets and the banking system.
A CASE FOR CUTS
In any case, events have already overtaken our authors. The only potentially effective response to the global slump has been for the Federal Reserve to sharply cut U.S. interest rates and ensure a depreciation of the dollar. These measures help slow the flight of capital to the United States, return confidence to Asian markets, and restore the balance sheets of otherwise insolvent Japanese banks. Inflation targeting would have delegitimized these policy goals. The argument for having our central bank exclusively address inflation not only ignores the reality of the crisis but assaults the urgent present priorities of the Federal Reserve itself.
What of the claim that inflation-targeting countries have enjoyed superior economic performance, even if employment and growth are omitted and inflation alone is considered? A fair evaluation of this claim would require a comparative perspective, which the authors do not provide. We are left then to review the historical record and ask, What kind of evidence do Bernanke and his colleagues actually present that inflation targeting succeeded?
This part of Inflation Targeting merits careful reading, for much of the story in detail is interesting and competently told. But what is striking is that even the authors admit that inflation targeting in practice has actually done little to fight inflation. In the case of New Zealand, they write, "the decision to announce inflation targets occurred after most of the disinflation . . . had already taken place." The same is true for Canada, and Britain also embraced inflation targets when "it was most likely to meet them." Sweden "was in deep recession" with inflation "down to a historically low rate of three percent per year" when its central bank adopted inflation targets.
In other words, the countries in question never introduced inflation targets when inflation posed a serious threat, nor did adopting targets reduce the cost of any ongoing inflation battle. In all cases, the declaration of war came after the fighting was over. So why did the central bankers do it? Bernanke and his colleagues are quite honest about the reasons. Inflation targeting in all cases coincided with high unemployment, and its main effect was to excuse central bankers from addressing this crisis. Second, inflation targeting could substitute for the messy practice of money supply targeting, an earlier misguided enthusiasm that Britain had once embraced and that Germany used until the launch of the euro. Third, and in sharp contradiction with the first motive, inflation targeting provided in a few cases some camouflage for central bankers who were actually planning to ease monetary policy in order to fight unemployment. They said one thing to placate conservatives and did another to accommodate the political and economic realities of the hour.
Central bankers, like generals, are often accused of refighting the last war. But as the motives above suggest, this case is somewhat different. First, inflation targeting commits itself in principle to fight the last war -- the war against inflation -- as a way to avoid addressing the present threat -- unemployment. Second, inflation targeting allows central bankers to change tactics of the last war even though it has already ended. And third, it permits central bankers to assert that the inflation war is still raging, even when they are really planning to fight unemployment. These mechanisms are useful from a narrow public relations standpoint, but it is hard to see how they actually relate to economic performance, including the pursuit of low inflation.
What should the United States do? The Federal Reserve is an independent executive agency under the authority of Congress. It therefore comes under the Humphrey-Hawkins Full Employment and Balanced Growth Act of 1978, which rewrote U.S. economic policy goals to specify that they include, among many things, full employment, balanced growth, and reasonable price stability. In particular, the act set interim targets of four percent unemployment and three percent inflation -- goals that are now, within a few tenths of a percentage point, achieved.
The authors of Inflation Targeting do not discuss the Humphrey-Hawkins Act. If they had the chance, however, they would likely rewrite it and order the Federal Reserve to fight inflation alone. They do not say what would become of the Humphrey-Hawkins goal of "full employment." In principle, perhaps some other agency could address the task of sustaining full employment through a jobs program funded by tax increases or deficit spending. But it is unlikely that Bernanke and his colleagues have this in mind. One suspects instead that what they really want is to abandon full employment as a formal objective of American policy.
It is ironic that this book appears just as Alan Greenspan, Alice Rivlin, and the rest of the Federal Reserve leadership have demonstrated how spurious the natural-rate doctrine is by proving that full employment, balanced growth, and reasonable price stability are not mutually exclusive. This is a remarkable accomplishment, and it is due in part to the willingness of Chairman Greenspan to overrule the adherents of the Friedman/Lucas view and experiment cautiously with continuing reductions in unemployment. In this way, Greenspan and company have affirmed the good sense of the Humphrey-Hawkins law. The fact that the unfolding crisis of go-go globalization now threatens this accomplishment does not diminish its validity or its importance. And in their attempt to stabilize the financial markets and the world economy as the deflationary crisis of 1998 unfolded, the Federal Reserve's leadership demonstrated far more sophistication, flexibility, and common sense than Bernanke, Laubach, Mishkin, and Posen show in this evasive, unpersuasive book.
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