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Over at the Washington Post, Ezra Klein argues that a change in the Consumer Price Index (CPI) could make for better policy and better politics in helping address the budget deficit. Klein isn’t alone in his view, and I’ll admit that my dissent is a minority, but I think I’ve got a good point.

The CPI is used to adjust Social Security and other federal benefits, as well as to increase the dollar values assigned to income tax brackets. Klein and others propose shifting federal policy from the conventional CPI to the so-called chain weighted CPI, which better measures how consumers shift between competing products as prices change.

I have no disagreement that, in general, the chain weighted CPI is a superior measure of inflation to the standard CPI-W used to calculate COLAs or the CPI-U used to index the income tax brackets. However, the chained CPI is the wrong measure for Social Security benefits and the income tax code. A better measure for Social Security would be a chain weighted version of the CPI-E, which measures price changes for individuals over 65. This probably would still show lower inflation than the current CPI, by around 0.1 percentage point annually, but would be superior to the current CPI-W, the chained CPI, or the CPI-E on its own (which tends to show higher inflation).

The chained CPI is also inappropriate for use in the tax code. By lowering adjustments to the tax brackets, over time it would make more of individuals’ earnings subject to higher tax rates, an effect known as “bracket creep.” Even using the current CPI, and assuming that the Bush tax cuts were made permanent, average tax rates and tax revenues relative to the economy would soon rise to record levels, according to the Congressional Budget Office (CBO). Applying the chained CPI to the tax code would only speed up this effect. A more appropriate way to index the tax brackets is by the growth of incomes or wages. This would keep average tax rates, and taxes relative to GDP, stable over time. If people wish to raise taxes, that’s fine, but it should be done overtly rather than through stealth. Having an in-built bias toward ever-higher taxes isn’t good policy.

Despite the firm stance taken against the Federal Reserve’s second round of quantitative easing (QE2) by many conservatives, including Sarah Palin, Senator Pat Toomey (R-Pennsylvania), and the Economics 21 cohort, I think we can say with some certainty that the majority of Right-thinking people don’t know where to stand on this issue.

In fact, most Americans don’t get QE2 at all.  The debate tends to be esoteric and often technical, and it’s hard for the average person to tell whether inflation or deflation is a bigger threat to our economy; whether increasing the money supply would start a global currency war; or whether a devalued dollar would help boost our economy through increased exports.

So AEI’s going to do its part to bring this issue down to Earth. Next Wednesday, January 12, two bona fide conservatives—AEI resident scholar John Makin and former chief economic policy advisor to McCain 2008, Douglas Holtz-Eakin—will debate each other on the QE2 question, in plain English. Reihan Salam, policy advisor at Economics 21 and author of the Agenda over at National Review Online, will moderate. Here’s a preview:

After the event, which starts at 5 PM, Nick Schulz will sit down with The Atlantic’s Megan McArdle and John Tamny of RealClearMarkets and Forbes.com for a special, online-only post-debate discussion.  If you’re not in town, you can also watch the debate live here.

Federal Reserve Chairman Ben Bernanke’s Jackson Hole speech today attests to how little he has learnt from the 2008-2009 Great Economic Recession. On the very morning that U.S. gross domestic product growth estimates for the second quarter were revised down to a paltry 1.6 percent, Bernanke grudgingly acknowledges that “the pace of economic recovery in output and employment has slowed somewhat.”

And, seemingly oblivious to the fast-fading economic support from the fiscal stimulus package and inventory cycle, as well as to the major drag on U.S. economic growth from the unemployment and housing foreclosure crises, he assures us that “despite the recent economic slowing, it is reasonable to expect some pick-up in growth in 2011.” This all too sanguine assessment leads him to believe that at present there is no need for further monetary policy easing.

Sadly, Bernanke’s dismissal of any real risk of a double-dip economic recession and of a rise in unemployment to double-digit levels is putting him once again behind the monetary policy curve. As in 2008, he will find again that once he is forced to aggressively resort to quantitative easing by a crumbling domestic economy, it will be too late to have prevented the onset of a new recession.

It will also prove too late to have prevented deflationary forces from taking hold in the U.S. economy. This is all the more the pity since with the U.S. public finances already so compromised, monetary policy is now the only game in town. And Bernanke’s speech today suggests that he is once again in the process of dropping the ball.

As Vince Reinhart says in a recent Enterprise Blog entry, “Political pundits place a high probability on the [Federal Reserve] retaining its existing supervisory powers and even getting new ones.” Alternately stated by MarketWatch, “The Federal Reserve may be winning the political turf-battle.”

This might strike one, considering the Fed’s dubious performance when faced with the bubble and controversial performance in financing the bust, as odd. Isn’t this the same Fed which helped inflate the great housing and mortgage bubble, denied that bubbles could be identified or stopped, promoted the unfortunate Basel II capital regulations, was very late to recognize the seriousness of the mortgage collapse, and then had to take extraordinary measures in the ensuing panic?

Yes, of course it is. But coming out of economic and financial messes with enhanced power is part of the Fed’s mystique.

The long history of the Fed is strikingly marked by a series of severe economic and financial problems, after which its policies have been revealed as deflationary or inflationary blunders, just as they have been this time.

I recommend economic historian Bernard Shull’s The Fourth Branch: The Federal Reserve’s Unlikely Rise to Power and Influence (published in 2005 while the bubble was still growing). Shull acutely observes that the Fed “has been winning [political] battles since its establishment in 1914, regardless of the merits of its policies,” and that its position and power “ratcheted upward during several distinct periods when its policies were so profoundly disappointing.”

Shull quotes an economist colleague who “disconsolately asked, ‘How is it that the Federal Reserve always wins?’” An intriguing question, worth ruminating on, to which I don’t know the answer—although it may simply be the extreme usefulness to politicians of being able to print money.

In any case, here we go again.

Image by Dan Smith.

So, it had to happen one day. Donald L. Kohn, vice chairman of the Federal Reserve Board of Governors, announced his intention to retire in late June. Don had worked his way up through the staff ranks to his current position, only the third person to do so in Fed history.

With 40 years of experience in central banking, no one comes close to understanding the Fed as well as Don. (I spent 20 of those years working for him in one capacity or another.) As a colleague remarked on Don’s appointment to the board in 2002, “He not only knows where the bodies are buried, he buried some of them himself.” That understanding of the intricacies of an intricate organization has made him an important ally for Chairman Ben Bernanke and a voice listened to carefully at Federal Open Market Committee meetings.

When first giving advice and then voting on monetary policy, Don has always been deeply respectful of the Fed’s dual mandate of fostering price stability and maximum employment. The best explanation he gave of that was that the Fed had to remember that the long run was a succession of short runs. Economic slack in the near term did have to be weighted against the speed of the pursuit of price stability.

He will be missed. The most apt description of Don I ever heard was that he was the lead rod in the reactor pile of monetary policy. Pulling it out risks the process going critical. Making it otherwise is the job of President Obama and his economic advisers now that there are three open slots on the Board of Governors. The Senate will also have to be watchful of confirming people with terms that stretch as long as 14 years.

In hearings at the House and Senate this week, Federal Reserve Chairman Ben Bernanke showed two rare outbursts of passion (at least as judged by the stoic standard of central bankers). Rep. Ron Paul strung together a conspiracy theory that put Fed funding at the center of the Watergate scandal and the invasion of Iraq. A puzzled Bernanke stung the Texas congressman by calling that allegation “absolutely bizarre.”

More of substance, Bernanke told Senator Richard Shelby that “stripping the Federal Reserve of supervisory authorities in the light of the recent crisis would be a grave mistake.” The crux of his argument was that the financial crisis highlighted the need for an encompassing view of risk taking, one that the Fed already had. His summary was, “It’s hard for me to understand why in the face of a crisis that was so complex and covered so many markets and institutions, you would want to take out of the regulatory system the one institution that has the full breadth and range of those skills to address those issues.”

Sounds persuasive. But, on closer examination, it is not logical. A favorite Fed tactic in defending its turf is to resort to what rhetoricians call a false dichotomy or invalid binary choice. The chairman gave Senator Shelby the alternatives of either letting the Fed retain its supervisory powers OR having the critical responsibility of overseeing the financial system as a whole left undone. In fact, there are many other possibilities, including, as the Senate Banking Committee is considering, consolidating supervision in a single agency. Rather than debate the merits of the full range of options, Bernanke framed the issue in a way that gave only one plausible answer.

The lack of a full discussion of the issue is a shame, but Bernanke’s binary beguilement seems to be working. Political pundits place a high probability on the Fed retaining its existing supervisory powers and even getting additional ones.