Federal Reserve Chairman Ben Bernanke has recently been on the receiving end of significant criticism for recent monetary policy. One critique can be labeled the American conservative critique, and is associated with the Wall Street Journal. The other can be termed the European critique, and is associated with prominent European Economist and Financial Times contributor, Willem Buiter.
Both argue the Fed has engaged in excessive monetary easing, cutting interest rates too much and ignoring the perils of inflation. Their criticisms raise core questions about the conduct of policy that warrant a response.
Brought up on the intellectual ideas of Milton Friedman, American conservatives view inflation as the greatest economic threat and believe control of inflation should be the Fed’s primary job. In their eyes the Bernanke Fed has dangerously ignored emerging inflation dangers, and that policy failure risks a return to the disruptive stagflation of the 1970s.
Rather than cutting interest rates as steeply as the Fed has, American conservatives maintain the proper way to address the financial crisis triggered by the deflating house price bubble is to re-capitalize the financial system. This explains the efforts of Treasury Secretary Paulson to reach out to foreign investors in places like Abu Dhabi. The logic is that foreign investors are sitting on mountains of liquidity, and they can therefore re-capitalize the system without recourse to lower interest rates that supposedly risk a return of ‘70’s style inflation.
The European critique of the Fed is slightly different, and is that the Fed has gone about responding to the financial crisis in the wrong way. The European view is that the crisis constitutes a massive liquidity crisis, and as such the Fed should have responded by making liquidity available without lowering rates. That is the course European Central Bank has taken, holding the line on its policy interest rate but making massive quantities of liquidity available to Euro zone banks.
According to the European critique the Fed should have done the same. Thus, the Fed’s new Term Securities Lending Facility that makes liquidity available to investment banks was the right move. However, there was no need for the accompanying sharp interest rate reductions given the inflation outlook. By lowering rates, the European view asserts the Fed has raised the risks of a return of significantly higher persistent inflation. Additionally, lowering rates in the current setting has damaged the Fed’s anti-inflation credibility and aggravated moral hazard in investing practices.
The problem with the American conservative critique is that inflation today is not what it used to be. 1970s inflation was rooted in a price – wage spiral in which price increases were matched by nominal wage increases. However, that spiral mechanism no longer exists because workers lack the power to protect themselves. The combination of globalization, the erosion of job security, and the evisceration of unions means that workers are unable to force matching wage increases.
The problem with the European critique is it over-looks the scale of the demand shock the U.S. economy has received. Moreover, that demand shock is on-going. Falling house prices and the souring of hundreds of billions of dollars of mortgages has caused the financial crisis. However, in addition, falling house prices have wiped out hundreds of billions of household wealth. That in turn is weakening demand as consumer spending slows in response to lower household wealth.
Countering this negative demand shock is the principal rationale for the Fed’s decision to lower interest rates. Whereas Europe has been impacted by the financial crisis, it has not experienced an equivalent demand shock. That explains the difference in policy responses between the Fed and the European Central Bank, and it explains why the European critique is off mark.
The bottom line is that current criticism of the Bernanke Fed is unjustified. Whereas the Fed was slow to respond to the crisis as it began unfolding in the summer of 2007, it has now caught up and the stance of policy seems right. Liquidity has been made available to the financial system. Low interest rates are countering the demand shock. And the Fed has signaled its awareness of inflationary dangers by speaking to the problem of exchange rates and indicating it may hold off from further rate cuts. The only failing is that is that the Fed has not been imaginative or daring enough in its engagement with financial regulatory reform.
Copyright Thomas I. Palley
Thank you for this post. I’ve been wondering all the Keynesians, Monetarists, and Fisherians had gone. You have provided a voice that’s been missing for the last little while.
Absent higher money supply, cost-push inflation cannot materialize. Therefore, contrary to what most long-bond bears believe, the risk of higher future inflation in the developed world remains low. Here’s where it gets interesting. Money supply is being increased at an alarming rate in Asia Ex-Japan. Do you think that the U.S. will be forced to experience inflation given a quasi-fixed exchange rate with Asia?
Henry Bee
Vancouver, Canada
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Tom,
Why isn’t Europe facing a similar demand shock? I have read that housing prices in Europe (Ireland, Spain, GB) are going to fall even farther than in the US.
It is helpful that you clarify that many of the critics of Bernanke are coming from conservative places. But that last line is such a zinger: the criticism from the rest of us is that the Fed has not been able to get the financial sector out of the driver’s seat, even when they nearly crashed the car. But I guess you have said that already in earlier posts.
The paragaph about worker’s power being eviscerated, and therefore stagflation will not be a threat, because workers will not be able to get wage increases to counteract higher prices–that is really chilling, because it rings so true. People are saying that a little inflation could be a good thing for debtors, and that the Fed knows it. But it seems to me that a little inflation could only be good for household debt if the households were able to get compensating wage increases, while holding their debt service payments constant. I wonder what your opinion would be about this issue that inflation could help debtors.
Good commentary, well beyond the similar argument by Paul Krugman in last week’s NYT that did not comment on liquidity. Both pieces focus on a “model,” where “wages” influence “prices;” and it is a “model” where only those workers with bargaining power, whose earnings in any case account for the preponderance of “demand,” are capable of “spiraling.” Acceptance of this model has led to a bubble in upper-level incomes and a mud puddle for the rest of humanity. The fact that it leaves Bernanke’s prospective reelection unaffected is the least of problems.
Hi Tom,
you are insightful as always, though your analysis I don’t think gives sufficient attention to the argument that falling confidence in the dollar might be the explanation behind rising inflation. That future price of oil has been steadily rising just as the signs that the US recession will not be short-lived are becoming stronger points in that direction. In a nutshell, the effectiveness of the expansionary fiscal stance and monetary easing in the US is predicated not only upon foreigners’ holding onto their dollar reserves but also willingness to keep accumulating them. While they do not seem to be diversifying out of their dollar reserves in droves, they seem to be losing their apatite for accumulating more dollar assets at a faster clip. Looked at from this point of view, the emergence of commodities as a new asset class – and, rapid growth of investment in them by hedge funds, pension funds and sovereign wealth funds along with investment banks – is but a sign of the increasing flight from the dollar. Much of the usual focus on the dollar peg in the so-called dollar zone countries in Bretton II, thus, misses the fundamental point about dollar denominated financial assets losing their effectiveness in moping up the excess liquidity the US is continuing to create in the world economy. When a reserve currency begins to cease to function as a reserve currency, reserves – whether of countries that peg their currency or not – fail to function as a sink for whatever excess money increase there is. Thus, in the absence of such a sink, the larger dollar reserves the increasing supply of dollars give rise to around the world raise the domestic money supply in the countries they are accumulating and bid up the prices of oil and commodities overseas, only to return to the US like a ping pong ball in the form of higher priced imports. That these countries peg their currency to the dollar matters little. If they did not, the inflationary shock and thus the pressure to raise rates in the US would only be stronger. If one were to think of a one-liner to summarize it all, it would go something like this: Output can be increased steadily by raising the money supply with a currency that enjoys the full confidence of agents in an economy, but if overdoing it eventually busts the currency it will cause inflation. What do you think?
Korkut Erturk
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