Bailouts… theory and practice.

I just visited Ben Bernanke’s academic website at Princeton, after H sent me a link to an exchange between him and Ron Paul.

On the website, he has a paper entitled “Should Central Banks Respond to Movements in Asset Prices?”, which argues that “stochastic simulations show little gain from an independent response to stock prices by the central bank”. More precisely:

… inflation targeting has generally performed well in practice. However, so far this approach has not often been stress-tested by large swings in asset prices. Our earlier research employed simulations of a small, calibrated macro model to examine how an inflation-targeting policy, defined as one in which the central bank’s instrument interest rate responds primarily to changes in expected inflation, might fare in the face of a boom-and-bust cycle in asset prices. We found that an aggressive inflation-targeting policy rule (in our simulations, one in which the coefficient relating the instrument interest rate to expected inflation is 2.0) substantially stabilizes both output and inflation in scenarios in which a bubble in stock prices develops and then collapses, as well as in scenarios in which technology shocks drive stock prices.

… In the spirit of recent work on robust control, the exercises in our earlier paper analyzed the performance of policy rules in worst-case scenarios, rather than on average.  However, the more conventional approach to policy evaluation is to assess the expected loss for alternative policy rules with respect to the entire probability distribution of economic shocks, not just the most unfavorable outcomes.  That is the approach taken in the present article.

The past few weeks must surely count as the most unfavorable outcome mentioned above. I don’t mean to cast aspersions on the ability of the people concerned, but this just underlines how little we understand about the concept of robustness and what to do about it. For instance, Mandelbrot has spent a lifetime exhorting people to believe in the fat tails, and I think people do, but we still lack a firm footing for getting simulations of such things to mirror the realities that matter!

Indeed, we live in most interesting times!

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