Ben Bernanke | Normative Narratives

Yesterday, Federal Reserve Chairman Ben Bernanke went before Senate to defend the Federal Reserves loose monetary policy. The Federal Reserve has engaged in “Quantitative Easing“, pumping “cheap money” (because the fed can borrow at basically 0% interest rates) into the economy to stimulate consumption and investment (and therefore reduce unemployment).

It is important for the Federal Reserve to partake in unconventional monetary policy. Usually, the Fed adjusts the interest rate to stimulate the economy in one direction or another (speed up a slumping economy or “cool down” an over-leveraged economy). But up against the “zero-bound“, the Fed has to use less conventional policy as the interest rate cannot be lowered below 0 to stimulate the economy.

“The Fed, which has amassed almost $3 trillion in Treasury and mortgage-backed securities to promote more borrowing and lending, is expanding those holdings by $85 billion a month until it sees clear improvement in the labor market. It plans to hold short-term interest rates near zero even longer, at least until the unemployment rate falls below 6.5 percent.”

The Fed is going to keep buying assets until the economy recovers, measured either by an unemployment rate below 6.5% or an inflation rate above 2%. As Inflation does not seem to be an issue currently (despite greatly increasing the supply of money in the economy, the USD has remained stable), the unemployment target seems to be the one that the Fed has focused on.

Exactly why the dollar has remained stable despite greatly increasing the monetary base is up for debate. The main argument is that since we are in a “liquidity crisis”, newly printed Fed money is simply taking the place of private sector money (which is being horded, see corporate profits). Therefore, even though the overall money supplied by the Fed has increased, the actual amount of dollars available to the market has not really increased.

Another explanation is that the USD is a global reserve currency (about 60% of global reserves are denominated in dollars). Not only does the US have stake in a strong dollar, but every other country does as well. Other countries have no interest in seeing their real reserve levels fall, and export-based economies have no interest in competing against a weaker dollar (which would make their imports cheaper and exports more expensive).

Therefore, a concerted global effort has kept the dollar stable despite the expansion of the monetary base. It is probably some combination of these two forces, along with other forces, that has kept the dollar stable. It should be heartening to see that the world still believes in the USD as a reserve currency post-Great Recession, a signal that the U.S. BOP and Federal deficits are sustainable (even if they are higher than politically popular).

Back to Bernanke being grilled by Senate: ” Mr. Corker [Senator, R, Tennessee] then accused Mr. Bernanke of insufficient concern about potential inflation, saying, ‘I don’t think there’s any question that you would be the biggest dove since World War II,’ using the term “dove” to denote a Fed official who is more concerned about unemployment than higher inflation.

Mr. Bernanke, clearly piqued, responded, ‘You call me a dove, but my inflation record is the best of any chairman in the postwar period.'”

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Mr. Bernanke is simply using the policy tools available to him that fit the current situation. If inflation was high and unemployment was low, his policies would be very irresponsible. But given the current economic climate, the Fed’s policies make sense. Mr. Bernanke understands the monetary system better than most; his academic work revolves mainly around monetary policy during and after the Great Depression (and liquidity crisis monetary policy). His knowledge of monetary policy in face of economic downturns is amongst the best in the world, and I for one believe having Bernanke as the chairman of the Fed has helped an otherwise weak economic recovery.

But might the Feds actions disrupt markets, causing asset bubbles instead of helping the real economy?

“Jeremy C. Stein, a member of the Fed’s Board of Governors, and some other Fed officials have expressed concern in recent months that low interest rates were encouraging excessive risk-taking by investors pursuing higher returns. Mr. Stein in a recent speech highlighted rising demand for junk bonds and certain kinds of real estate investments, and shifts in bank balance sheets, as areas of potential concern.

Mr. Bernanke said the Fed took these concerns “very seriously,” noting that the central bank had significantly expanded its efforts to monitor financial markets, as well as giving greater priority to financial regulation.”

One could argue that the Fed should be lending directly to business and individuals instead of using the financial system as an intermediary (after all, the financial system by-and-large got us into the mess we are currently in). There is a strong argument here, but this is simply not how the Fed functions (and drastically changing the policy of a major institution takes time, this cannot be a short term fix but perhaps an idea to consider going forward). This time around, it is up to strengthened financial regulation and adequate capital market taxation to ensure bubbles are not a byproduct of loose monetary policy (hopefully the sequester doesn’t hit the SEC too hard, or this job will prove even more difficult than it already is):

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Monetary policy cannot shoulder the whole load of this economic recovery, as Bernanke himself has stated. However, while fiscal policy remains deadlocked in partisan bickering (it seems that fiscal stimulus is unlikely anytime soon; it would be a victory if the U.S. could avoid fiscal austerity, a.k.a. the “sequester”). It is therefore even more important than usual to have loose monetary policy (both because of the reality of a global liquidity crisis and the inability to address economic concerns via fiscal policy).

Bernanke has made it part of his mission to make the Fed more transparent and engaged with the American people. This is a noble pursuit, as members of the Fed are not elected but instead appointed by elected officials. Monetary policy is inherently confusing, even to trained economists; the ability of Bernanke to make people feel more engaged in the process is a difficult proposition. I hope I am in some small way doing my part to help explain why the Fed is doing what it is doing. People have to forget any Econ 101 they may know or think they know (increasing the supple of something reduces it’s value), as we are currently in a very specific situation which calls for a very specific policy response.

It seems Bernanke’s words have had a calming effect on the global economy, as assurance that the Fed will not abandon it’s bond buying program drew a favorable response from markets. It would be nice if people agreed with what Bernanke was doing, but it is unrealistic to expect the lay-man to understand liquidity crisis monetary policy (even I, and people with more training than me, have trouble with it). It is a great benefit to the U.S. and global economy to have someone as knowledgeable as Ben Bernanke running the Federal Reserve.

Some of you may remember, way back when Normative Narratives started a few months back, a prickly little topic on every news outlets agenda–The Fiscal Cliff. The Fiscal Cliff was supposed to be an outcome so unthinkable that it forced congress to act and pass a reasonable budget by new years day 2013. While this is no easy task during a recession (partisan gridlock aside), congress had from the summer of 2011 to come up with some sort of deal. Unfortunately, the best our congress could do was kick the can down the road for a bit.

True important tax reforms we’re secured during the Fiscal Cliff debate (raising the top rate on incomes over $400,000 and raising the capital gains tax, as well as keeping Bush era tax cuts in place for everyone else). Not to take anything away from the significance of averting the “fiscal cliff”, but it was at best an incomplete victory. But on the spending side, nothing permanent was decided. Congress was able to agree that the economy would be unable to absorb the shock of spending cuts without causing a double-dip recession / increasing unemployment, and succeeded in kicking the can down the road for a few months. If congress couldn’t figure it out in the year and a half time period between the original debt-ceiling debate and the “fiscal cliff”, was it realistic to think they would be able to reach an agreement on mostly the same issues over the course of two months?

Whether it was reasonable or not, we are currently face-to-face with another austerity program that could indeed send the U.S. economy back into a recession / greatly increase unemployment:

“In less than two weeks, a cleaver known as the sequester will fall on some of the most important functions of the United States government. About $85 billion will be cut from discretionary spending over the next seven months…The sequester will not stop to contemplate whether these are the right programs to cut; it is entirely indiscriminate, slashing programs whether they are bloated or essential…These cuts, which will cost the economy more than one million jobs over the next two years are the direct result of the Republican demand in 2011 to shrink the government at any cost, under threat of a default on the nation’s debt.”

This New York Times article does a great job of highlighting exactly how and where the cuts would take place.

Initially I was going to go through the article piece by piece and explain how each cut could hurt a specific group of Americans. But this is pretty obvious from reading the article, so I will leave it up to the reader to read about specific cuts and make their own judgements. Much less obvious is why these cuts will hurt the U.S. economy overall (and not just specific groups withing the economy). There are two main reasons for this:

1) The Government provides “public goods” that cannot be adequately provided by the private sector

2) We are still in what economists call a “liquidity trap”

First #1. The government provides public goods, such as schooling, infrastructure, and security (military / policing). Public goods are public because they inherently suffer from the “free-rider” problem. Everyone benefits from public goods, there’s no way of excluding someone from benefiting from a better school system, or better roads, or more police officers. These positive externalities mean that, left up to the private sector, investment in these goods will be insufficient. People will expect someone else to pay for the program and try to reap the benefits for free (hence the “free-rider” problem). Insufficient spending on public goods leads to higher crime (less law enforcement available combined with higher poverty rates due to cuts in social programs), and depresses both current (think poor infrastructure) and future (think inadequate schooling) economic prospects.

The private sector cannot decide to buy public goods just for certain people, as it cannot take advantage of “economies of scale” necessary for public goods to be affordable. Think how expensive it would be for a rich community to decide to pave it’s own roads, or build it’s own schools, and the security bill needed to ensure other people do not use these services. These bills would be much greater than the taxes otherwise needed to pay for such goods.

But lets suppose that the private sector could make up for this government spending. This is where #2 comes in–the liquidity trap:

A liquidity trap is a situation in which despite very low interest rates (up against the “zero-bound”), private sector funds are not being adequately invested into the economy, but instead dumped into government T-bills (or other low yield but safe asset). A common argument against fiscal stimulus is that it will “crowd-out” private sector spending, and therefore cannot lead to growth. In times of economic growth, this is somewhat true (although not true for “public goods”, as explained above). But in a liquidity crisis, this argument does not hold. Even given incredibly low rates of return, the private sector is unwilling to invest the money needed to create the aggregate demand needed for economic growth / job creation.

If the private sector instead decides it is better to give this money to the government, it should be a strong signal that the government should be spending the money in productive ways (instead of letting it sit in the Federal Reserve, and for it’s part the Fed led by Ben Bernanke has done a marvelous job making sure the economic recovery has not been even more stagnant / non-existent by pursuing unprecedented expansionary monetary policy, known as “quantitative easing”. But this alone is not enough, expansionary fiscal policy is also needed. If stimulus is not politically realistic, contractionary fiscal austerity must be avoided at least.

There is no additional cost to the government spending money, as it essentially pays zero interest on borrowed funds. Given high unemployment, why not put that money to work, and worry about paying it back later? Economically speaking, with an interest rate near zero, and a fiscal multiplier > 1, stimulus spending can be a magic bullet of sorts. Government spending costs the government less now than it otherwise would, and the expansionary effects of fiscal spending are greater now then they otherwise would be. Currently, stimulus is both fiscally responsible and economically necessary to boost aggregate demand (and stimulate economic growth / reduce unemployment / increase tax receipts by growing the economy).

So again here we are; the G.O.P. is playing a game of chicken with “the full faith and credit of the United States of America” (which is one of the reasons we are able to borrow at such low rates despite a relatively high debt / GDP ratio, the fact that American debt is considered “safe”). The effects of a default on our debt would cripple America’s ability to pursue meaningful monetary policy in the future. The effects of contractionary fiscal policy would depress an already weak U.S. economy (which would send out a ripple effect, depressing global economic growth) and raise unemployment. Yet the G.O.P. is willing to consider these unthinkable scenarios in order to push it’s tried and failed Austerian ideology.

America will have to reign in it’s deficit one day, especially with rising healthcare / social security costs, but that day is not today. Artificially forcing that day to be today, due to the sequester / debt-ceiling, will do nothing but hurt America’s credibility as an economic power both at home (by forcing the government to cut essential programs) and abroad (by making people reconsider whether U.S. debt is a “safe” investment or not).