The Incredible Credibility Problem

One area in which I think some prominent left-of-center voices have gone badly awry is in suggesting that the Federal Reserve faces some serious credibility problem in attempting to reflate a depressed economy. Paul Krugman’s famous  line about trying to credibly promise to be irresponsible is funny, but I think makes the issue sound more paradoxical than it is.

The paradoxical formulation is this: If the Federal Reserve would raise its inflation target, that would boost growth. But once the growth is in place, maybe the Fed would prefer to not have the extra inflation. So if people think the Fed would responsibly backtrack in the face of success, then the expectations-management strategy won’t work. So how can the Fed promise to be irresponsible in the future? Then we start talking about delivering monetary policy statements while drunk or wearing a Hawaiian shirt.

The non-paradoxical formulation is that the responsible way to behave is to live up to your promises. If a bunch of serious-looking public officials say “we promise not to raise short-term interest rates unless inflation goes above 5 percent or unemployment falls below 6 percent” then precisely because they have a reputation for seriousness people will doubt that they would throw their reputations away by backing out of their commitment. If the officials in question want to further increase the credibility of their promise, they can hire a lawyer and get a form drawn up where each of them contractually obligates themselves to write a $100,000 check to the United States Treasury if they violate the terms of their no-rate-hike agreement. Now it’s true that the Board of Governors can’t promise that congress won’t impeach them all or whatever, but in life there are never any really absolute guarantees.

The point is that the problem of promising and social trust is a pretty general one, and it’s precisely people with a reputation for sober-minded seriousness who have the least trouble getting their promises taken seriously.