es for questions and I have already got about
three or four people on my list. First is Allan Meltzer.
Mr. Meltzer: I would like to start with a comment on Currency
Boards by saying that, from the time of John Stewart Mill onward, it
was recognized that there was no long-run advantage or disadvantage
to fixed or floating rates. The question is the short run. Can countries
be better off?
What I missed in the discussion from all of the panelists is the choice
between deflation and devaluation. Deflation is, after all, the alterna-
tive to devaluation. If we are going to get real exchange rate adjust-
ment, we have to do it either by deflation or devaluation.
It seems to me that people have ignored deflation, particularly in the
case of Japan. They have said, Well, Japan perhaps is right. How
could anyone have raised the interest rate to 8 percent in the 1980s? I
do not think that is the correct question. The question is, are you better
off, either yourself or your neighbors, if you devalue or if you deflate?
Japan, after all, by choosing a policy of deflation, ran into the problem
of some rigidity in wages and prices. And, consequently, it runs into
the problem of continued recession in Japan. This also was not to the
advantage of its neighbors.
411 The issue is whether it is less costly for a country to deflate than it is
to devalue. And that will depend very much on whether it takes its
prices from the rest of the world or whether it has some domestic influ-
ence on prices and wages, so it does not take them from the rest of the
world. And I think the answer to the question of whether countries
will end up with fixed pegs or whether they will end up with floating
rates will depend very much on which is going to be cheaper for
themdevaluation or deflation.
Mr. Mishkin: One of the issues that came up in the discussion here
was the whole question about whether flexible inflation targeting can
actually deal with asset price collapses. I think the answer is yes, but
you have to think of a more sophisticated kind of inflation targeting,
which is, in fact, something that is starting to happen at central banks
and is also part of what even non-inflation targeting central banks
think of all the time, which is to not only to worry about your point
forecast but to worry about the distribution of your inflation forecast.
And, in particular, even in central banks that are not formally inflation
targeting, like the Federal Reserve, there is always a discussion of the
balance of risks. And a very important way to think about during mon-
etary policy is to think of the balance of risks. In that context, if you
have a sharp asset price collapse, which, in fact, because of previously
weak balance sheets, means that you may end up with a financial cri-
sis. Then, indeed, what you do want to do is to have a very strong mon-
etary policy response and a very sharp drop in interest rates. And the
justification for it is that, indeed, you now have a significant probabil-
ity of having very strong deflationary impulses. And, indeed, what
you want to do is take out insurance against those deflationary
impulses.
In that context, dealing with these asset price collapses can be dealt
with in terms of a flexible inflation target. Indeed, I would interpret the
way the Federal Reserve dealt with these events that occurred in the
fall of 1998 as actually being completely consistent with that. There
was a sharp decline in the federal funds rate. It was taking out insur-
ance against a financial crisis and, indeed, I think that helped also to
prevent deflationary impulses.
412
General Discussion I think a more sophisticated way of thinking about inflation target-
ing, which is exactly where central banks like the Bank of England and
the Central Bank of Sweden are headed, will be a way of dealing with
this.
Mr. Barnes: I would like to press this issue of moral hazard as it
relates to asset prices and monetary policy a bit harder. It was briefly
touched on by Rudi Dornbusch but not really explored. If it is widely
accepted that central banks should not and will not target asset prices
but they will stand ready, as Fred Mishkin implied, to deal with the
negative consequences of a sharp drop in asset prices, clearly this cre-
ates the impression in investors minds that the upside is relatively
clear and the downside is protecteda classic moral hazard situation.
With hindsight, Mr. Yamaguchi suggested that perhaps the Bank of
Japan could have done more to advise investors of the risksthe jaw
boning approach. But the problem is that the markets have learned to
watch what the central bank does, not what it says. And if words are
not followed by actions that can actually fuel even more investor
euphoria because it suggests that the central bank is somehow handi-
capped.
Alan Greenspan said that it is the markets that are asymmetric not
policy, because prices rise steadily but can fall precipitously. That is,
indeed, true. But this market asymmetry seems to me endogenous to
the whole moral hazard problem. I know there is no easy solution to this,
but I would be very interested in the panels view if this is something
we just have to live with or whether there really are some solutions.
Mr. Angell: I would like to comment about equity bubbles, real
property bubbles, and price level targeting. With price level targeting
bringing the inflation rate down will cause equity prices to be higher
and price to earnings ratios will rise. Price level targeting, however,
can cause real property prices to be lower. What we have to understand
is that all equity bubbles tend to be preceded by disinflation turning
into deflation, which causes equity prices to be higher. So, we have
kind of a trade-off. Would we prefer in the United States to maintain
about a 2 percent or 1½ percent inflation and have the present P/E
General Discussion
413 ratios close to 30? Or would we prefer to go, as I would, to a 1 percent
price level target rate of inflation? And if that happens, surely price to
earnings ratios will rise. Now, if you prefer lower equity prices and
lower P/E prices, I would suggest that an inflation target of 3 percent
or, surely, 4 percent would clearly take price to earnings ratios down
below 10 and equity values as low as you would like.
Mr. Kaufman: In these closing moments of this wonderful confer-
ence, I would like to make a final appeal that the academics in this
room, as well as the central bankers, do raise the importance of finan-
cial asset values in monetary policy deliberations. As Andrew has
already indicated, perhaps we do not know what a bubble is. But when
you look back over the last three or four years, there is an expectation
of price increases in financial asset values in the markets that only par-
allels the 1920s. There are other manifestations of this, as we know by
now that the household sector is very much dependent on increases in
financial values. The corporate sector is very heavily leveraged in the
United States, and it is hidden by the fact that we have had these
increases in equity values.
Last year, we had an interesting example in which central bankers
made a rescue. That is being applauded, and it was a wonderful rescue
operation. But so far, there is no indication that that rescue operation
can work perfectly well in the future. If you look back, first of all, no
one has raised the question: Why did we need the rescue? Where was
the supervision over financial institutions and markets? How much
has it improved since then to assure us that such an event will not
materialize anytime soon?
The dilemma is as financial asset values have continued to bubble
after that event, we have had higher values. Now, that raises the diffi-
cult and perplexing issue for monetary policy that in the event this
bubble does break and it intercedes, at what level will it intercede?
When it is clear that there is a deflation? When it is clear that perhaps
there is a financial mishap? When will it intercede? Will it intercede to
hold the values high? If those values remain relatively high then, of
course, we continue the bubble and bubble some more. That is a serious
issue I think for central bankers.
414
General Discussion The underlying dilemma is something that is very difficult for all of
us. The financial bubbling euphoria is popular with everyone. Every-
one that is a consumer, that is a businessman, that is a politician. The
question before us really is can central bankers withstand that kind of
popularity? Can they do things that are difficult to do, just as it was in
the 1970s? The problem then was different, but it took us a long time to
unwind inflation because central bankers had a difficult time in deal-
ing with it.
Mr. Feldstein: I want to come back to the issue of the inflation tar-
get. I think Mervyn argued very convincingly that an inflation target of
zero is feasible and that an unchanged price level as a long-term goal
can be built into that process. Nevertheless, as you said Andrew, most
central banks target an inflation rate, if they have an implicit target, of
more than zeroabout 2 percent.
After listening for two days, I have become more convinced than
ever that if there is to be an inflation target, it should be zero and not 2
percent. My reason is not Milton Friedmans case about money
demand. I think that is quantitatively very small. I think the tax effects
are much more important. Even a 2 percent inflation rate causes a very
substantial increase in effective t