Eli Dourado

The elitist case against Bernanke

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:

  1. Using monetary policy to keep nominal GDP growing at a predictable rate.
  2. Discouraging the use of fiscal policy, both by doing #1 and by saying that it is a bad idea.
  3. 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:

  1. It is not timely. Much of the recent fiscal stimulus will not be spent until after the economy returns to full employment.
  2. 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.
  3. 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.