What Should the Central Banks Do?

Monday is central banking day. The media is alight with the latest meme, that austerity is dead, along with the prospects of Nicolas Sarkozy. The French president, of course, is trailing socialist François Hollande in the presidential runoff, which is less than a week away; and the French public's apparent interest in stimulus only follows the fall of the Dutch government last week. Then there's Spain, now pondering, according to the Financial Times, a good bank, bad bank, though how the bad bank is going to get financed is still an open question. But the central banks remain, well, central. In the New York Times Magazine, Princeton economist Paul Krugman leads off by hammering Ben Bernanke at the Federal Reserve for being too passive, particularly in terms of inflation targeting, despite a well-known 2000 paper by then-Princeton economics professor Bernanke criticizing the Japanese for not being Rooseveltian enough in the face of deflation. ("Rooseveltian" is interesting and revealing because FDR was, of course, president, not running the central bank.) Krugman's case, as usual, is clear, cool and smoothly rational -- to a fault. And for those who don't think the world fits together quite so seamlessly, the FT has a piece warning about central banks losing their credibility and independence if their (relative) activism goes awry.

It's pretty clear that Krugman was right about austerity; he was not alone in this, but he had the bulliest pulpit around. He may well be right about the need for the Fed, not to say the European Central Bank, to loosen the bolts on inflation a bit to work down unemployment. Krugman is so certain that a modicum of inflation is the answer that he barely pauses to argue for it: it appears to him evidence enough that Bernanke once supported it, at least in the Japanese context. The bulk of Krugman's essay is to wonder why Bernanke went from Rooseveltian to Bushian once he became a Fed governor in 2002. Krugman even locates it in time (citing research by Laurence Ball of Johns Hopkins): 2003, when Fed staff wrote a report dumping all over Bernanke's earlier activist ideas. In a delicious moment of academic self-regard, Krugman takes affront by that report. Bernanke, he says, was "a towering figure in his field. Why should he have taken his cues from a staff report?" Maybe because the staff reported to the now invisible but then smotheringly dominant force at the Fed, Alan Greenspan.

Bernanke, by the way, responded to Krugman's critique in a press conference last week that argued that Japan was different because it was in deflation. (In case you were wondering, the magazine piece appeared last Tuesday.) In his blog, Krugman sniffed that this was "pretty disappointing."

Anyway, whether Bernanke was bullied by right wingers (the FT, not Krugman, quotes Texas Gov. Rick Perry that Bernanke was "treasonous") or captured by what he calls the "Fed Borg," or done in by his "shy personality" (another interpretive contribution from Ball), Bernanke, in Krugman's view, hasn't done enough. In fact, replace Krugman with Romney, and Bernanke with Obama, and you've got the basic outline of the general election. But Krugman, who as a public polemicist is never a man of grays, does discount the complex effect of politics on a) a sitting president as opposed to a stumping candidate, and b) a Fed chief with responsibility for a beleaguered institution and an academic who can freely write just about anything he wants without the public knowing or caring. Krugman admits that the attempt to raise inflation could "lead to an embarrassing failure. When buying government bonds, on the other hand, the Fed can always claim that the policy worked, because it can insist that things would have been even worse without its actions. So by retreating to a narrow definition of the Fed's role, Bernanke has also adopted a position that is much more comfortable for the Fed as an institution."

Is that so bad? Is that so inexplicable? Well, it is to Krugman who thinks Bernanke has wimped out; but Krugman is a mere economics professor and columnist, though, like Bernanke, "a towering figure." It's easy for him to downplay the treacherous waters swirling around central banks -- the very subject of the FT piece today. The FT reviews the extraordinary steps the major central banks took to soften the blow and the continued policy of nearly 0% short-term interest rates and is worried about how they exit, not how they take even more aggressive steps. "Even if the willingness to buy sovereign debt is not monetary financing, it has blurred the distinction between monetary and fiscal policy. With the banks' veneer of independence tainted, politicians increasingly consider the world's monetary authorities fair game. Both candidates in this week's French presidential election ... have attacked the ECB for failing to do enough to promote growth and stability." And then there's Perry, not to say Ron Paul, calling Bernanke names. Recall that the GOP crowd cheered Perry's statement.

The FT concludes that we may be seeing the return to a more traditional central banking emphasizing stability more than full employment or inflation. The paper then wheels out shy Ben himself to defend that view, albeit with that bland balancing of statements that they must teach would-be central bankers at the Bank for International Settlements. "My guess is that the current framework for monetary policy ... will remain the standard approach. However, central banks are also heeding the broader lesson, that the maintenance of financial stability is an equally critical responsibility."

The FT may be overselling this one. It's a little difficult to see the ECB pursuing stability, as the Germans would like, if Spain collapses or is set ablaze by unemployed workers (or by Portugal, Italy, Ireland or even France). Bernanke has a better chance to adhere to go-it-slowly policies in the U.S. because austerity has not bitten quite so hard and recovery has been unfolding. Again, from a purely economic base, it's hard to argue with Krugman, but you better be very careful with an inflation policy (and, if it works, you may well be setting up a ripe temptation for pols and policymakers down the line; we've been here before, of course.) But in arguing the case for the primacy of economic action, Krugman blithely ignores the difficult situation of central banking in the modern world. Politics, institutions and feverish ideas beyond the walls of the rational still matter a lot.

Originally published at The Deal.