January 30, 2008
Bernanke’s reflation gamble may work too well
By Martin Wolf
Whatever else it may be, the Federal Reserve is not boring. Indeed, by the standards of other central banks, it is hyperactive. The shock 0.75 percentage point reduction in the Federal Funds rate of interest last week, particularly if followed by the widely expected 0.5 percentage points on Wednesday, is a dramatic example. The Fed is the exemplar of an activist central bank. But US fiscal authorities are not far behind, as the $150bn (just over 1 per cent of gross domestic product) fiscal package going through Congress demonstrates.
So what are the US monetary and fiscal authorities trying to do? Will it work? What are the risks? Should others follow suit? The urgency of these questions was made clear at the annual meetings of the World Economic Forum in Davos last week. The consensus was gloomy. Comfortingly, the Davos consensus is usually wrong. The Fed is certainly trying to prove it so this time.
The answer to the first question is: apply “risk management”. That approach is associated with Alan Greenspan, the former Fed chairman. But it is also central to the thinking of the Fed under Ben Bernanke.
The remainder of this column can be read here. Debate from our panel of economists appears below.
Christopher Carroll: Martin Wolf channels a plausible concern that the Fed’s “reflation gamble” might be a bet on the wrong horse: if the US economic slowdown reflects supply problems like the soaring price of oil, rather than faltering demand, then monetary and fiscal stimulus alike will result in higher inflation which will have to be unwound by painful future stringency.
In a few years we will probably know the answer. But at the moment, the Fed’s gamble seems well judged, not because the concerns of the inflation hawks are unwarranted but because they are balanced by a more dangerous possibility on the opposite side. Put it this way: if I’m hiking a narrow cliff-hugging mountain trail, I don’t want to stroll right down the middle of the path. Instead I will edge to the to the side of the trail away from the precipice, even if this means an occasional scraped ankle or a bit of extra scrambling. This is the “precautionary principle” in mountain-climbing.
The cliff, for monetary policy, is the possibility of deflation, whose dangers were calamitously illustrated by the Japanese government during the 1990s. And the precautionary principle would say that it is worth risking a spell of extra inflation to avoid even a small risk of a deadly dose of deflation.
This interpretation is given greater force by the argument Guillermo Calvo made a few days ago in a prior Economists’ Forum post: the unfolding events in the US look more like a credit crunch than like either a traditional demand or supply shock.
Calvo argues that neither monetary nor fiscal stimulus is well targeted for clearing up dysfunctional credit markets. But one has to ask, “compared to what?” Policymakers in poorly performing economies are sure to do something, usually a variety of somethings, in response to a slump. As the Japanese showed us, many of the things they might do can make the problems worse. Japanese policymakers were obsessively concerned with preventing insolvent firms from being forced to lose face and admit that their loans could never be repaid. The result was a lost decade of “zombie firms” who everyone knew would never pay off their loans but whose lenders were pressured into not cutting them off.
One might imagine that nothing so foolish could happen in the United States; but the way the wind is blowing is indicated by the Bush administration’s proposal for a voluntary freeze on interest rates on adjustable rate mortgages, which several of the presidential candidates have called for making mandatory, for five years or longer, for mortgages issued at the height of the subprime lending frenzy. Undoubtedly much of this lending was unwise, and perhaps even exploitative or fraudulent (recent news reports indicate that the FBI has belatedly launched probes). But the last thing we need to do is freeze the disaster in place; credit markets need to sort through the mess and separate the hopeless loans from the ones that can be worked out, not be required to treat them all the same according to some formula hammered out by political deals in Congress.
This situation provides a more than sufficient rationale for the Fed’s dramatic actions: Deflation combined with a debt crisis make a toxic combination, because as prices fall, real debt rises. This point was amply illustrated in Japan, where deflation amplified both the number of zombies and the degree of zombification (among the initial stock of the undead). It was also the basis of Irving Fisher’s theory of what made the Great Depression great, and has clear echoes in the macroeconomic literature on the “financial accelerator” pioneered by none other than Ben Bernanke (along with a few other authors who have pursued more respectable careers).
In this context, the risk of an extra year or two of an extra point or two of inflation (if the deflation jitters prove unwarranted and the subprime crisis proves transitory) seems a gamble well worth taking.
Christopher Carroll is professor of economics at Johns Hopkins University, and former staffer at the Federal Reserve
Posted by: Christopher Carroll | January 31st, 2008 at 8:52 pm | Report this commentAdam Posen: Martin unfortunately perpetuates a popular canard amidst some good points. He asserts a risk is “a further round of the very asset bubbles and credit expansion that created the present crisis … the direct result of past Fed efforts at the risk management.” This is false (which is why I didn’t list it among my costs of the Fed doing the right thing in my own comment article).
No matter how many times people say it on the FT comment page and elsewhere, activist monetary policy did not cause the bubble. Looser money is a necessary pre-condition for a bubble, but it is not sufficient to cause one on its own. This can be seen in the ample research, including the frustrated attempts by monetary moralists, to show a direct link between monetary ease and asset prices - all of which failed to do so. Too many times there has been ease without any bubble or harm from asset prices.
Rather than recap that econometric research, consider the following. You walk out your door one February morning, slip on an ice patch, and fall. While this may confirm your preference for summer, you do not say “winter made me fall” if your concern is to prevent future crashes. You say: “Why wasn’t this walk cleared of ice? Why didn’t I look where I was going? Should I be wearing boots when it ices over?” While one does not slip on ice in summer, winter did not cause the accident, and that season is not something one can feasibly prevent even locally.
The same is true for asset price bubbles. If there is a problem from them, it is because of regulatory and supervisory failings, and market participants being foolhardy, not because of monetary ease - even if it takes place against a background of monetary ease, the practical steps for improvement and repair are the micro not the macro.
It is time for us to focus on the regulatory reforms we need, and stop blaming monetary policy for what supervisory failures caused. One doesn’t shake one’s fist against the weather if one wants to do more than emote.
Posted by: Adam Posen | February 1st, 2008 at 3:15 pm | Report this commentMartin Wolf: I am very grateful to Christopher Carroll, not only for what he has said, but for elucidating further the thinking that is driving the Fed. I am a little bit puzzled by the argument.
Developed countries have suffered three monetary policy disasters in the last 80 years: the Great Depression of the 1930s; the Great Inflation of the 1970s; and the Japanese Debt Deflation of the 1990s. Why is the Fed focused so heavily on the last (and, to a lesser degree, the first)? Was the Great Inflation not also a disaster, from which Paul Volcker had to rescue us, at very great cost? So should not the risk of reigniting inflation also be taken seriously?
I would suggest that the image of a mountain path which Professor Carroll uses is not quite right. Rather, the Fed is walking a tight-rope between two opposite dangers - inflation and recession. By exaggerating the threat of falling into one, it increases the likelihood of falling into the other.
In particular, I do not accept that the chances of a Japanese-style debt-deflation are that high in the US. As an external deficit country, it does not suffer from any surplus of savings (and so structural deficiency of domestic demand) as Japan did. On the contrary, the US suffers from excess demand, as shown in the current account deficit. Should not savings be higher and the current account deficit smaller? Does that not require a cut-back in domestic spending?
So what the Bernanke Fed seems to be trying to halt (with enthusiastic assistance from Congress and the president) is a natural and necessary adjustment, as Ricardo Hausmann argued in the FT on January 31st. I agree that this adjustment must not be too brutal. I agree, too, that both a steep recession and deflation should be avoided. I agree, finally, that market adjustments must not be frozen, as happened in Japan. But I disagree that the US confronts a huge threat of deflation from which the Fed must rescue the economy at all costs. What I fear it is doing, instead, is bailing out the banking system and so trying to reignite the credit cycle, with the consequent dangers of a flight from the dollar, considerably higher inflation and much more bad lending ahead.
We will never know whether the Fed had to take such dramatic action if the US does indeed avoid deflation. But if the next cycle proves even more destabilising than the last one, the Fed cannot possibly escape some blame.
Posted by: Martin Wolf | February 1st, 2008 at 4:39 pm | Report this commentMartin Wolf: Let me also add a comment on Adam’s remarks.
Let us agree that monetary ease is merely a necessary condition for a bubble, not a sufficient one.
I would put it as follows. Aggressive monetary ease is like pouring petrol on straw. That may well not start a fire, as Adam writes: the straw may be wet, for example, or the people around the straw may be responsible. As it happened, these people were pyromaniacs. But the Fed did next to nothing to discourage them. On the contrary, it was opposed to tighter regulatory standards. This was the combination that created the credit blaze. So the combined policies - monetary easing along with regulatory laxity - do indeed bear responsibility for what happened.
I will go further. Since the chances of serious regulatory tightening (the subject of my next column) are close to zero (in my judgement), I fear the same danger still exists. If the Fed pours on petrol once again, the pyromaniacs will try to restart the fire.
I agree that the straw is very wet at the moment. So this will take a while. I also agree with Adam that this does not have to be the case if effective regulatory changes are made. But since I do not expect the latter to happen, I fear the longer-term consequences of present policies.
Posted by: Martin Wolf | February 1st, 2008 at 4:56 pm | Report this comment