COMMENT 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.
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