Krugman: Fed is Running Out of Tricks

Krugman, in his New York Times op-ed today, “Betting the Bank,” reminds us that the Fed is much like the Wizard of Oz: the perception of its power vastly exceeds reality. In normal times, the limited tools central bankers have at their disposal can be used to great effect, but extreme conditions reveal their impotence.

Krugman points out that the Fed’s aggressive and inventive measures haven’t and can’t fix the underlying problem, namely, that a very large number of people not only bought houses that they couldn’t afford, but also did so at high prices. Interestingly, Krugman says that the Fed cannot and should not try to stem the resulting losses.

While it is good to see a Serious Economist tell the Fed in a highly public venue that it is destined to fail, I wish Krugman had also addressed the collateral damage resulting from the central bank’s frantic reflation efforts, namely a collapsing dollar and commodities price inflation (obviously worse in dollar terms, but operative even in economies with currencies rising relative to the dollar, such as China). What is even more worrisome is that Bernanke may deem a continued slide in the dollar to be entirely a good thing. As Mark Gilbert pointed out in Bloomberg on Thursday:

In November 2002, when Bernanke was merely a Fed governor, he gave a speech about “Deflation: Making Sure `It’ Doesn’t Happen Here.” More than five years on, the text provides a step- by-step guide to the Fed’s reaction to the current credit crisis, and hints at the tricks left up the central bank’s sleeve.

The speech is relevant even though two of its premises — a general decline in consumer prices and a benchmark central-bank rate that’s close to zero — don’t currently apply to the U.S. experience. Bernanke detailed the Fed’s likely response once the blunt instrument of cutting borrowing costs had lost its potency to revive the economy — which is exactly the situation the central bank finds itself in now.

“When inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates,” Bernanke said. “By moving decisively and early, the Fed may be able to prevent the economy slipping into deflation…..

“Another option would be for the Fed to use its existing authority to operate in the markets for agency debt,” he said. It could offer “fixed-term loans to banks at low or zero interest, with a wide range of private assets, including, among others, corporate bonds, commercial paper, bank loans and mortgages deemed eligible as collateral…..

“The U.S. government has a technology called a printing press that allows it to produce as many U.S. dollars as it wishes at essentially no cost,” Bernanke said. “A determined government can always generate higher spending and hence positive inflation. Sufficient injections of money will ultimately always reverse a deflation…..

“It’s worth noting that there have been times when exchange-rate policy has been an effective weapon against deflation,” Bernanke said, citing the 40 percent devaluation of the dollar against gold enacted in 1933 to 1934. “The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Monetary actions can have powerful effects on the economy.”

The problem with this line of thinking is that it contradicts another premise he mentioned:

“A healthy, well-capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks.”

The international capital markets are looking very wobbly. Bernanke, however, is looking at our credit mess as if our economy exists in isolation. Tanking the dollar has led to a massive unwinding of the carry trade, which exacerbates the deleveraging already underway. And his 1933-1934 remedy is dangerous medicine at this point. By then, the Depression was a well entrenched, international phenomenon. Moreover, Great Britain had abandoned the gold standard In 1931; the US was merely following suit.

But most important is that in 1933, the dollar was not the world’s reserve currency. There are tremendous advantages to being the reserve currency, namely, you can borrow without incurring foreign exchange risk, which is a non-trivial matter. Moreover, a rapid decline in the reserve currency creates tremendous international instability, and can damage financial institutions in other countries, thus further imperiling capital markets functioning. But that doesn’t seem to have occurred to Bernanke.

As ECB president Jean-Claude Trichet noted:

”On exchange rates, particularly against the dollar, I reaffirm that disorderly movements in exchange rates are undesirable from the point of view of economic growth.”

It appears that at least some of the commodity bubble is due to speculation, and the more the Fed engages in desperate measures, the more grist for the commodity bulls. So there will be increasing political hostility to the Fed’s course of action, particularly if gas goes to $6 a gallon and bread prices double.

We are in a very similar position to the weaker nations hit by the emerging markets crisis in 1997. George Friedman of Stratfor (ironically in a 2006 article, “The Looming China Crisis“) described the known ways out:

Asia has been here before. Japan encountered this problem around 1990, and East and Southeast Asia encountered it in 1997. Roughly three models for dealing with the problem exist:

* Japan model: Use reserves and formal and informal measures to avoid actions that would trigger massive bankruptcies and unemployment. Accept economic stagnation for the better part of a generation.

* South Korea model: Move rapidly to restructure the economy, using economic and political means. Control social unrest with security measures. Move out of the problem in a matter of years.

* Indonesia model: Lacking resources to manage the crisis, suffer both financial dysfunction and political strife among the elite and between regions.

Japan was able to do what it did because it is a highly disciplined, cohesive society, in which shared pain is viewed as preferable to social dislocation. South Korea was able to do what it did because the magnitude of its crisis was relatively less than Japan’s, and because the state had the means for suppressing unhappiness. Indonesia failed to do what it needed to do because it lacked resources and political power.

Other countries have fallen somewhere along this continuum. China will make its own path. However, it should be pointed out that China is not socially similar to either Japan or South Korea. Like Indonesia, China is a diverse and divided nation. The Communist Party lost its moral standing in the 1970s. As with Suharto’s government, its legitimacy now derives from the fact that it has created prosperity. When prosperity slows down or stops, the Party cannot fall back on inherent legitimacy, as was the case with the system in Japan. And the wildly diverse levels of economic development make a single, integrated solution, as was used in South Korea, unlikely. The most likely direction for China, therefore, is massive social and political instability.

Although the US is not as “diverse and divided” as China, faith in our government is falling as fast as the value of the greenback and will decline further. if we enter a serious, prolonged slump. Indonesia’s GDP fell 17% in 1997 (reader CrocodileChuck reminded me; he was on the ground there); we won’t fall anywhere near that far. But we could well come out somewhere between South Korea and Indonsesia on Friedman’s list, which is an ugly place to be.

From Krugman:

Four years ago, an academic economist named Ben Bernanke co-authored a technical paper that could have been titled “Things the Federal Reserve Might Try if It’s Desperate” — although that may not have been obvious from its actual title, “Monetary Policy Alternatives at the Zero Bound: An Empirical Investigation.”

Today, the Fed is indeed desperate, and Mr. Bernanke, as its chairman, is putting some of the paper’s suggestions into effect. Unfortunately, however, the Bernanke Fed’s actions — even though they’re unprecedented in their scope — probably won’t be enough to halt the economy’s downward spiral.

And if I’m right about that, there’s another implication: the ugly economics of the financial crisis will soon create some ugly politics, too.

To understand what’s going on, you have to know a bit about how monetary policy usually operates.

The Fed’s economic power rests on the fact that it’s the only institution with the right to add to the “monetary base”: pieces of green paper bearing portraits of dead presidents, plus deposits that private banks hold at the Fed and can convert into green paper at will.

When the Fed is worried about the state of the economy, it basically responds by printing more of that green paper, and using it to buy bonds from banks. The banks then use the green paper to make more loans, which causes businesses and households to spend more, and the economy expands.

This process can be almost magical in its effects: a committee in Washington gives some technical instructions to a trading desk in New York, and just like that, the economy creates millions of jobs.

But sometimes the magic doesn’t work. And this is one of those times.

These days, it’s rare to get through a week without hearing about another financial disaster. Some of this is unavoidable: there’s nothing Mr. Bernanke can or should do to prevent people who bet on ever-rising house prices from losing money. But the Fed is trying to contain the damage from the collapse of the housing bubble, keeping it from causing a deep recession or wrecking financial markets that had nothing to do with housing.

So Mr. Bernanke and his colleagues have been doing the usual thing: printing up green paper and using it to buy bonds. Unfortunately, the policy isn’t having much effect on the things that matter. Interest rates on government bonds are down — but financial chaos has made banks unwilling to take risks, and it’s getting harder, not easier, for businesses to borrow money.

As a result, the Fed’s attempt to avert a recession has almost certainly failed. And each new piece of economic data — like the news that retail sales fell last month — adds to fears that the recession will be both deep and long.

So now the Fed is following one of the options suggested in that 2004 paper, which was about things to do when conventional monetary policy isn’t getting any traction. Instead of following its usual practice of buying only safe U.S. government debt, the Fed announced this week that it would put $400 billion — almost half its available funds — into other stuff, including bonds backed by, yes, home mortgages. The hope is that this will stabilize markets and end the panic.

Officially, the Fed won’t be buying mortgage-backed securities outright: it’s only accepting them as collateral in return for loans. But it’s definitely taking on some mortgage risk. Is this, to some extent, a bailout for banks? Yes.

Still, that’s not what has me worried. I’m more concerned that despite the extraordinary scale of Mr. Bernanke’s action — to my knowledge, no advanced-country’s central bank has ever exposed itself to this much market risk — the Fed still won’t manage to get a grip on the economy. You see, $400 billion sounds like a lot, but it’s still small compared with the problem.

Indeed, early returns from the credit markets have been disappointing. Indicators of financial stress like the “TED spread” (don’t ask) are a little better than they were before the Fed’s announcement — but not much, and things have by no means returned to normal.

What if this initiative fails? I’m sure that Mr. Bernanke and his colleagues are frantically considering other actions that they can take, but there’s only so much the Fed — whose resources are limited, and whose mandate doesn’t extend to rescuing the whole financial system — can do when faced with what looks increasingly like one of history’s great financial crises.

The next steps will be up to the politicians.

I used to think that the major issues facing the next president would be how to get out of Iraq and what to do about health care. At this point, however, I suspect that the biggest problem for the next administration will be figuring out which parts of the financial system to bail out, how to pay the cleanup bills and how to explain what it’s doing to an angry public.

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  1. vlade

    The main problem I see is that when (widely) people realize Fed is powerless, the panic will follow. It’s irrational, but so are the markets.
    From that perspective, it would have been better if Fed said at the start (and adhered to it strictly) that it will let failing institutions fail (CW being a prime example).
    I believe that a large institution half a year ago would cause panic too, but one from which the recovery would be faster and Fed would be more powerfull to do something about it
    Psychology matters. The more Fed tries and fails, the less impact it’s going to have and the more drastic action it will have take, only to be doubted on T+1 whether it will have any effect (based on previous performance).
    From psychological perspective, the best thing Fed could do, is to fire Bernanke (regardless of what we think of his performance so far), and take in someone who has the credentials to calm the market (no, not Greenspan. Someone Volcker-like).

  2. Jojo

    Your point about collateral damage as the FED frays about makes a lot of sense!

    The law of unintended consequences and Murphy’s law will surely hit the FED (and all of us, sadly) hard.

  3. Anonymous

    Bernankie the academic who spent his whole life studying the great depression threw his current actions are going to lead to the next one. Sometimes I wonder if he is like the fire fighter who is also the arsonist. Either that or he is sitting at the poker table and doesn’t know who the sucker is. Now that’s scary

  4. Anonymous

    “Jingle mail” redistributes losses from household equity to banking system equity.

    One could argue this constitutes an excessive distortion of intended loss bearing. To that degree intervention is warranted.

  5. S

    So now the NY Fed and Jamie “CDS” Dimon have a plan for BSC. Barney Frank has a plan for housing. Dodd also has a plan, like Barney. CNBC heasdline: “Stock Rally on US Bankruptcy.” The negative feedbakc loop is self fullfilling. These morons need to get outside thier ooda loop and understand and perhaps that means reading the NYT today.

    Watching the markets everyday has become an existential experience and any iota of rationalism is gone. Today we get a CPI report which says that prices were flat sequentially and down Y|Y. The sequential performance driven by a DECLINE in ENERGY and TRANSPORT offset by a RISE in HOUSING.

    Confidence lost.

  6. vader

    Maybe the prescription for avoiding the next “Great Depression” is not known and may be not knowable. There was a lot of analysis of what the Fed did in the late 20s and 30s, but no one really knows if the proposed solutions would have avoided it.

  7. Anonymous

    Yves, I love your blog, but I wish people who are going to comment on commodities would do some serious research before they start to opine.

    Commodities are not in a bubble–there are serious supply/demand issues, and Bernanke can’t do anything about them. What he can do is try to keep the banking system from collapse. I don’t want my money lost in a collapse of the banking system, do you? He’s doing exactly the right thing, and he is the right man for a terrible job.

    Bernanke has a good grasp of what’s going on with commodity prices. He understands that declining oil production, and rising oil prices, are key. At most, the fall in the dollar is worth a few bucks of the current price.

    Oil prices will stabilize for a while here (partly because China is on a little buying strike) no matter what Bernanke does with rates, and oil prices will have another leg up soon no matter what Bernanke does with rates.

    Moe Gamble

  8. S

    an is long oil. Gas inventoruies at record highs and record prices. In the long run we are dead. China is only as good as its exports hence the no depeg, yet. let that happen and see if the 24% FA growth is sustainable. Unintended conseq. of dolalr devaluation is fracturing of BWII – -read not good for China industrialization policy. If it doesn’t break and dollar rebounds that commodity long will look subprime.

  9. Boat 52

    A severe recession is not a nuclear war and wipe out a huge segment of the population. It would serve to clean house and provide a strong economic base to move forward. Ben B is living in yesterday. Bye bye Ben, the sooner the better. Hopefully the next president will remove him within the first 100days.

  10. minka

    Let the dollar tank. It’s the platinum lining to our crisis, via the export sector.

    Our industrial base has been hammered in part because of Asian mercantilism. We need the industrial base back. If the EU suffers enough because of the dollar crash, there may be enough political pressure for China to give up its peg. Or imported inflation will cause that. It’ll hurt like hell but we will have a path out of this morass.

    Our govt has been so dominated by corporate interests that we’ve allowed the massive outsourcing of jobs so that multi-nationals can sell us ever cheaper goods made in China. That was never sustainable and now the unwind is a big part of this collapse.

    Annoying corporate shills like Roach at Morgan Stanley have been talking about rebalancing for years. What we need is rebalancing American democracy, to take power from corporations and return it to the people.

  11. kwark

    Despite Moe’s comment above, Bernanke’s “solutions” all seem stop-gap at best – designed to keep the shell game going a bit longer in the hope that everything will straighten itself out somehow. Even Krugman seems a bit confused “… But the Fed is trying to contain the damage from the collapse of the housing bubble, keeping it from causing a deep recession or wrecking financial markets that had nothing to do with housing.” Nothing to do with housing? The slow-motion disaster caused by all the lies and liquidity sloshing around is evidence that the housing bubble is just one of the excesses of the financial markets.

  12. S

    minkia couldnt agree more. Funny defense worries about china’s military buildup, but the once scary China surplus dollars is becoming an albatross rapidly. The dollar decline while painful ought to be pressed by the policy community for exactly the reasons you stipulate. Bush takes every opportunity to tout free trade as he knows well that the halcyon days are over/gone/done. By the way halcyon capital going public (hedge fund) kind of ironic. Reindustrialzation along the german model will work nicely thanks you. And the productivity myth (4 more hours a day for an extra button on the remote) that the goverement loves to tout ought to be added to the dustbin).

  13. Max

    I would not be so enthusiastic about dollar devaluation. Traditionally, the US thrived on good investment opportunities it offered here, I’m sure Ives, as a former ibanker, can vouch. A deliberate debasement of the dollar will be fatal for the investment climate here, the capital will flee, and the resulting high interest rates will kill the rest of the economy. Also, as any complex economy with a high degree of specialization, we are vastly dependent on affordable imports to do business here.

  14. Anonymous

    Having read the preceding posts about the “causes” of the current economic problems and the proposed solutions, it is clear to me why Dr. Bernanke and the politicians haven’t come up with a solution(s). The problem is too amorphous and there is no simple solution. You can decry the efforts of Bernanke and congress, but none of you have a “good” solution. Just admit it and move along. Most of us will come out the other end of this, poorer because our economy is weaker and we bailed out the institutions we can’t live without. I’m 55 years old and I have now seen this happen at least 3 times. Unfortunately, we are running out of reserves with which to bailout the big guys who exploit the system. At my age I’m supposed to be pretty conservative economically, but I am being driven back to my twenty something liberal economic ways. More government oversight, a steeper progressive income tax and unions. Business and the market have brought it on themselves.


  15. S


    capital finds ideas if the market is allowed to work. The problem is we haven’t been very good at that lately. It is the very system you espouse works that has gotten us here. The system needs an overhaul which requires retarding conventional consensus “principles” that have acted to buoy a foundation that is crumbling as the superstructure is decorated with ever more bells and whistles. As for relying on investment bankers, being an escapee, not the place to be searching for ideas for the most part. I wonder how many people on the Forbes list are i-bankers (pre 2000 and post 2002). be an interesting look.

  16. S


    There are clear and present solutions to the crisis, they are just too painful and require sacrifice for more than the sound bite attension spans. THe solution is to retard the system and change the game. You do that by being willing to endure some pain and asking for collective sacrifice. The governement vastly underestimates the resolve of the American people. The nly thing lacking is someone who can articulate why policy has failed, why conventional thinking is flawed and offer a courageous vision of a different path. Not some change slogan, but a demonstrated understanding of the various issues that have tied the United States down in self defeating conventions/rule sets (to borrow a Barnett phrase). The rule set needs to change and devaluing the dollar, while I agree is not the path to prosperity, but it may unfortunelty A path to changing the rule set.

    The simple solution is to let the instutions fail in the natural process of creative destruction. There are far too many ibankers, analysts ect. The market works best when left to its own devices. There has been so much mal investment across retail, constuction, finance and other as a direct result of government action that espousing more action is exactly the wrong thing to do. Yves is right, let it fail. And if Lehman goes too so be it. Goldmas is still American and it will have to hire more people to do the work of 3. What is wrong with that?

    3 simples steps.
    1. get out of the way and let the market work
    2. elect someone who understands the complexities inherent in the current market system.
    3. galvanize grassroot support to change the rules with an upfront buyin for the short term pain. Inspire the next greatest generation via a neo -reconstruction.

  17. Inquisitor

    Great analysis. I wish the Fed would get out of the way and let the market correct itself. History has shown time and time again that intervention of this sort only prolongs recessions and makes things worse.

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