The Guardian Unlimited, August 16, 2010
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Last week the Fed announced that it would use the proceeds from retired mortgage-backed securities to buy up more government bonds. This may have a very modest effect in keeping long-term interest rates low, thereby giving a small boost to the economy.
Such a measure would be reasonable if the economy was basically fine and just in need of a modest lift. But this is not the case.
The unemployment rate is 9.5 percent and virtually certain to rise in the 2nd half of the year. Job growth has basically stopped and the GDP is likely to be in the range of 1-2 percent in the next four quarters, as state and local governments cut back spending, the stimulus phases down and the housing market resumes its slide.
In this scenario, the Fed should be taking aggressive steps to bring the economy back to full employment. After all, this is part of its job description. Its responsibility is to promote price stability and full employment. There is no concern about price stability in the sense of the rate of inflation being too high right now. Therefore the Fed’s responsibility should be to do everything within its power to reach full employment; obviously we are nowhere close now.
Bernanke even knows exactly what needs to be done, as the Wall Street Journal recently reminded us. He wrote a paper back in 1999 about Japan’s stagnant economy and mild deflation. Following a recommendation by Paul Krugman, he urged Japan’s central bank to target an inflation rate in the range of 3-4 percent.
A rate of inflation in this range would substantially reduce real interest rates, giving firms a powerful incentive to invest. It would mean, for example, that if they built a factory this year, the goods it produced would be selling for 15 to 20 percent more in five years. This modest level of inflation would also go far in reducing the debt burdens of households. The burden of their mortgages and other debt would be eroded as wages rise roughly in step with inflation, while the size of the debt remains fixed.
In spite of knowing exactly what needs to be done, Bernanke and the Fed show no inclination of moving in this direction. Instead, the Fed seems prepared to ignore its legal mandate to promote full employment.
The explanation for this incredible policy failure is straightforward. The people that Bernanke must answer to are the Wall Street bankers, not Congress and the public. The Wall Street bankers are not troubled by 9.5 percent unemployment. Their profits are back to pre-recession levels and bonuses are again hitting record levels.
For the Wall Street bankers, everything is just fine now. If Bernanke were to pursue a policy of targeting 3-4 percent inflation, it could erode the real value of many of their assets. These banks own mortgage debt and other assets whose value would be reduced by even modest rates of inflation. While targeting a slightly higher rate of inflation may be a no-brainer from the standpoint of workers and most of the country, it is not good for Wall Street, and this is who our supposedly independent Fed is answering to.
This is not the first time that Bernanke has done Wall Street’s bidding. When Goldman, Citigroup and the rest were on the edge of bankruptcy, Bernanke deliberately misled Congress to help pass TARP. He told them that the commercial paper market was shutting down, raising the prospect that most of corporate America would be unable to get the short-term credit needed to meet its payroll and pay other bills.
Bernanke neglected to mention that he could single-handedly keep the commercial paper market operating by setting up a special Fed lending facilities for this purpose. He announced the establishment of a lending facility to buy commercial paper the weekend after Congress approved the TARP.
Of course, the whole crisis stems directly from the Fed and Bernanke’s fealty to Wall Street. It was easy for any competent economist to recognize the housing bubble and the danger it posed to the economy as early as 2002. Yet, the Fed and Bernanke (then working as Greenspan’s sidekick as a Fed governor) insisted that everything was just fine with the housing market. After all, the Wall Street banks were making tons of money, what could be the problem?
The country badly needs a central bank that is independent of Wall Street, where its governors can do what they believe is best for the economy and the country. Unfortunately, we do not have such a Fed. Until Congress and the public start putting heat on Bernanke for his policy failures, we can expect to get kicked in the face again and again.