Wednesday will be an interesting day, and not just because of the introduction of the iPad. It is also likely to be the start of Fed Chairman Ben Bernanke’s confirmation hearings for a second term. The final result no longer seems to be in doubt. Intrade now reports over a 90 percent probability of confirmation; last week it was in the 70s.
Bernanke’s confirmation was momentarily in jeopardy because politicians are beginning to fear the rise of populism, especially after the surprising election of Scott Brown as the new Republican Senator from deep-blue Massachusetts. Indeed, most Tea Party/End the Fed types probably would like to see Bernanke’s confirmation fail. But I think there is a strong elitist case for why Bernanke should be dismissed.
The role of the Fed is or ought to be to do whatever it takes to keep Congress and the President from messing with the economy. Among other things, this means:
- Using monetary policy to keep nominal GDP growing at a predictable rate.
- Discouraging the use of fiscal policy, both by doing #1 and by saying that it is a bad idea.
- Displaying an appearance of control and competence, so that the elected politicians do not get involved.
Whatever your views on the relative theoretical merits of abstract monetary and fiscal policy, monetary policy conducted by the Fed is more effective than fiscal policy conducted by Congress. In my view, even in pure theoretical terms, monetary policy can do everything that fiscal policy can, so there is no reason to use fiscal policy. Some will of course dispute this. But in practice, fiscal policy indisputably ends up being far less effective because:
- It is not timely. Much of the recent fiscal stimulus will not be spent until after the economy returns to full employment.
- It is not targeted. To be effective, fiscal policy should target idle assets and produce relatively useful stuff. Members of Congress are of course eager to spend money, but their incentives are to use the funds for political purposes rather than on useful projects employing idle people and assets.
- It is not temporary. When politicians use fiscal policy as an excuse to increase government expenditures on a permanent basis, any stimulative effect gets completely wiped out by increased deadweight loss of taxation and increased risk of a debt or currency crisis.
On Bernanke’s watch, nominal GDP fell below trend beginning in 2008. This slip-up caused or at least exacerbated a financial crisis that made nominal GDP fall further. Bernanke then got on TV with Hank Paulson, told everyone the sky was falling, and got Congress involved in the financial rescue effort. In addition, Bernanke has refused to say anything that might constrain Congress or dissuade it from wasting money on pseudo-stimulus. Had Bernanke kept nominal GDP growth steady, used the tools the Fed already had (quantitative easing) to buy toxic assets in the milder financial crisis (without Congress’s or Treasury’s approval or involvement), spoken out against fiscal policy, and appeared in control, the economy would be in a much better state today. For these reasons, Bernanke does not deserve to be confirmed.
Nevertheless, I do worry about who would replace him. If populist sentiment really is as powerful as they say, it could be a lot worse. I have seen lots of calls online to “End the Fed,” but proponents do not seem to realize that this would give Congress much more power over the economy and that they would not like the results. The Fed is the lesser of evils, and the Fed Chairman ought to believe this. A more populist nominee, even if he would not go so far as to abolish the Fed, would be even less likely than Bernanke to view his role as Protector of the Economy from Congress. Perhaps it is a good thing after all that there is a 90 percent chance Bernanke will be confirmed, but in a just world, he would be on the first train back to Princeton.
4 Comments
There’s something fundamental I don’t understand. Why does keeping nominal GDP on track make things better during a recession? What if prices are all out of whack relative to one another? And what about the theory that during a recession all the instruments (monetary or whatnot) that you thought you had before, all of a sudden start to malfunction?
Pietro, there are multiple stories for why keeping nominal GDP on a stable trajectory is a good idea. The simplest one is that it’s a good heuristic. NGDP = [monetary base] * [how fast the monetary base is spent]. One of the characteristics of a recession is usually that the velocity of money decreases because 1) there aren’t good investment projects and 2) some people hoard cash. If you are keeping NGDP on a stable trajectory, then you’ve got to increase the monetary base when velocity falls, and decrease it when velocity rises. This is a pretty good, if not perfect, rule.
I agree that relative prices also matter, and in a perfect world they would reflect people’s genuine preferences. But I think that an explicit NGDP target would not actually be that damaging to relative prices, particularly if it were rigorously adhered to. Even Hayek argued that stabilizing NGDP is important, and some modern Austrian economists, who are clearly sensitive to the relative prices issue, endorse the idea. The real problem for relative prices comes when you try to get a little boost from a monetary surprise, above and beyond the stated NGDP target.
I think the idea you’re referring to is a liquidity trap. The simple version of the liquidity trap story is that during a bad recession, money demand becomes highly elastic. Injections of money just get hoarded and never make it to the loanable funds market, so interest rates don’t go down. There is a related story in which nominal interest rates are already at zero and cannot go lower. If monetary policy can’t affect the interest rate, the argument goes, then it is ineffective. I don’t buy either of these stories. First, the hoarding argument is overstated. A more sophisticated version is that people invest in lower risk assets, which I think is probably true. But even this is not that important because, second, interest rates are not the only channel through which monetary policy affects the economy. If the Fed printed a billion dollars and gave it to me, I would spend some money, regardless of what interest rates are. The reality is that the Fed has lots of tools to stimulate the economy, even if the injections don’t go directly to the market for loanable funds.
I have to disagree here. The current stimulus package will all be spent by the end of 2010. I know of no one who is forecasting unemployment below 8% by then and many who are forecasting unemployment above 8% until 2012-14. If you know of someone who is predicting a return to full employment (however you want to define that) by the end of 2010, I’d love to see it.
That is a fair point, and it underscores how bad monetary policy has been. But look at it in expectational terms: had Bernanke done his job, I think there would have been full employment in 2010. Probably a lot of other people thought this would be the case as well. Telling people in 2008 that a fiscal stimulus will hit in 2010, when they expect to be back at full employment, does no good. It creates no additional motive for investment, because entrepreneurs expect to be fully crowded out. Only if they expect less than full employment in 2010 will a stimulus scheduled for 2010 be stimulating in 2008. So while I am happy to cede the point that ex post the fiscal stimulus will be spent before a return to full employment, that does not diminish the fact that the timeliness of fiscal stimulus is a problem, both in general and in this recession.