The limits to irresponsibility

Traditionally, international commentators have been critical of the way the Japanese tried to revive their economy following the stock and property crash in the early 1990s. There are typically two parts to this criticism: (i) the Japanese (notably the BoJ) acted too slowly after the crash, allowing private-sector expectations to gradually turn deflationary, and; (ii) they were not brave enough when it came to thinking about and introducing 'unconventional' policies.The strong consensus in the West, associated with the research of Paul Krugman and Ben Bernanke, was that central banks would always be able to prevent/end deflation if only they were prepared to do radical things. Indeed, for such policies to work, Krugman claimed policymakers had to be 'credibly irresponsible'.

As it turned out, of coure, Ben Bernanke was well placed to implement the lessons he learned from the Japanese experience. As Fed Chairman responding to the US fiancial crisis, he adopted unconvetional quantitative easing within months, rather than waiting years as the BoJ had done. And as the recovery has faltered, the Fed has quickly turned to other unconventional policies - most notably the Fed's apparent commitment to keep the Fed Funds rate on hold into 2013.

But Mr Bernanke has surely also developed a better appreciation of the constraints on 'credibly irresponsible' policy. While as an academic it might be possible to sing the virtues of radical policies, policymaking intitutions are simply not designed to accommodate them. In particular, monetary-policy decisions are taken by committees and it will always be dificult to find a consensus for policies that look irresponsible. Then there is the Chairman's reputation to think about. Taking radical action will make you a hero if it works out, but if it doesn't (and especially if there is a strong consensus it wont) history will remember you as a comedy figure.

It is not surprising then that Bernanke's policies have not been as radical as one might have expected based on the speech he gave in late 2002. Yes, the Fed quickly adopted quantitative easing, but a lack of consensus on the FOMC now seems to be halting this particular policy response. And even the commitment to keep the Fed funds rate unchanged till 2013 wasnt really a commitment or a promise, it was simply a forecast. If the Fed's growth and infltion forecasts change, so will this part of the forecast.

QE3 now seems imminent. This will most likely involve selling short term paper and using the proceeds to buy longer-term bonds, with the aim of pushing down long-term interest rates. The Fed prefers this option because it wont increase the overall size of its balance sheet and so minimizes inflation risks. The very mention of inflation risk shows the FMOC is a long way from adopting 'credibly irresponsible' policies.
Yet, the Japanese experience suggests these might be the only policies that work. So while Macro Maestro accepts there is no theoretical reason why the Fed can't prevent deflation (create inflation), practically it might not be willing to do what is necessary. (Which makes him wonder, are independent central banks ultimately doomed?)