"The firefighting school of economic thought insists that we have to fight the immediate threat before the next one."

I guess I've said what I believe over and over. We will beat deflation, and then have to fight inflation, but that's an easier and more familiar enemy. Here's Wolfgang Munchau in the FT:

"Never before have European central banks cut interest rates by so much in such a short period of time. The European Central Bank, the Bank of England and the Swedish Riksbank are all inflation-targeters. This means that such rate cuts can only be explained in two ways.

The first and obvious would be an expected persistent undershoot of the target itself. But I simply cannot see how this is possible. Of course, headline inflation rates will come down sharply next year and may turn briefly negative. But the trend will probably reverse again in the second half, when the sharp falls in oil and commodity prices are no longer in the index. For the eurozone, the ECB’s own officials are forecasting annual inflation of between 1.1 per cent and 1.7 per cent next year and between 1.5 per cent and 2.1 per cent in 2010. These forecasts suggest that the ECB is more or less on target right now"

Fine. What's the better explanation?

"The second explanation is that the central banks attach a small but positive probability to a liquidity trap, a situation in which an economy hits such a downward spiral that monetary policy becomes ineffective. To avoid such a calamity, they may be prepared to cut interest rates below the rate that would otherwise be consistent with their own forecasts. There is a price to be paid for such insurance.

It comes in the form of an increased risk of inflation later. Those who defend such insurance say the two risks are asymmetric and therefore worth taking. Twenty per cent inflation, they say, is ultimately not as harmful as 5 per cent deflation."

Aye. So say I.

"Let us assume for argument’s sake that prices will indeed start falling from next year for a sustained period. In such a situation, the central banks would have no choice but to cut interest rates to zero. What then?

There is actually quite a lot central banks can do in such a situation. For starters, they can drive right through the zero boundary and impose negative interest rates. A negative interest rate is like a tax on deposits. People could avoid paying this tax by moving into physical cash.

But there are costs associated with physical storage as well. The mattress is not a safe cash storage device. You might have to invest in a safe deposit box, or pay higher insurance rates against theft. Obviously there will come a point when people may be prepared to do just that. Some lower boundary for interest rates surely exists. But it is minus 1 or minus 2 per cent, not zero.

If you want to push interest rates even lower, you could for instance put expiry dates on banknotes, possibly in electronic form, since modern banknotes are full of technical gizmos. Renewal would be taxed – at a rate at least as high as the interest rate is negative. This would discourage people rushing into hard cash."

I've already talked about these. Stamping and charging and taxing, etc. For one thing, would people actually stand for such counter-intuitive measures? I don't credit it.

"But before you want to adopt such unorthodox and unpopular measures, there is a whole string of effective alternative, or additional, available policies. One is quantitative easing. This involves blowing up your balance sheet with short-dated securities to drive down short-term market interest rates. The Federal Reserve recently started to do just this. It was the most important and least flagged monetary policy decision it took this year."

You're not reading the right blogs, my friend. Check my list out on the right.

"In a next step, you could buy longer-dated government bonds, which would reduce long-term interest rates. If central banks get truly desperate, they could even buy shares. Equipped with such a tool kit, and the readiness to use it if necessary, a central bank can effectively prevent, or end, deflation.

Since all the European central banks are committed to maintaining a positive inflation rate of about 2 per cent, they can print as much money as they like and buy up high-quality securities until they have inflation back to where they want it. If they overshoot, they can easily reverse. James Hamilton, professor of economics at the University of California in San Diego, recently listed these and even more extreme zero-bound policy options in his blog, and concluded: “ . . . if inflation is what you want, put me in charge of the Federal Reserve and, believe me, I can give you some inflation.”

I believe that Hamilton is correct. His blog is on the right. Econbrowser.

"The converse of this statement is that central bankers need to panic a little less. Cutting interest rates to zero at this point is probably inconsistent with their own inflation forecasts, even considering that the economic outlook is somewhat scary.

What are the risks of overshooting? The biggest risk is that central banks cannot reverse their policies in time. This risk increases with the extent of unsellable junk securities on the central bank’s balance sheet. Also, when the recession ends, central banks will come under pressure not to endanger the incipient upswing. So the more aggressively they act now, the greater the risks of an inflationary overshoot later. That risk is clearly greater in the US than in Europe."

It's going to be a rough ride. No doubt about it.

"The economic downturn will no doubt be very unpleasant. But so will the economic recovery if accompanied by a sustained rise in inflation. The firefighting school of economic thought insists that we have to fight the immediate threat before the next one. Deflation is a more immediate threat than inflation. But I dispute the claim that we lack the means to fight it and that we have to succumb to panic in each downturn."

I'm not actually sure what he just said. What is the claim that he is disputing? That we lack the means to fight deflation? Everybody agrees that we can fight deflation. That we lack the means to fight inflation? Everybody agrees that we can fight inflation. Now, they don't agree on particulars, but, I'm sorry, is he against the "firefighting school"? Or is he just saying that we should be preparing to fight inflation now? If so, I agree with him completely. If he isn't, then...You know what? I'm just going to assume that he agrees with me because, if he doesn't, well, then he should.

Where did he come up with the "Firefighting School"? Doesn't it make general sense to fight the immediate threat before the next one? After all, it might not even occur.