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     Jun 11, 2008
Bernanke Fed getting it right
By Thomas I Palley

US Federal Reserve Board chairman Ben Bernanke has recently been on the receiving end of significant criticism for his monetary policy. One approach 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 that 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 supporting 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. This explains the efforts of Treasury Secretary Henry Paulson to reach out to foreign investors in places like Abu Dhabi. The logic is that foreign investors are sitting on mountains of liquidity and can therefore re-capitalize the system without the US taking recourse to lower interest rates that supposedly risk a return of '70s-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 crisis, in the European view, constitutes a massive liquidity problem, and as such the Fed should have responded by making liquidity available without lowering rates. That is the course the European Central Bank has taken, holding the line on its policy interest rate but making large 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, which 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. Inflation in the 1970s was rooted in a price-wage spiral, in which price increases were matched by nominal wage increases. 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 overlooks the scale of the demand shock the US economy has received. Moreover, that demand shock is continuing. Falling house prices and the souring of hundreds of billions of dollars of mortgages have caused the financial crisis. However, in addition, falling house prices have wiped out hundreds of billions of dollars 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 the 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 policy stance 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.

Thomas I Palley is the founder of the Economics for Democratic and Open Societies Project.

Copyright 2008 Thomas I Palley.

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