In 2003, Mr. Hubbard, like Mr. Bernanke, wrote about the economic problems in Japan, suggesting that the BoJ was making a colossal mistake by sterilizing monetary injections. He had no problems seeing that deflation had become a problem in Japan, and that the BoJ wasn’t helping its economy buy “faking” actions that might be helpful in stimulating a sustainable recovery.

In an article written by Mr. Hubbard and published by AEI in 2003, Hubbard described the Japanese problem thus (emphasis added):

Some in the U.S. have expressed concern that repeated Japanese currency interventions are unhealthy for the U.S. and the global economy. In Japan, there is a realistic fear that an appreciating yen will choke off the fledgling recovery. A deeper issue missing from the conversation is that monetary policy is too restrictive in Japan, reducing Japanese growth and collaterally damaging the U.S. and global recovery.

The clear sign that monetary policy remains too tight is the continuing deflation and expectation of deflation in Japan… The high real returns from holding cash further retard willingness to hold riskier, more productive assets. Deflation also weakens consumer spending by leading households to postpone purchases.

…  Japanese currency interventions are not likely to assist the Japanese economy as long as they are sterilized. (In a sterilized intervention, the central bank conducts offsetting transactions to leave the monetary base unchanged.) While anecdotal evidence seems to indicate that recent Japanese currency interventions have been unsterilized–thereby contributing to monetary expansion–the data are not so clear. In any event, a strategy of monetary expansion through a series of ad hoc unsterilized interventions is not the best way to advance the expansionary policy Japan needs.

Bank of Japan Governor Toshihiko Fukui has commented on several occasions on the need to restore a reference price level in Japan. The BoJ could define the price-level gap it wants to make up, and announce that it will undertake any and all measures to achieve this reflation. The precise tactics are less important than articulating the strategy. But follow-through will be essential. Stop and go policies toward operating targets should give way to more aggressive expansion.

A sustained, credible monetary expansion in Japan to restore price stability may well weaken the foreign-exchange value of the yen in the near term (consistent with the objective of the ad hoc interventions). But the reflationary monetary policy importantly will reduce the many effective tax burdens deflation exacts from the private economy. The longer-term effect on the yen’s value is ambiguous because a vigorous, recovering Japanese economy may, all else being equal, result in a stronger currency.


So let me be sure I understand what he’s saying here:

  1. Deflation is bad because of the “high real returns on holding cash”
  2. The BoJ isn’t going to get anywhere by pretending to do something meaningful, sterilizing its expansion
  3. The BoJ could announce a new price level and pledge to do what it takes to get there – and actually start doing it
  4. The long term effects of a recovering economy would likely be a stronger currency

From the Market Monetarist perspective, there is little to disagree with, with the exception that inflation targeting presents a perceptional problem and communications difficulties that need not exist. There is much more to the debate over inflation targeting vs. NGDP level targeting that I don’t need to bring up for purposes of this post, so I will leave there where it is.

That was Mr. Hubbard in 2003 with an opinion that I think can be considered reasonably objective.

By the time 2008 rolls around however, Mr. Hubbard’s opinion has dramatically changed in this article published by AEI entitled “Are We Expecting Too Much From the Fed?” Here are some quotes from it:

The combination of eye-popping headline inflation of 5% year over year and dramatic expansions of the Federal Reserve’s lending activities to limit the credit crunch raise a key question: Are we asking too much of monetary policy?

The simple answer is yes. The expansion of the Fed’s lending has been extraordinary in scale and scope. But it is not the best response to the present credit crunch, and may bring unwelcome side effects.

I agree. It wasn’t the best response. The best response would have been to have nothing to respond to out of reacting to headline inflation. But there is more:

To assess the Fed’s role as firefighter in the current financial turmoil, it is useful to start with the roots of the problem. Shocks to financial institutions’ net worth affected the supply of credit from those institutions. Such credit restrictions reduced consumption and investment–otherwise known as a “credit crunch.” The Fed’s interventions have, of course, aimed at liquidity–the ability to fund increases in assets and meet obligations as they become due.

What are the roots of the shocks to financial institutions’ net worth? He doesn’t say – but perhaps as he was writing this piece in July of 2008, it could have been that these asset prices were screaming that we were going over the deflationary cliff.

Of course, the Fed should not ignore systemic risk just to limit moral hazard. But if liquidity intervention is inevitable, the central bank must be able to supervise and regulate the beneficiaries of its liquidity insurance. Otherwise, such insurance fans moral hazard by failing to discourage taking on still more liquidity risk (read: the most recent crisis). And making that insurance more available simply raises this concern (read: where we are now).

Isn’t this just like a statist. After the financial system has been flung off the tight money cliff, it is now time to be concerned about moral hazard involved in liquidity injections and supervising the victims. The economy has been hurled into the vortex of the giant crapper from the deep hot place in a hand basket, and the statists believe it is time to pick and choose potential survivors and bend them over the barrel. These Bush guys are just great, aren’t they? Such heroes!!

The events of the past three years highlight that risk misperceptions in a boom can lead to a scramble for liquidity if collateral values decline. Ascertaining this problem in real time will always be tough for regulators (even for the increased number of regulators the Treasury recently proposed).

Importantly, Bagehot’s admonition goes on to say: “The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times.” That is, regulation of capital adequacy could require more capital to support incremental risk-taking in a boom, and lower such capital in a bust. With such requirements, financial institutions would find risk-taking marginally more costly in a credit boom, in which credit risk and liquidity risk are very low. In a downturn, a scramble for liquidity to meet capital requirements would be attenuated.

This is an interesting side note considering Mr. Hubbard was instrumental in the reserve requirement reductions for security purchases from the Government Sponsored Enterprises, Fannie and Freddie. Having written several economics textbooks about financial markets and being Chair of the CEA made him the go-to guy for stimulating homeownership. If he didn’t know how all of that happened, he should have. But that was probably someone else’s problem too, right? Of course there is also a problem that in the middle of an unfolding crisis is NOT the time to talk about increasing reserve requirements or play around with ideas like IoR – but they did it anyway; no doubt following his advice.

We have been down this road before. In the aftermath of the 2001 recession, the Fed maintained the federal-funds rate below the rate of inflation even after the pickup in aggregate demand following the 2003 tax cut and the economy’s recovery. The failure to normalize rates in a more timely way contributed both to house-price appreciation and to inflationary pressures. By contrast, the Fed’s policy normalization in the mid-1990s built the Fed’s inflation-fighting credibility without damaging the continued recovery from the 1990-1991 recession.

The current policy stance of holding the federal funds rate at 2% will keep monetary stimulus in place. With inflationary expectations not declining, this stimulus will almost surely raise inflationary expectations as the economy improves. This consequence can be seen already in surging commodity prices and the weakness in the foreign-exchange value of the dollar.

It is worrisome that the Fed’s own 2008 projections have risen over the year both for headline inflation (by about 1.5 percentage points) and core inflation (by about 0.2 percentage points). Furthermore, the Fed’s projections of receding inflation in 2009 and 2010 coming true will almost surely require increases in the federal funds rate.

A continuation of a negative real federal funds rate and the increase in money growth accompanying it raises the risk of increasing inflationary expectations, a costly mistake to fix.

So where was the immediate inflation problem? He says so – headline and I think he should know that the Fed doesn’t have any control over headline inflation. It would be interesting to see if he can justify the inflation jitters based on his comments here. And why – oh why – would we increase in the FF rate in the face of declining inflation? Maybe now is a good time to do it then since velocity has collapsed? You know, I am so glad I never wasted money on any of this guy’s books.

The overall problem with the idea here is that the value of the dollar had started to soar and he cites weakness. TIPS had started to decline and his sites inflation expectations not declining. It reminds me of someone going outside, not bothering to look at leaves on the trees turning gold, and declaring it spring because it’s a warm day.

Which problems are more costly to fix? Is it problems created from being wrong and erring on the side of tight money or is it erring on the side of allowing headline inflation to take care of itself? I think history, especially of the calamity that was the Great Depression, has the unequivocal answer to that.

And last but not least, Mr. Hubbard illustrates for us that there is no shortage of hubris and irony among Washington elites:

It is asking a lot for monetary policy alone to carry the burden of supporting aggregate demand. Fiscal policy can play a role. Congress and President Bush did pass an economic stimulus package centered on tax rebates. But clarity about a positive future for the 2001 and 2003 tax cuts which bolster collateral values–along with a cut in corporate tax rates to promote investment–would offer a much more potent tonic.

While the Fed’s heeding of Bagehot’s “lend freely” advice has been in some ways helpful, central bankers may also want to note the limits contained in his earlier comment in “Physics and Politics” that “[a]n inability to stay quiet . . . is one of the most conspicuous failings of mankind.

Whose inability to stay quiet should we really be concerned about?