MacroScope

Of all the questions Federal Reserve Chairman Ben Bernanke was asked during his press conference on Wednesday, one appeared to pique his interest in particular: Was he being less aggressive as central bank chairman than the advice he dished out to Japan as an academic in the 1990s would prescribe?

It was the second half of the question asked by Binyamin Applebaum and yet the chairman was eager to get right to it: “Let me tackle that second part first,” he began.

Applebaum may have been channeling the Nobel-winning economist Paul Krugman, a Princeton colleague of Bernanke’s and critic of Fed policy, who recently argued the Fed chief was being inconsistent and overly cautious.

Bernanke argued that the Fed has done a lot already to support growth and bring down unemployment. Actively aiming for higher inflation with additional use of unconventional tools would risk the central bank’s long-term credibility. Here is his answer in full:

So there’s this view circulating that the views I expressed about 15 years ago on the Bank of Japan are somehow inconsistent with our current policies. That is absolutely incorrect. My views and our policies today are completely consistent with the views that I held at that time.

The reality of  ‘political economy’  is something that irritates many economists – the ”purists”, if you like. The political element is impossible to model;  it often flies in the face of  textbook economics;  and democratic decision-making and backroom horse trading can be notoriously difficult to predict and painfully slow.  And political economy is all pervasive in 2010 – Barack Obama’s proposals to rein in the banks is rooted in public outrage; reading China’s monetary and currency policies is like Kremlinology; capital curbs being introduced in Brazil and elsewhere aim to prevent market overshoot; and British budgetary policies are becoming the political football ahead of this spring’s UK election. The list is long, the outcomes uncertain, the market risk high.

But nowhere is this more apparent than in well-worn arguments over the validity and future of Europe’s single currency — the new milennium’s posterchild for political economy.

For many, the euro simply should never have happened –  it thumbed a nose at the belief that all things good come from free financial markets; it removed monetary safety valves for member countries out of sync with their bigger neighbours and put the cart before the horse with monetary union ahead of fiscal policy integration. But the sheer political determination to finish the European’s single market project, stop beggar-thy-neighbour currency devaluations and face down erratic currency trading meant the  currency was born and has thrived for 11 years.

The Federal Reserve has gone on the offensive to sell its exit strategy to investors and the public, in the hopes that it can stall an increase in inflation expectations. The effort was first launched by Fed Board Governor Kevin Warsh, who argued in a Wall Street Journal editorial, followed by a speech, that when the time came for Fed tightening, policymakers might have to move quickly. Even Bernanke, whose Great Depression expertise usually pegs him as a dove, was particularly meticulous about describing the Fed’s stimulus-withdrawal tools this week, sending the bond market into a tailspin.

But with the unemployment rate rapidly climbing toward 10 percent — and expected to remain up there for the foreseeable future, some economists are telling Fed officials to hold their horses. Paul Krugman, in his blog, makes a vehement case for an ultra-dovish policy stance. He calculates that the ideal fed funds rate given current economic conditions should be, get this, -5.6 percent. In another post, he argues that even if the U.S. economic recovery is more robust than most believe, the Fed should still keep rates at rock-bottom lows for at least two years.

So where’s the case for monetary tightening? For some reason many Fed officials seem to view it as inherently unsound to stay at a zero rate for several years running — but I’m at a loss to understand what model, or even conceptual framework, leads them to that conclusion. One gets the impression of officials who have decided that they want to tighten, and are making up new conceptual frameworks on the fly to justify their desires.

On Monday, Nobel-laureate Paul Krugman wrote that Treasury Secretary Timothy Geithner’s plan was not only doomed to fail, it was, in fact, filling him with despair.

But life can’t be all despair for the Princeton prof. Earlier this month, an enterprising songwriter named Jonathan Mann wrote a catchy little diddy wondering why the New York Times columnist wasn’t in the corner office at 1500 Pennsylvania Avenue.

Tell us what you think. Should Obama dump Tim and put in Paul?

Posted by Alister Bull

Highly regarded Federal Reserve historian Allan Meltzer has some sharp words for journalists calling for his views on whether the United States is heading for a Japan-style bout of deflation.

“The last time somebody asked me that question it must have been the fifteenth time that I’d heard it, and I said that it must be the most stupid question I’ve heard in 40 years of dealing with the press,” he told the Cato Institute during its annual monetary policy conference this week.

“It is time that the people talking about deflation go back to school and learned about the difference between maintained rates of change and one-time changes in level,” he lectured the high-powered audience of economists, which included Fed Vice Chairman Donald Kohn and Richmond Fed President Jeffrey Lacker.