naked capitalism

I’ve been quite taken with Thomas Palley’s few but very high quality posts, particularly since they have often made bold, persuasive arguments. Today, however, he does himself a disservice by giving a well written but conventional (among US academic economists) defense of the central bank’s conduct. Note that he deals only with monetary policy (he treats the various new facilities as an extension of that responsibility, rather than as a quasi-nationalization of the banking system) and (save a brief comment at the end) does not address the Fed’s role as banking regulator.

Note that he also presents the two most common lines of attack on Bernanke & Co. Below, we’ll give a third line of criticism of the Fed which we find compelling, namely, that the central bank has mistakenly looked at the US as an economy in isolation as far as monetary policy and macroeconomic performance are concerned. Failure to consider the impact of trade and financial flows has led the central bank to repeatedly adopt overly loose monetary policy.

First, from Palley. Note that the position he calls “American conservative” has also been advocated by senior Japanese officials trying to prevent the US from repeating its mistakes:

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….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.

The hope that merely holding off from further rate cuts would be sufficient to defend the dollar (if that can even be done) was dashed today by the sharp fall in the dollar and the $11 per barrel spike in the price of oil. The 0.4% rise in unemployment means the Fed is not raising rates anytime soon, when the belief the Fed would tighten was the basis of recent dollar strength.

More broadly, what bothers me about Palley’s argument is that combating what he calls a demand shock is neither realistic nor desirable. First, labeling it a demand shock is overly dramatic; until today, a large number of economists felt this downturn could be short and shallow because jobs and consumer spending appeared to be holding up well.

I’ve been in the pessimistic camp because the current level of consumption to GDP (71-72%) is high and unsustainable. It has been achieved only via increasing debt to GDP to unprecedented levels (hence our credit crisis). Charts courtesy Frank Veneroso:

Thus “preventing demand shock” is tantamount to “keeping current levels of demand going” which per above, was accomplished via rising debt levels. We simply cannot keep doing that. The longer we go on, the worse the day of reckoning.

Similarly, the flip side of “consumption is too high” is “savings are too low”, and insufficient savings result in capital influxes which are accompanied by current account deficits. You can debate how the causality runs, but that’s how the math works.

Even with the fall in the dollar, our current account deficit to GDP ratio is over 5%, down from over 6%. That’s all well and good, except a level over 4% leads to a depreciating currency. So again, if you want to defend the dollar, that means more savings (and reducing debt is a form of savings) and less consumption. Thus, lower demand NEEDS to happen; the question isn’t preventing a demand decline (i.e. a recession or prolonged low growth period) but whether and how much the powers that be should intervene to alleviate the pain.

But that sort of reasoning doesn’t go over very well in an America where everyone likes to have their cake and eats it too.

A more respectable, academically rigorous argument comes from Richard Alford, Tim Duy, and Axel Leijonhufvud, who independently have come to broadly similar views. Alford gives a good synopsis:

One of the interesting aspects of economic policy in the US is a belief that we exist independent of the rest of the world. In the minds of many policy makers, the US is the focus and the rest of world economy is just a stable background. To open the model up to external factors, market imperfections, and quasi-floating exchange rates would increase the complexity of the model and limit the number of policy prescriptions that could be made, so most US economists pretend that the rest of the world does not exist, is stable, or that the dollar will quickly adjust so as to maintain US external balances. It has only been in the past few years that the trade deficit has moved to a level that is clearly unsustainable….

If you look at the difference between gross domestic purchases and potential output, by US consumers, businesses, and government — all are above potential output. The only time in recent memory when the difference between these two measures started to narrow was in 2001 when we were in a recession. One of the things we need to consider is that that US may need to see consumption drop significantly before we can achieve a sustainable position, for example vis a vis the dollar…

[T]he demand side is fine. Remember, US domestic purchases are still running around 105-106% of potential domestic output. The problem is not the level of demand but rather the composition of demand. Americans are buying too many imported goods and the world is not buying enough of our exports. So we have a growing wedge growing between gross domestic purchases, which is what the Fed really controls, and net aggregate demand, which is defined as gross domestic purchases less the trade deficit. Given the inability or unwillingness of the US to correct the trade imbalance, the Fed has run expansionary monetary policy almost continuously, generating higher levels of domestic purchases so as to keep net aggregate demand near potential output. The Fed did this using low interest rates, which generated asset bubbles, large increases in consumer debt and sharp declines in savings, and also a larger trade deficit. What has been totally missing is any policy aimed correcting the external imbalance. We are relying on the tools of counter-cyclical domestic demand management to address problems caused by a structural external supply shift..

Tim Duy echoes some of Alford’s themes:

Years of academic research led Bernanke to conclude that the Fed’s best response to the financial crisis is that which should have been deployed during the Great Depression. Fine on paper, but in practice he is using 1930’s monetary policy in the economy of 2008. And that 70+ year gap is exceedingly important in many respects, but perhaps none is more important than the current status of the US Dollar as a reserve currency, a status that allows the US to run a gaping current account deficit. The concern is that the Fed treats the external sector with something of a benign neglect when setting policy, effectively ignoring the reserve currency function of the Dollar. Hence, in a bow to Wall Street, policymakers unwittingly created an overly stimulative environment that feeds back to the US in the form of higher inflation.

Axel Leijonhufvud, in more formal policy paper, makes arguments similar to those of Alford and Duy and makes other pointed observations, such as:

The other lesson to draw from the Japanese experience is that once the credit system had crashed, a central bank policy of low interest rates could not counteract this intertemporal effective demand failure. Year after year after year, the Bank of Japan kept its rate so close to zero as to make no difference, and even so the economy was under steady deflationary pressure and healthy growth did not resume. The low interest policy served as a subsidy that enabled the banks eventually to earn their way back into the black, but this took a very long time.

Contrast this experience with that of Sweden or Finland in the wake of their real estate bubbles (and in Finland’s case the loss of its Soviet Union export markets) in the early 1990s. Both Nordic countries fell into depressions deeper than what they had experienced in the 1930s. Both had to devalue and Sweden in particular had to climb far down from its lofty perch in the world ranking of per capita real income. But, in contrast to the Japanese case, the governments intervened quickly and drastically to clean up the messes in their banking systems (Jonung 2008). Both Sweden and Finland took some three years to overcome the crisis but have shown what is, by European standards, strong growth since. The devaluations that aided their export industries were no doubt of great importance for this growth record but it is extremely unlikely that anything like it could have been achieved without the policy of ‘quarantining’ and then settling the credit problems resulting from the crash.

We had commented earlier on the experience of the United Kingdom, Sweden. Norway and Finland in the wake of their early 1990s housing crashes. All experienced peak to trough price falls in excess of 25%. All had bad recessions (recessions, mind you, not depressions) and then had strong recoveries once the mess was behind them. Yet for some reason their experience gets short shrift.