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Ego Inflation

Can the new Fed chair resist the lure of his own pet theories?

From Alan Greenspan to Benjamin Bernanke: The transition at the Federal Reserve is from insider to academic, from man of action to man of ideas. Greenspan's Ph.D. was awarded by New York University in 1977 as a decoration; he didn't do any work for it. Bernanke, on the other hand, has stellar credentials: summa cum laude from Harvard, Ph.D. from MIT, professorship at Princeton. But apart from a few months at the Council of Economic Advisers, Bernanke has never run anything larger than an economics department. Greenspan ran the Fed for 19 years without ever losing a vote.

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Bernanke is known as a model professor. He has a careful mind, an open manner, a not-very-partisan disposition. (He helped recruit Paul Krugman to Princeton, after all -- did Bush realize this?) He has written about monetary theory for years; his views are known and settled. Thus the transition is also partly from obscure prose and flexible belief to clarity and conviction.

It sounds great. But at least since Mary Shelley, wise voices have warned that academics in the grip of big ideas can be dangerous. There is the awful temptation to test one's views. And if you happen to be chairman of the Federal Reserve, you're using the entire country as your lab.

Bernanke's big idea is "inflation targeting" -- the notion that the Federal Reserve should set a numerical inflation objective and pursue that over all other goals, raising rates when inflation exceeds the target and cutting them when inflation falls below it. (He coauthored a book on this in 1999; I gave it a harsh review.) This policy would depart from the Fed's legal mandate, which requires it to pursue "full employment" and "balanced growth" in addition to "reasonable price stability." Bernanke's rule would also force changes in current practice. Though under Greenspan the Fed always cited the threat of inflation when raising interest rates, in fact, it acted for a wide variety of reasons, stated and unstated; one of Greenspan's defining traits was his unwillingness to be pinned down to any simple policy rule.

Sometimes inflation targeting is harmless. In 2002, Bernanke used it to help argue for lower interest rates. He felt that after 9/11 the danger was of deflation, which hurts those with debt, like most homeowners. There was really very little chance of deflation in 2002 (overall wages and prices in advanced industrial countries rarely decline); the real risk was of a financial panic. Targeting helped sell the correct policy -- lower interest rates -- but since the forecast was spurious the episode was no great proof of Bernanke's theory.

Inflation targeting would be much more dangerous if applied today. Recently we've seen a small spate of inflation, most of which is due to rising oil prices brought on by the war in Iraq, the hurricanes along the Gulf Coast, and plain old speculation. Suppose the Fed were following a 2 percent inflation target and the "oil shock" pushed overall price increases up to 3 or 4 percent. Should the Fed raise interest rates in response?

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