Ben S Bernanke: Panel discussion: what have we learned since October 1979?
Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, to the Conference on Reflections on Monetary Policy 25 Years after October 1979, Federal
Reserve Bank of St Louis, St Louis, Missouri, 8 October 2004.
The references for the speech can be found on the Board of Governors of the Federal Reserve System's website.
* * *
The question asked of this panel is, "What have we learned since October 1979?" The evidence
suggests that we have learned quite a bit. Most notably, monetary policy-makers, political leaders, and
the public have been persuaded by two decades of experience that low and stable inflation has very
substantial economic benefits.
This consensus marks a considerable change from the views held by many economists at the time
that Paul Volcker became Fed Chairman. In 1979, most economists would have agreed that, in
principle, low inflation promotes economic growth and efficiency in the long run. However, many also
believed that, in the range of inflation rates typically experienced by industrial countries, the benefits of
low inflation are probably small - particularly when set against the short-run costs of a major
disinflation, as the United States faced at that time. Indeed, some economists would have held that
low-inflation policies would likely prove counterproductive even in the long run, if an increased focus
on inflation inhibited monetary policy-makers from responding adequately to fluctuations in economic
activity and employment.
As it turned out, the low-inflation era of the past two decades has seen not only significant
improvements in economic growth and productivity but also a marked reduction in economic volatility,
both in the United States and abroad, a phenomenon that has been dubbed "the Great Moderation."
Recessions have become less frequent and milder, and quarter-to-quarter volatility in output and
employment has declined significantly as well. The sources of the Great Moderation remain somewhat
controversial, but as I have argued elsewhere, there is evidence for the view that improved control of
inflation has contributed in important measure to this welcome change in the economy (Bernanke,
2004). Paul Volcker and his colleagues on the Federal Open Market Committee deserve enormous
credit both for recognizing the crucial importance of achieving low and stable inflation and for the
courage and perseverance with which they tackled America's critical inflation problem.
I could say much more about Volcker's achievement and its lasting benefits, but I am sure that many
other speakers will cover that ground. Instead, in my remaining time, I will focus on some lessons that
economists have drawn from the Volcker regime regarding the importance of credibility in central
banking and how that credibility can be obtained. As usual, the views I will express are my own and
are not necessarily shared by my colleagues in the Federal Reserve System.
Volcker could not have accomplished what he did, of course, had he not been appointed to the
chairmanship by President Jimmy Carter. In retrospect, however, Carter's appointment decision
seems at least a bit incongruous. Why would the President appoint as head of the central bank an
individual whose economic views and policy goals (not to mention personal style) seemed, at least on
the surface, quite different from his own? However, not long into Volcker's term, a staff economist at
the Board of Governors produced a paper that explained why Carter's decision may in fact have been
quite sensible from the President's, and indeed the society's, point of view. Although the question
seems a narrow one, the insights of the paper had far broader application; indeed, this research has
substantially advanced our understanding of the links among central bank credibility, central bank
structure, and the effectiveness of monetary policy.
Insiders will have already guessed that the Board economist to whom I refer is Kenneth Rogoff,
currently a professor of economics at Harvard, and that the paper in question is Ken's 1985 article,
"The Optimal Degree of Commitment to an Intermediate Monetary Target" (Rogoff, 1985).1 The
insights of the Rogoff paper are well worth recalling today. Rather than considering the paper in
isolation, however, I will place it in the context of two other classic papers on credibility and central
bank design, an earlier work by Finn Kydland and Edward Prescott and a later piece by Carl Walsh.
As I proceed, I will note what I see to be the important lessons and the practical implications of this line
of research.2
Central bankers have long recognized at some level that the credibility of their pronouncements
matters. I think it is fair to say, however, that in the late 1960s and 1970s, as the U.S. inflation crisis
was building, economists and policymakers did not fully understand or appreciate the determinants of
credibility and its link to policy outcomes. In 1977, however, Finn Kydland and Edward Prescott
published a classic paper, entitled "Rules Rather than Discretion: The Inconsistency of Optimal Plans"
(Kydland and Prescott, 1977), that provided the first modern analysis of these issues.3 Specifically,
Kydland and Prescott demonstrated why, in many situations, economic outcomes will be better if
policymakers are able to make credible commitments, or promises, about certain aspects of the
policies they will follow in the future. "Credible" in this context means that the public believes that the
policymakers will keep their promises, even if they face incentives to renege.
In particular, as one of Kydland and Prescott's examples illustrates, monetary policy-makers will
generally find it advantageous to commit publicly to following policies that will produce low inflation. If
the policymakers' statements are believed (that is, if they are credible), then the public will expect
inflation to be low, and demands for wage and price increases should accordingly be moderate. In a
virtuous circle, this cooperative behavior by the public makes the central bank's commitment to low
inflation easier to fulfill. In contrast, if the public is skeptical of the central bank's commitment to low
inflation (for example, if it believes that the central bank may give in to the temptation to overstimulate
the economy for the sake of short-term employment gains), then the public's inflation expectations will
be higher than they otherwise would be. Expectations of high inflation lead to more-aggressive wage
and price demands, which make achieving and maintaining low inflation more difficult and costly (in
terms of lost output and employment) for the central bank.
Providing a clear explanation of why credibility is important for effective policymaking, as Kydland and
Prescott did, was an important step. However, these authors largely left open the critical issue of how
a central bank is supposed to obtain credibility in the first place. Here is where Rogoff's seminal article
took up the thread.4 Motivated by the example of Carter and Volcker, Rogoff's paper showed
analytically why even a president who is not particularly averse to inflation, or at least no more so than
the average member of the general public, might find it in his interest to appoint a well-known "inflation
hawk" to head the central bank. The benefit of appointing a hawkish central banker is the increased
inflation-fighting credibility that such an appointment brings. The public is certainly more likely to
believe an inflation hawk when he promises to contain inflation because they understand that, as
someone who is intrinsically averse to inflation, he is unlikely to renege on his commitment. As
increased credibility allows the central bank to achieve low inflation at a smaller cost than a
non-credible central bank can, the president may well find, somewhat paradoxically, that he prefers
the economic outcomes achieved under the hawkish central banker to those that could have been
obtained under a central banker with views closer to his own and those of the public.
2
In focusing on three landmark papers I necessarily ignore what has become an enormous literature on credibility and
monetary policy. Walsh (2003, chap. 8) provides an excellent overview. Rogoff (1987) was an important early survey of the
"first generation" of models of credibility in the context of central banking.
3
In another noteworthy paper, Calvo (1978) made a number of points similar to those developed by Kydland and Prescott.
The extension of the Kydland-Prescott "inflation bias" by Barro and Gordon (1983a) has proved highly influential.
4
Rogoff was my graduate school classmate at M.I.T., and I recently asked him for his recollections about the origins of the
conservative central banker. Here (from a personal e-mail) is part of his response:
[T]he paper was mainly written at the Board in 1982 . . . It came out as an IMF working paper in February 1983 (I
was visiting there), and then the same version came out as an International Finance Discussion paper [at the Board
of Governors] in September 1983 . . . The original version of the paper . . . featured inflation targeting. Much like the
published paper, I suggested that having an independent central bank can be a solution to the time consistency
[that is, credibility] problem if we give the bank an intermediate target and some (unspecified) incentive to hit the
target . . . I had the conservative central banker idea in there as well, as one practical way to ensure the central
bank placed a high weight on inflation. Larry Summers, my editor at the [Quarterly Journal of Economics], urged me
to move that idea up to the front section and place inflation targeting second. This, of course, is how the paper
ended up.
[Regarding the Fed], Dale Henderson and Matt Canzoneri liked the paper very much . . . many other researchers
gave me feedback on my paper (including Peter Tinsley, Ed Offenbacher, Bob Flood, Jo Anna Gray, and many
others) . . . Last but perhaps most important, there is absolutely no doubt that the paper was inspired by my
experience watching the Volcker Fed at close range. I never would have written it had I not . . . ended up as an
economist at the Board.
BIS Review 57/2004
Appointing an inflation hawk to head the central bank may not be enough to ensure credibility for
monetary policy, however. As Rogoff noted in his article, for this strategy to confer significant credibility
benefits, the central bank must be perceived by the public as being sufficiently independent from the
rest of the government to be immune to short-term political pressures. Thus Rogoff's proposed
strategy was really two-pronged: The appointment of inflation-averse central bankers must be
combined with measures to ensure central bank independence. These ideas, supported by a great
deal of empirical work, have proven highly influential.5 Indeed, the credibility benefits of central bank
autonomy have been widely recognized in the past twenty years, not only in the academic literature
but, far more consequentially, in the real-world design of central banking institutions. For example, in
the United Kingdom, the euro area, Japan, and numerous other places, recent legislation or other
government action has palpably strengthened the independence of the central banks.6
Rogoff's proposed solution to the credibility problems of central banks does have some limitations,
however, as Ken recognized both in his paper and in subsequent work. First, although an
inflation-averse central banker enhances credibility and delivers lower inflation on average, he may not
respond to shocks to the economy in the socially desirable way. For example, faced with an aggregate
supply shock (such as a sharp rise in oil prices), an inflation-averse central banker will tend to react
too aggressively (from society's point of view) to contain the inflationary impact of the shock, with
insufficient attention to the consequences of his policy for output and employment.7 Second, contrary
to an assumption of Rogoff's paper, in practice the policy preferences of a newly appointed central
banker will not be precisely known by the public but must be inferred from policy actions. (Certainly the
public's perceptions of Chairman Volcker's views and objectives evolved over time.) Knowing that the
public must make such inferences might tempt a central banker to misrepresent the state of the
economy (Canzoneri, 1985) or even to take suboptimal policy decisions; for example, the central
banker may feel compelled to tighten policy more aggressively than is warranted in order to convince
the public of his determination to fight inflation. The public's need to infer the central banker's policy
preferences may even generate increased economic instability, as has been shown in a lively recent
literature on the macroeconomic consequences of learning.8
The third pathbreaking paper I will mention today, a 1995 article by Carl Walsh entitled "Optimal
Contracts for Central Bankers," was an attempt to address both of these issues.9 To do so, Walsh
conducted a thought experiment. He asked his readers to imagine that the government or society
could offer the head of the central bank a performance contract, one that includes explicit monetary
rewards or penalties that depend on the economic outcomes that occur under his watch. Remarkably,
Walsh showed that, in principle, a relatively simple contract between the government and the central
bank would lead to the implementation of monetary policies that would be both credible and fully
optimal. Under this contract, the government provides the central banker with a base level of
compensation but then applies a penalty that depends on the realized rate of inflation - the higher the
observed inflation rate, the greater the penalty.
If the public understands the nature of the contract, and if the penalty assessed for permitting inflation
is large enough to affect central bank behavior, the existence of the contract would give credence to
5
Walsh (2003, section 8.5) reviews empirical research on the correlations of central bank independence and economic
outcomes. A consistent finding is that more-independent central banks produce lower inflation without any increase in output
volatility.
6
The benefits of central bank independence should not lead us to ignore its downside, which is that the very distance from
the political process that increases the central bank's policy credibility by necessity also risks isolating the central bank and
making it less democratically accountable. For this reason, central bankers should make communication with the public and
their elected representatives a high priority. Moreover, central bank independence does not imply that central banks should
never coordinate with other parts of the government, under the appropriate circumstances.
7
Lohmann (1992) shows that this problem can be ameliorated if the government limits the central bank's independence,
stepping in to override the central bank's decisions when the supply shock becomes too large. However, to preserve the
central bank's independence in normal situations, this approach would involve stating clearly in advance the conditions
under which the government would intercede, which may not be practicable.
8
Evans and Honkopohja (2001) is the standard reference on learning in macroeconomics. Recent papers that apply models
of learning to the analysis of U.S. monetary policy include Erceg and Levin (2001) and Orphanides and Williams
(forthcoming).
9
Persson and Tabellini (1993) provided an influential analysis of the contracting approach that extended and developed
many of the points made by Walsh (1995).
BIS Review 57/2004
central bank promises to keep the inflation rate low (that is, the contract would provide credibility).10
Walsh's contract has in common with Rogoff's approach the idea that, in a world of imperfect
credibility, giving the central banker an objective function that differs from the true objectives of society
may be useful. However, Walsh also shows that the contracting approach ameliorates the two
problems associated with Rogoff's approach. First, under the Walsh contract, the central banker has
incentives not only to achieve the target rate of inflation but also to respond in the socially optimal
manner to supply shocks.11 Second, as the inflation objective and the central banker's incentive
scheme are made explicit by the contract, the public's problem of inferring the central banker's policy
preferences is significantly reduced.
There have been a few attempts in the real world to implement an incentive contract for central
bankers - most famously a plan proposed to the New Zealand legislature, though never adopted,
which provided for firing the governor of the central bank if the inflation rate deviated too far from the
government's inflation objective.12 But Walsh's contracts are best treated as a metaphor rather than as
a literal proposal for central bank reform. Although the pay of central bankers is unlikely ever to
depend directly on the realized rate of inflation, central bankers, like most people, care about many
other aspects of their jobs, including their professional reputations, the prestige of the institutions in
which they serve, and the probability that they will be reappointed.
Walsh's analysis and many subsequent refinements by other authors suggest that central bank
performance might be improved if the government set explicit performance standards for the central
bank (perhaps as part of the institution's charter or enabling legislation) and regularly compared
objectives and outcomes. Alternatively, because central banks may possess the greater expertise in
determining what economic outcomes are both feasible and most desirable, macroeconomic goals
might be set through a joint exercise of the government and the central bank. Many countries have
established targets for inflation, for example, and central bankers in those countries evidently make
strong efforts to attain those targets. The Federal Reserve Act does not set quantitative goals for the
U.S. central bank, but it does specify the objectives of price stability and maximum sustainable
employment and requires the central bank to present semi-annual reports to the Congress on
monetary policy and the state of the economy. Accountability to the public as well as to the legislature
is also important; for this reason, the central bank should explain regularly what it is trying to achieve
and why. In sum, Walsh's paper can be read as providing theoretical support for an explicit,
well-designed, and transparent framework for monetary policy, one which sets forth the objectives of
policy and holds central bankers accountable for reaching those objectives (or, at least, for providing a
detailed and plausible explanation of why the objectives were missed).
In the simple model that Walsh analyzes, the optimal contract provides all the incentives needed to
induce the best possible monetary policy, so that appointing a hawkish central banker is no longer
beneficial. However, in practice - because Walsh's optimal contracts can be roughly approximated at
best, because both the incentives and the policy decisions faced by central bankers are far more
complex than can be captured by simple models, and because the appointment of an inflation-averse
central banker may provide additional assurance to the public that the government and the central
bank will keep their promises - the Walsh approach and the Rogoff approach are almost certainly
complementary.13 That is, a clear, well-articulated monetary policy framework; inflation-averse central
bankers; and autonomy for central banks in the execution of policy are all likely to contribute to
increased central bank credibility and hence better policy outcomes. Of course, other factors that I
could not cover in this short review, such as the central bank's reputation for veracity as established
over time, may also strengthen its credibility (Barro and Gordon, 1983b; Backus and Driffill, 1985).14
Let me end where I began, with reference to Paul Volcker and his contributions. I have discussed
today how Volcker's personality and performance inspired one seminal piece of research about the
determinants of central bank credibility. In focusing on a few pieces of academic research, however, I
have greatly understated the impact of the Volcker era on views about central banking. The Volcker
disinflation (and analogous episodes in the United Kingdom, Canada, and elsewhere) was
undoubtedly a major catalyst for an explosion of fresh thinking by economists and policymakers about
central bank credibility, how it is obtained, and its benefits for monetary policy-making. Over the past
two decades, this new thinking has contributed to a wave of changes in central banking, particularly
with respect to the institutional design of central banks and the establishment of new frameworks for
the making of monetary policy.
Ironically, the applicability of the ideas stimulated by the Volcker chairmanship to the experience of the
U.S. economy under his stewardship remains unclear. Though the appointment of Volcker
undoubtedly increased the credibility of the Federal Reserve, the Volcker disinflation was far from a
costless affair, being associated with a minor recession in 1980 and a deep recession in 1981-82.15
Evidently, Volcker's personal credibility notwithstanding, Americans' memories of the inflationary
1970s were too fresh for their inflation expectations to change quickly. It is difficult to know whether
alternative tactics would have helped; for example, the announcement of explicit inflation objectives
(which would certainly have been a radical idea at the time) might have helped guide inflation
expectations downward more quickly, but they might also have created a political backlash that would
have doomed the entire effort. Perhaps no policy approach or set of institutional arrangements could
have eliminated the 1970s inflation at a lower cost than was actually incurred. If so, then the
significance of Paul Volcker's appointment was not its immediate effect on expectations or credibility
but rather the fact that he was one of the rare individuals tough enough and with sufficient foresight to
do what had to be done. By doing what was necessary to achieve price stability, the Volcker Fed laid
the groundwork for two decades, so far, of strong economic performance.