‘leaning against the wind’ when an asset or credit bubble is inflating by operating a tighter monetary policy

From Alphaville:

"The need for greater realism in monetary policy Posted by Tracy Alloway on Jun 10 15:50.

Is it ironic that the following conclusion is coming out of the Bank of England?

(Emphasis FT Alphaville’s):
. . . What lessons might be drawn for the operation of monetary policy? As we have argued, monetary policy can play a role in bringing credit booms to an end. But deploying monetary policy is much easier when credit growth is also accompanied by strong output growth and inflationary pressures. For a combination of reasons, this was not the case in many countries in the late 1990s and early 2000s. Some have argued that this means that the objectives of monetary policy should be changed — with a greater focus on ‘leaning against the wind’ when an asset or credit bubble is inflating by operating a tighter monetary policy than a conventional focus on price stability — such as an inflation target — would imply.

However, we see three problems with this approach. First, it is very difficult to operate because it is not always clear at what point in the growth of a credit cycle the monetary policy-maker should intervene. Second, it potentially creates confusion about the objectives of monetary policy by shifting the focus away from price stability as experienced by the general public towards a more complex set of objectives. This may undermine the credibility of monetary policy and its ability to anchor inflation expectations at a low and stable level. Third, and most crucially, however, this ‘leaning against the wind’ approach takes no account of the globalised nature of the financial system.

In the recent episode, the global financial crisis has been driven primarily by developments in the US mortgage market and within global financial markets and institutions. It is hard to see that a different course for monetary policy in other countries – such as the UK, the euro area or Japan — could have made much difference on either front. Within such a globalised fnancial system, a policy which sought to ‘lean against the wind’ risks having a deflationary bias at the national level - growth is held back in the upswing to head off a national credit bubble and yet the economy concerned is still at risk from a recession generated by a global financial crisis. The fact External MPC Unit Discussion Paper No. 27 June 2009 38 that Germany and Japan did not participate in the credit boom has not shielded them from the effects of the current global recession. Indeed, the export and manufacturing orientation of their economies means they have been among the hardest hit, in the short term at least.

Could better global coordination of monetary policies have helped in these circumstances? It could certainly be argued that while monetary policy seemed appropriate for many countries individually, at the global level it was too loose. The global credit boom was a symptom of this, as was the inflationary pressure which emerged in energy and other commodity markets in the mid-2000s. But effective coordination is likely to be very difficult to achieve when it is most needed. It is true that the current recession, along with an increased recognition of global interdependencies, has led to a renewed interest in policy coordination. But this has been against a background of strong mutual interest in the common goal of lifting the world economy out of recession. It would be much harder to achieve an appropriately coordinated monetary response when the world economy was growing healthily and the sense of common purpose was absent.

Maybe a more appropriate conclusion for monetary policy is the need for greater realism about what it can and cannot achieve. Monetary policy can deliver price stability over the medium term. But it cannot also single-handedly maintain the broader stability of the financial system or avoid all recessions. Economies experienced cycles and recessions going back to biblical times — long before inflation became a problem in the 1970s. Financial instability was an important driver of cycles before the Second World War. And the recent crisis provides a reminder that the instabilities of the earlier historical experience can re-emerge.

Another important conclusion for policy is that long expansions eventually come to an end. And they can be brought to an end by behaviours which are themselves encouraged by the experience of a long period of growth. The long expansion we saw in the 1950s and 1960s resulted in a sustained build-up in inflationary pressures which was responsible for at least two of the previous three UK post-war recessions. And we now recognise the financial excesses which built up in the recent period of sustained global economic growth ultimately sowed the seeds of the current recession. In a long period of economic expansion, policy-makers need to be alert to the imbalances and vulnerabilities which might bring a period of stability to an end. Even in a world in which inflation is generally low and stable recent experience suggests that financial instability is another powerful mechanism which can bring a long expansion to an end.

You can read the full BoE discussion paper — which focuses on the credit boom and the challenges it poses for macroeconomics and policy — here.

Related links:
Thinking anew on UK monetary policy - Martin Wolf, FT
Success and failure of monetary policy since the 1950s - Speech by Donald Kohn, BIS

This entry was posted by Tracy Alloway on Wednesday, June 10th, 2009 at 15:50 and is filed under Capital markets. Tagged with bank of england, boe, Monetary policy."

Me:

Don the libertarian Democrat Jun 10 20:46

I never get irony. Sorry. However, the policy of a Central Bank leaning against the wind should be called "P---ing Against The Wind. In the same way that a Central Bank is a Lender Of Last Resort, it's a Leaner Of Last Resort. The Central Bank will always lag a bubble because it has to slow the entire economy to act against the bubble. It will not do that until the bubble is about the size of one's face and about to burst. **** this idea out before someone begins to take it seriously.

But there are worse things than inflation. And guess what? We have them today.

TO BE NOTED: From the NY TIMES:

"It May Be Time for the Fed to Go Negative

By N. GREGORY MANKIW

WITH unemployment rising and the financial system in shambles, it’s hard not to feel negative about the economy right now. The answer to our problems, however, could well be more negativity. But I’m not talking about attitude. I‘m talking about numbers.

Let’s start with the basics: What is the best way for an economy to escape a recession?

Until recently, most economists relied on monetary policy. Recessions result from an insufficient demand for goods and services — and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.

The problem today, it seems, is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools, such as buying longer-term debt securities, to get the economy going again. But the efficacy of those tools is uncertain, and there are risks associated with them.

In many ways today, the Fed is in uncharted waters.

So why shouldn’t the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent?

At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.

The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less.

Unless, that is, we figure out a way to make holding money less attractive.

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. (I will let the student remain anonymous. In case he ever wants to pursue a career as a central banker, having his name associated with this idea probably won’t help.)

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn’t a flaw — it’s a benefit.

The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. With banks now holding substantial excess reserves, Gesell’s concern about cash hoarding suddenly seems very modern.

If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.

Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations.

Ben S. Bernanke, the Fed chairman, is the perfect person to make this commitment to higher inflation. Mr. Bernanke has long been an advocate of inflation targeting. In the past, advocates of inflation targeting have stressed the need to keep inflation from getting out of hand. But in the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative.

The idea of negative interest rates may strike some people as absurd, the concoction of some impractical theorist. Perhaps it is. But remember this: Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace. Even children can be taught that some problems (such as 2x + 6 = 0) have no solution unless you are ready to invoke negative numbers.

Maybe some economic problems require the same trick.

N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President George W. Bush."

"The bottom line is that Bernanke has made a gamble with something approaching 2 trillion."

James Hamilton on Econbrowser:

"Federal Reserve balance sheet

Here I survey how we got here, where things currently stand, and what it all means.

Let me begin by reviewing some first principles of what the Fed is all about. How did the cash currently in your wallet get there? You withdrew it from an ATM, perhaps. But these wonderful contraptions don't just give you the green stuff for free-- you had to have deposits in the bank to be able to withdraw the cash. You can think of your account with your bank as credits you can use to get cash whenever you want it.

But where did your bank get the cash? It likely has an account with the Federal Reserve System, which account, just like the one you have with your bank, shows a certain level of deposits that the bank has in its account with the Fed. Your bank can then go to the Fed and withdraw those deposits in the form of cash. So you can think of your bank's deposits with the Fed as credits it can use to get cash whenever it wants.

And how did your bank come to have those deposits with the Fed? These deposits are something the Fed has the power to create out of thin air. This indeed is its primary power-- the ability to create money( TRUE ). That's a power that could be easily abused, so our system is set up to prevent the Fed from creating deposits willy-nilly. Specifically, the traditional operation of the Federal Reserve was to purchase assets such as Treasury securities from a private dealer, paying for them by simply crediting the dealer's account with the Fed with new deposits. The Fed hasn't created any wealth with this transaction, it has simply introduced a new asset (ultimately, money) and retired an old (the Treasuries that were formerly held by a member of the public are now held by the Fed). ( OK )

Although private sector wealth is unchanged as a result of this transaction, there is one important implication for the Treasury. Before the Fed made this open-market purchase, the Treasury was obligated to pay interest on those securities to someone in the private sector. Now as a result of the open-market purchase, the Treasury is making that payment to the Fed. The Fed in turn returns those payments back to the Treasury. You can see those payments from the Fed back to the Treasury each month in Table 4 of the Monthly Treasury Statement( GO TO FMS LINK ).

But wouldn't the Treasury want the Fed to simply buy up all of its outstanding debt, and relieve the taxpayers forever of that nasty burden? It might, but to do so would require so much new money creation that it would cause a horrific inflation. To avoid that, we have a careful separation of powers, asking the Fed to take responsibility for inflation and letting the Treasury worry about how to pay its bills.

The Fed could always use its power to acquire assets other than Treasury securities. For example, the Fed could make a loan to a private bank through its discount window. The bank receives the loan in the form of new deposits with the Fed, which again the Fed simply creates out of thin air. The receiving bank presumably used those deposits to pay somebody else, but that transaction simply transferred the Fed deposits to another bank, so that newly created deposits stay in the system until they are withdrawn as cash. The Fed in this case acquired an asset (the loan) whose value by definition exactly equaled that of the newly created deposits( OK ).

Alternatively, the Fed might want to add reserves to the banking system temporarily, to satisfy what it saw as a temporary liquidity need. Traditionally it would do so with a repurchase operation, in which the Fed temporarily takes ownership of an asset held by a dealer, and temporarily credits the reserves of the dealer in exchange. Essentially a repo is a collateralized short-term loan from the Fed to someone in the private sector.

There are some other categories of assets the Fed could acquire, and some other potential disposition of reserves it creates on the liabilities side. The chief among the latter that I will mention here is the Treasury's account with the Federal Reserve. This traditionally was used by the Treasury for cash management of its receipts and expenditures. Some of the deposits that the Fed creates (for example, with a discount window loan) might have ended up being transferred between banks (as individual customers send checks to customers of other banks) and ultimately end up in the Treasury's account (as income taxes get withheld, for example). Since the Treasury isn't going to withdraw these funds as cash, they're counted separately on the liabilities side of the Fed's balance sheet.

There are a lot of other little categories we could discuss, but historically there was really just one big story-- the Fed created deposits primarily by buying Treasury securities, and these ultimately ended up as cash held by the public( OK ). The left column of the table below summarizes the assets (factors supplying reserves) and liabilities (factors absorbing reserves) as of December 5, 2007. At that time, 85% of the Fed's assets were held in the form of Treasury securities, and 89% of its liabilities took the form of currency held by the non-bank public.

Balance sheet of the Federal Reserve.
(Based on end-of-week values, in billions of dollars). Data source: Federal Reserve Release H.4.1.

	Dec 5, 2007	Dec 17, 2008
Securities	779.7	493.8
Repos	46.5	80.0
Loans	2.1	1039.9
Other	92.0	733.0
Factors supplying reserve funds	920.4	2346.7
Currency in circulation	819.3	877.7
Reverse repos	36.7	71.9
Treasury accounts	5.1	484.6
Service and reserve balances	16.0	801.8
Other	43.4	110.7
Factors absorbing reserve funds	920.4	2346.7
Off balance sheet
Securities lent to dealers	4.5	186.5

Over the last year, however, there were some profound changes in the composition of the Fed's balance sheet. These initially were dictated by the desire of the Fed to make more loans (which it thought it needed to do to alleviate problems in the credit market) without creating any new money (which it worried would create inflation). The way the Fed sought to achieve this was by selling off a large chunk of its holdings of Treasury securities, and replacing them with loans and alternative assets. These came in a variety of shapes and colors, but the two biggest categories at the moment are the Term Auction Facility, which essentially is a systematic program to encourage a particular volume of borrowing by banks from the Federal Reserve, and amounted to $448 billion as of last week, and currency swap lines, the biggest factor in the "other" asset category reported on the Fed's H.4.1, said other category coming to some $682.4 billion last week. Up until September of this year, the Fed was implementing these changes without increasing the total level of assets on its balance sheet. The graph below plots the composition of the end-of-week asset holdings of the Federal Reserve over the last two years.

Federal Reserve assets in billions of dollars. Data source: Federal Reserve Release H.4.1..

Beginning in September, the Fed decided it couldn't afford to sell off any more of its Treasuries, but wanted to lend more and still have no effect on the money supply. To do so it needed to find a way to funnel the reserves created by the new loans it would make into categories on the liabilities side that would not result in more cash held by the public. The first such device was to reach an agreement with the Treasury for the Treasury to simply hold on to a huge volume of Federal Reserve deposits, some $484.6 billion as of last week. The way this worked is that two operations were implemented simultaneously. First, the Fed created a lot of new deposits, for example, $318.8 billion from the Commercial Paper Lending Facility alone. Second, the Treasury borrowed an additional half trillion from the public, forcing somebody in the public to send a check to the Treasury. In the aggregate, the reserves created by the Fed through the CPLF end up just being parked in the Treasury's account with the Fed, with no creation of money. The graph below plots the composition of the liabilities side of the Fed's balance sheet over the last year. By definition, the height of the line in the graph below is identical for every date to the height of the line in the graph above.

Federal Reserve liabilities in billions of dollars. Data source: Federal Reserve Release H.4.1..

The second measure that the Fed employed to allow this ballooning of its assets was to start paying banks an interest rate on reserves that is exactly equal to its target for the fed funds rate itself, essentially eliminating any incentive for the banks to lend fed funds and encouraging banks instead to simply let excess reserves accumulate. Last week, banks were sitting on about $800 billion in excess reserves with the Fed, doing absolutely nothing with them. The Fed was in effect lending those funds in place of the banks. I have been quite apprehensive about this scheme( I THOUGHT IT WAS AN INCENTIVE TO HOARD, AND NOT LOAN IN THE CURRENT SITUATION ), particularly now that we have reached a point where, in my opinion, the Fed in fact does want the money supply to increase so as to cause a little inflation. But the present arrangement makes it quite awkward for the Fed to do so( YEP ).

And what's the risk associated with the Fed's new strategy? Back when the Fed held $800 billion in Treasuries, these were a liability of the Treasury and an asset of the Fed. In effect, the Treasury's nominal obligation was one for which taxpayers would never owe a dime. Now that more than half of those securities have been lent or sold off by the Fed, and the Treasury has borrowed a half-trillion extra to make this work, that's more than a trillion extra for which the taxpayers are potentially on the line( OK ). If the loans and other assets that the Fed has acquired with those funds do not make a loss, then all is still well and good. But if the Fed's new loans do not perform, there won't be a positive receipt in the Monthly Treasury Statement corresponding to interest returned from the Fed to the Treasury. In other words, the federal deficit will rise by the amount of the extra interest the Treasury owes on up to a trillion dollars in new debt( THAT'S THE RISK ).

And how about the Fed's "free money" from the ballooning excess reserves? If those funds do start to end up as cash held by the public, then the Fed will need to worry again about inflation, in which case it has two options. One is to sell off some of its remaining assets (or fail to roll over some loans). In this case, the consequences for the Treasury are the same as above-- that income from the Fed's earnings is no longer coming back to the Treasury, and it's as if the $800 billion in excess reserves was again replaced by direct Treasury borrowing.

The second option is just allow the inflation.

The bottom line is that Bernanke has made a gamble with something approaching 2 trillion. If the gamble wins, taxpayers owe nothing. If the gamble loses, taxpayers are committed to borrow a sum equal to any losses and start making interest payments on it( THAT'S IT ).

For the record, let me reiterate my personal position on all this.

(1) I am doubtful of the Fed's ability to alter interest rate spreads through the kinds of compositional changes in its balance sheet implemented over the last two years. Whatever your prior ideas were about this, surely it's time to revise those in light of incoming data-- if the first trillion dollars didn't do the job, how much do you think it would take to accomplish the task? ( NOT SURE )

(2) I think the Fed's goal should be a 3% inflation rate( THAT'S REASONABLE ). Paying interest on reserves and encouraging banks to hoard them is inconsistent with that objective, as would be a new trillion dollars in money creation. ( ON THE FIRST POINT I AGREE. ON THE SECOND, WHAT WOULD THE INFLATION RATE BE ? )

I would therefore urge the Fed to eliminate the payment of interest on reserves( I AGREE ) and begin the process of replacing the exotic colors in the first graph above with holdings such as inflation-indexed Treasury securities and the short-term government debt of our major trading partners( WHICH PAY INTEREST ).

I think that this is a sensible moderate proposal, which would be great if it works. I simply believe that it might not work in creating inflation, but I hope that it does. I still think that we need to print money.

OK. Nick Rowe turned up in the comments with a more serious explanation of my concern:

"Let's compare the Fed's "gamble" with helicopter money.

With a "helicopter" increase in the money supply, the Fed's balance sheet shows a new liability, and no new asset( TRUE. THEY SIMPLY PRINTED MONEY AND GAVE IT AWAY ).

That is equivalent to the Fed buying an asset, with newly-printed money, and then the asset turning out to be worthless( TRUE ).

In other words, if you believe that a "helicopter" increase in the money supply is what is needed to get the economy out of a liquidity trap, then the destruction of the Fed's balance sheet net worth is exactly what the Fed is trying to achieve( YES ).

The only difference between helicopter money and the Fed's buying a worthless asset is in who gets the money: the person who picks it up off the ground (i.e. the one who receives the government transfer payment); or the person who sold the fed the worthless asset.

Let me put it another way: if it lost the gamble, the Fed would be forced to print money to make the same monthly transfer to Treasury, and this would be inflationary. But the expectation of future inflation is exactly what the Fed needs to create now, to escape the liquidity trap. This is a gamble the Fed wants to "lose".( TRUE )

Posted by: Nick Rowe at December 22, 2008 12:25 PM

Now a response from Hamilton:

"Nick Rowe: I agree that an increase in the monetary base is a good idea. I disagree that the appropriate number is a trillion dollars, or that uncertainty about what the number is going to be is a good thing."

Nick Rowe again:

"Uncertainty about the increase in the monetary base *is* a good thing, if the size of the increase in the money base is closely correlated with the amount that is needed, something about which we are equally uncertain.

The value of the Fed's risky assets is correlated with how quickly the economy returns to normal. If the economy returns to normal quickly, those assets will be worth a lot, and so the permanent increase in the money base will be very small. If the economy does not recover, those assets will be worth very little, and the permanent increase in the money base will be very large. And one trillion might not seem excessive in a worst case scenario.

So you have a negative-feedback equilibrating mechanism in place, created by the Fed's buying risky assets, the value of which is correlated with the Fed's success in getting the economy out of a deflationary slump.

It is as if Ben Bernanke made a very large bet, backed by the Fed's printing presses, about the future rate of recovery and inflation.

Posted by: Nick Rowe at December 22, 2008 01:19 PM

Now a question to Nick:

"Nick,

Not sure I understand your point on "helicopter money".

The Fed always has the option of asset backing a helicopter drop.

Why do it by debiting the Fed's capital position deliberately?

Posted by: JKH at December 22, 2008 01:20 PM"

Nick Rowe responds:

"JKH: "Helicopter money" is a *permanent* increase in the supply of money (by assumption), and it adds to private sector wealth, at the existing price level, (because it's just given away). These two features make it the most powerful form of increases in the money supply. Because it's permanent, it increases expected future price levels (which encourages people to spend money now). Because it's just given away, and increases household wealth (at the existing price level), you get a wealth effect on spending, not just the substitution effect (which is very weak or non-existent in a liquidity trap anyhow).

The purpose of "debiting" the Fed's capital position is to create the expectation that the Fed cannot buy back the money, so that it is seen as permanent, and thus more powerful.

Am doing a post on this at WCI now.

Posted by: Nick Rowe at December 22, 2008 02:09 PM"

I am essentially following Nick Rowe's reasoning in this. Thankfully he keeps commenting.

"If the new president had a target of full employment, and if Americans believed that he could reach it the confidence problem could be quickly solved

Robert J. Shiller has a post in the NY Times:

"IN the current crisis, discussions of economic policy have often centered on uninspiring, short-term goals. To restore confidence in our economic future, we need appropriate, firm targets that will clearly put us where we want to be."

I think that we can be excused for dwelling upon the immediate danger in these circumstances.

"For example, President-elect Barack Obama has framed his economic stimulus package in terms of the number of jobs he will create. The goal is to add 2.5 million jobs, he says, by hiring people to improve our highways, fix up our schools and do other infrastructure work around the country. All of that is fine, but it does not represent a commitment to full employment — providing a job for everyone who is willing to work. As a result, confidence remains abysmal.If the new president had a target of full employment, and if Americans believed that he could reach it, the confidence problem could be quickly solved."

I have spent years, ever since reading "The Share Economy", in trying to devise ways to get to full employment. Let me also remind readers that I favor, if I had my druthers, a Guaranteed Income with Health Care being provided within the bounds of that income. In doing this, I am following ideas first propounded by Milton Friedman, and most lately developed by Charles Murray. Within that guarantee, it would obviously be better to find ways for full employment.

"The Great Depression provides an analogy. Presidents Herbert Hoover and Franklin D. Roosevelt had at least a vague idea that economic stimulus would help the situation, but even Roosevelt lacked clear targets for such policies during the New Deal. The economic stimulus applied was inconsistent and inadequate. Confidence waned, and the depression was longer and deeper than it needed to be."

I don't agree with this. I believe that in many ways Roosevelt was more Conservative than Hoover, and found that, in the necessity of dealing with the Depression, he had to alter those beliefs as he went along. I would say that he was Pragmatic, and the fact that we survived is proof of his effectiveness. I've also tried reminding people of the context of the 30s, which is not our context, which was that many people believed that Capitalism was dead, and that Totalitarianism, namely Communism and Socialism, were the only choices. You simply cannot denude any decisions of that time, even Economic ones, of that context. His targets were necessitated by massive threats to our very survival.

"People still remember aspects of that depression history. The Works Progress Administration and the Civilian Conservation Corps tackled infrastructure projects, much as Mr. Obama proposes — but these New Deal programs were not enough to restore full employment. That history reduces the current credibility of Mr. Obama’s target of 2.5 million jobs."

That's because they were experimental, and were being tried out in order to assess their effectiveness.

"On the other hand, there have been some worthwhile targets in monetary policy in recent years. A number of central banks have adopted firm inflation targets, which has helped to contain inflation expectations. Those expectations have tended to coincide roughly with the targets."

I agree.

"At the moment, of course, inflation is no longer the fundamental risk. Our current problems are deflation and recession — possibly even depression — and so we must rethink our targets."

I agree.

"An immediate shift to a full employment target may not be possible, simply because there is no confidence right now that we can hit it. While people seem to believe that central banks can control inflation, there is little consensus that central banks can prevent a depression under circumstances like this."

Here's where I believe that I differ from him and most everybody else. I believe that, prior to Lehman, and even after for a time, people did in fact still believe that the government could avert and deal with this crisis effectively. There has been an ongoing deterioration in that belief throughout this year, with it being almost completely shattered by the performance and effectiveness of recent government policies. A large part of this deterioration, I believe, has to do with a general feeling that the Bush Administration will manage to make things worse. However, because this belief was so widespread and endemic to our actual system of governance and finance, there was no Plan B. Consequently, when the crisis hit, everybody had placed their bets on the government.

From a philosophical perspective, these assumptions limited and limit our possible responses, in the same way that a sentence's meaning is limited by its context and presuppositions. That's why, contrary to what many Kantians believe, you simply cannot toss in any theoretical plan that you can come up with and expect it to work in this context. In fact, it will be as effective as gibberish is in a conversation.

"In a forthcoming book I’ve written with Professor George A. Akerlof of the University of California, Berkeley, we argue that current circumstances call for a couple of intermediate targets. If we can hit them, we may credibly be expected to hit the ultimate target of full employment — and keep inflation at bay. The intermediate targets should be announced forcefully, with an immediate effort to achieve them."

Yes Sir. On the double, Sir.

"First, there should be an intermediate target for conventional fiscal and monetary policy, one ambitious enough to restore full employment in a typical recession. (Fiscal policy is the taxation and expenditure proposed by the president and voted by Congress; monetary policy is the province of the Federal Reserve Board.) "

What's the target?

"This target may be inadequate, however, because we are not in a typical recession. Conventional fiscal and monetary methods may fizzle, as they did in the 1990s in post-bubble Japan. After its stock market and real estate debacle early in the decade, the government of Japan moved its budget into deficit and brought interest rates down to zero. But the economy never entirely recovered, and in due course the government debt rose to 1.71 times the annual gross domestic product, versus a current multiple of 0.74 in the United States."

Does that mean that we might hit the target and yet that not prove target enough? Yes, we don't want to end in Japan's pickle. But we might.

"Similarly, we just do not know whether these measures will work in this country. That is why we also need a second intermediate target, for credit. The ability to borrow should be restored to an appropriate level for a normal economy at full employment."

I think that's what I've been calling a Credit Stimulus. I dimly remember expecting TARP to be that. Well, not really expecting. Praying, more like it.

"This is crucial because the most salient problem in our institutions is the drying up of credit. Without credit, companies that count on outside finance will go bankrupt, requiring an impossibly large fiscal and monetary policy stimulus to achieve full employment."

And your remedy is? Give us the most salient solution, friend.

"Furthermore, as long as the credit crisis continues, the economy’s response to conventional fiscal and monetary policy may be drastically reduced. A person who cannot borrow, for example, is unlikely to buy a car, even if a generous fiscal policy has provided him with the needed down payment. Under the current circumstances, the Keynesian “multiplier,” the economy’s response to fiscal policy, may be unusually low. Our best econometric models just won’t tell us how low."

Chuck them, mate.

"FOR months, the Fed has been working to expand credit, and has invented some good methods for doing so. On Nov. 25, it announced a smart method to jump-start credit, called the Term Asset-Backed Securities Loan Facility, which would issue loans, using securities backed by newly issued consumer and small-business loans as collateral. The Fed has started paying interest on reserves to control the inflationary impact of such a policy."

I think that paying interest on reserves was more like an incentive to save, rather than lend. But that's just me.

"This plan and others like it are promising. But all the government loan programs announced so far represent only a tiny fraction of the $52 trillion of total credit market instruments outstanding. We will need to go much further and extend credit to households and businesses that would otherwise be ignored."

Fine. How do we do that?

"Along with fiscal and monetary policy, credit needs to be targeted on a scale that would get us out of our current economic mess. That’s what Washington should do now."

It's fine to want full employment, but, unless he's arguing that the government just up and guarantee everybody a job, I'm not sure how to get it. If that's what he's saying, why not just say that the government should guarantee everybody a job?

The one point I definitely agree with him on is that this is a Crisis Of Confidence, and policies must address it.

"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.