Many of these have spent substantial parts of their careers studying ‘depression economics’: the Great Depression of the 1930s, the Japanese slump of the 1990s, or both. What informs the policy choices and strategies in these institutions at the current juncture are therefore, among other things, the lessons drawn from the past, including past mistakes.
The people
A list of the most important of these individuals reads like a who’s who of modern central banking:
- Ben Bernanke at the Fed: the foremost scholar on the economics of the Great Depression, he has also contributed to the study of Japan’s slump, including policy recommendations on how to deal with it;
- Athanasios Orphanides of the ECB : who has written papers on Japan and monetary policy at the Zero Lower Bound;
- Adam Posen of the Bank of England: who has written a long series of research papers on Japan);
- Lars Svensson at Sweden’s Riskbank: author of leading contributions on Japan and how to escape deflation.
These people are – to a greater or lesser extent – instrumental in shaping the policy response of the Global Central Bank. Importantly, the influence they exert over monetary policy goes beyond their voting power or the weight of their office in the institutional hierarchy. Through their research, they have shaped the thinking of a generation of economists – very likely including many of their colleagues on the various monetary policy committees.
The policies
So, what are the conclusions from this study of the past for monetary policy?
1. Avoid Deflation at All Costs
This is the policy lesson the study of the past offers above all others. How the US emerged from deflation and the Great Depression in the 1930s is not yet well understood, while Japan still hasn’t emerged from deflation. Worse, there is still no consensus today about how to escape deflation once the economy falls into such a state. Cognisant of this, economists’ single most important policy recommendation regarding deflation is: do not allow it in the first place!
The practical monetary policy implication of this is to be aggressive and, perhaps more importantly, to be proactive in the face of downside risks. All of the above policy-makers would agree that the Bank of Japan failing to act decisively contributed to Japan falling into, and remaining stuck in, deflation. It is this stance, we think, that explains the Fed’s QE2 and Operation Torque, as well as the Bank of England’s decision to relaunch QE recently – all measures taken pre-emptively in the face of mounting downside risks, rather than in response to such risks once they have materialised.
2. Err on the Side of Caution When Exiting
The past also offers insights about what not to do. Premature monetary tightening aborted the recovery out of the Great Depression in the 1930s. And Athanasios Orphanides emphasises that an early tightening of monetary policy by the Bank of Japan contributed to the 2001 recession (the BoJ tightened in August 2000).
The policy prescription therefore is to avoid premature tightening, as this could tip the economy (back) into recession or deflation. The way we would put it is: err on the side of caution when exiting – in other words, it’s better to exit too late rather than too early.
There are risks.
Aggressive monetary policy to avert deflation and ensuring one does not exit prematurely does not come without risks of its own – there is, after all, no free lunch. In particular, erring on the side of caution likely implies exiting too late, which in turn means elevated medium-term inflation risks. Yet, it is rational for a risk-averse central bank to prefer the lesser of two evils: if inflation is the price for avoiding deflation, then so be it – because central banks know how to deal with inflation.
To quote Adam Posen again: “I’d certainly rather have us temporarily overshooting by around 1% than facing oncoming deflation.”
This is one of the main reasons why we see inflation risks skewed to the upside over the medium term. But if we get to a medium term with higher inflation, it will mean that we did not fall into a deflation trap, and that’s because policymakers have learned the right lessons from the past – not least thanks to people like Bernanke, Orphanides, Posen and Svensson.
