In 2002, Ben Bernanke, then a member of the Federal Reserve's Board of Governors, spoke at a conference honoring Milton Friedman. Gov. Bernanke offered a public apology for the Fed's role in the Great Depression. Judging from the lengthy interview of the head of the Bank of Japan published in the Wall Street Journal on March 1, Gov. Masaaki Shirakawa is probably also expecting an apology from his Fed counterpart for second-guessing the BOJ's conduct of policy.
I was one of Bernanke's co-authors for an academic paper published in 2004 that did some of that criticizing. After seeing how other major central banks, including the Fed, handled similarly trying circumstances, I admit that Gov. Shirakawa has reason to feel aggrieved. In particular, the main point of contention, quantitative easing, is a policy that looks good on paper but has a flaw when implemented by a democratic central bank.
First is the theory. Quantitative easing works on the principle that the size and composition of a central bank's balance sheet influences financial markets and the economy over and beyond the direct effects of the level of the policy rate. When the BOJ or the Fed buys government securities, it pushes down their yields, pays for those purchases with reserves that banks may use to expand their own balance sheets, and signals that the policy rate will be kept low for some time. This works together to stir spending.
Second is the problem. Market participants have to be convinced that the central bank is committed to the policy for quantitative easing to be effective. If investors think the authorities will stop or reverse soon, then long-term yields will not move much nor will the extra reserves be used. Underappreciated in the theory (and the criticism) is that the monetary policies of major central banks, such as the BOJ, are decided by committees. Individual members do not usually see the world exactly in the same way. Because the balance of judgments may change over time, a decision at one meeting cannot presume the outcome of the democratic process at future committee meetings. As a consequence, policy statements tend to be hedged to foster compromise, making them tentative and undercutting the effectiveness of policies relying on a credible long-term commitment.
Ill effects of this drawback of democracy can be tempered if the central bank follows a policy rule. The BOJ ultimately did so, with the promise made in 2001 to keep the policy rate at zero as long as the price level was declining. The Fed has not yet seen fit to do so.
Evidently, getting from paper to practice is harder than it looks.
Vincent R. Reinhart is a resident scholar at AEI.