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mechanism. These errors are shared by many FOMC members and by senior staff. They are worth outlining here, because they serve as a warning as to what can happen when the research and economic analysis underlying monetary policy making become too insular and inward-looking, and motivated more by the excessively self-referential internal dynamics of academic research programmes than by the problems and challenges likely to face the policy- making institution in the real world.
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risks he indentified where a financial instability/collapse-led sharp contraction in economic activity. This is the “precautionary principle” (PP) applied to monetary policy. At times of high uncertainty, policy should be timely, decisive and flexible and focused on the main risk.
Even where it is applied correctly, I don’t think much of the PP. Except under very restrictive conditions, unlikely to be satisfied ever in the realm of economic policy making, I consider the behaviour it prescribes to be pathologically risk-averse. In its purest incarnation - under complete Knightian uncertainty - it amounts to a minimax strategy: you focus all your policy instruments on doing as well as you can in the worst possible outcome. Despite its axiomatic foundations, the minimax principle has never appealed to me either as a normative or a positive theory of decision under uncertainty.
But I don’t have to fight the PP, or minimax, here. The application of the PP to the monetary policy choices made by the Fed in 2007 and 2008 is bogus. The PP came to the social sciences from the application of decision theory to regulatory decisions involving environmental risk (global warming, species extinction) or technological risk (genetically modified crops, nanotechnology). Its basic premise in these areas is “... that one should not wait for conclusive evidence of a risk before putting control measures in place designed to protect the environment or consumers.”(Gollier and Treich (2003)). For instance, Principle 15 of the 1992 Rio Declaration states “Where there are threats of serious or irreversible damage, lack of full scientific certainty shall not be used as a reason for postponing cost- effective measures to prevent environmental degradation”.
Attempts to make sense of the PP in a setting of sequential decision making under uncertainty lead to the conclusion that, for something like the Rio Declaration version of the PP to emerge as a normative guide to behaviour, all of the following must be present (see Collier and Treich (2003) from which the following sentence is paraphrased): a long time horizon, stock externalities, irreversibilities (physical and socio-economic), large
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uncertainties and the possibility of future scientific progress (learning). Short-term policy should keep the option value of future learning alive. When the long-term effects of certain contingencies are unknown (but may be uncovered later on), it may be optimal to be more cautious in the early stages of the sequential management of risk.
I believe the analysis of Collier and Treich to be essentially correct. The question then becomes: what does this imply for whether the Fed, in the circumstances of the second half of 2007 and the first half of 2008, did the right thing when it cut the official policy rate from 5.25 percent to 2:00 percent rather than cutting it by less, keeping it constant or raising it? The Fed decided to give priority to minimising the risk of a sharp contraction in real economic activity. It accepted the risk of higher inflation. How does this square with the PP?
The answer is: not very well at all. There is no irreversibility involved in a sharp contraction in economic activity. Mishkin’s rather vague ‘non-linearities’ are no substitute for the irreversibility required for the PP to apply. This is not like a catastrophic species extinction or a sudden melting of the polar ice caps. The crash of 1929 became the Great Depression of the 1930s because the authorities permitted the banking system to collapse and did not engage in sustained aggressive expansionary fiscal and monetary policy even when the unemployment rate reached almost 25 percent in 1933. In addition, the international trading system collapsed. The Fed as LLR and MMLR has effectively underwritten the balance sheet of all systemically important US banks (investment banks as well as commercial banks) with the rescue of Bear Stearns in March 2008. Current worries about the international trading system concern the absence of progress rather than the risk of a major outbreak of protectionism.
Most of all, should economic activity fall sharply and remain depressed for longer than is necessary to correct the fundamental imbalances in the US economy (the external
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trade deficit, excessive household indebtedness and the low national saving rate), monetary and fiscal policy can be used aggressively at that point in time to remedy the problem. There is no need to act now to prevent some irreversible or even just costly-to-reverse catastrophy from occurring. Boosting demand through expansionary monetary and fiscal policy is not hard. It is indeed far too easy. We are also not buying time to uncover some new scientific fact that will allow us to improve the short-run inflation-unemployment trade off or to boost the resilience of the economy to future disinflationary policies. Cutting rates to support demand does not create or preserve option value.
If anything, the (weak) logic of the PP points to giving priority to fighting inflation rather than to preventing a sharp contraction of demand and output. Output contractions can be reversed easily through expansionary policies. High inflation, once it becomes embedded in inflationary expectations, may take a long time to squeeze out of the system again. Is the sacrifice ratio is at all unfriendly, the cumulative unemployment or output cost of achieving a sustained reduction in inflation could be large. The irreversibility argument (strictly, the costly reversal argument) supports erring on the side of caution by not letting inflation and inflationary expectations rise.
‘Fat tails’ and other decision theory jargon should only be arbitraged into the area of monetary policy if the substantive conditions are satisfied. They are not.19 With existing policy tools, we can address a disastrous collapse in activity if, as and when it occurs. There is no need for preventive or precautionary action.