A Kind Word for Ben

It brings me great angst to observe professional critics – many of them acquaintances and friends of mine – rhetorically beating Fed Chairman Ben Bernanke about the head and shoulders for launching QE2. At the same time, the fact that Sarah Palin has joined the chorus brings me great joy. If what Ben is doing offends both the learned and the unlearned, then he is clearly acting unconventionally relative to orthodoxy. And this is good, very good.

As I wrote on these pages over a year ago¹, acting irresponsibly relative to conventional wisdom is precisely the right approach for reversing an economy facing, or worst yet, mired in a liquidity trap. Indeed, in that essay, I wasn’t so much preaching my own analytical sermon but reciting Mr. Bernanke’s own sermons of 2002–2003, grounded in a sermon he preached (in Boston) in 1999 to the Bank of Japan. In these sermons, Mr. Bernanke was echoing and enhancing the work of Paul Krugman in 1998 and Gauti Eggertsson and Michael Woodford in 2003.

And the bottom line of all these epistles was simple. To reverse the debt-deflation pathologies of a liquidity trap, when private sector deleveraging renders private sector demand for credit inelastic to lower interest rates, especially when the central bank’s short-term policy rate is pinned against the zero nominal lower bound, the central bank should:

• Openly coordinate itself with the fiscal authority, accommodating increased fiscal expansion, for example printing money to finance an economy-wide tax cut.
• Openly encourage higher short- to intermediate-term inflation expectations, via an interregnum of price level targeting, rather than year-by-year inflation targeting, implying that below-target inflation sins are not forgiven, but recovered with above-target inflation rates, until the constantly-growing long-term price level path is restored.

Yes, those were the pillars of Mr. Bernanke’s academic thinking about liquidity trap macroeconomics, grounded in his own life-time study of the Great Depression, as well as the analytical work of his rock-star academic peers.

Mr. Bernanke is no longer an academic, of course, but the chairman of the most powerful central bank in the world, the custodian of the global reserve currency, operating independently within, but not of, the democratically-elected United States government.

From the Academy to the Arena
While Mr. Bernanke’s academic scribblings – that’s a compliment in the economist profession! – hugely inform his current policy-making framework and maneuvers, the fact is that he is working in the real world, where out-of-the-box thinking is welcomed only when in-the-box thinking is proven manifestly wrong or ineffective. His job is not easy. He is living and working in an arena where, in the words of Keynes, “worldly wisdom teaches it is better for reputation to fail conventionally, rather than to succeed unconventionally.”²

The fact that Mr. Bernanke is willing to take the heat – domestically and internationally, from friend and foe alike – to launch QE2 is testimony to the strength of his convictions as to the purpose of his office. The Federal Reserve was created in 1913 by Congress, which constitutionally has the power "to coin money, regulate the value thereof.”³

Since that time, and especially since 1951, when the Fed negotiated its operational independence from the Treasury, the Federal Reserve’s relationship with the rest of the United States government has evolved, with the Full Employment Act of 1978, commonly known as the Humphrey Hawkins Act, providing Congress’ present mandate to the Federal Reserve:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”⁴

Thus, while the Federal Reserve has independence in its day-to-day monetary tactics, known as operational independence, the Fed does not have independence in the setting of the goals toward which its tactics are directed. And this is the way it should be in a democracy. Congress is responsible to the American people, and the Federal Reserve is a creation of Congress.

To its credit, Congress recognizes that democracy is inherently given to wanting the fiscal authority to spend more than it taxes, running deficits: ice cream sells much better than castor oil in getting elected. And this is particularly the case when the entire House of Representatives must stand for election every two years.

Congress – and the Executive Branch, too – would, left to their own devices, inherently, and rationally, favor a monetary authority amendable to printing up money to cover the difference between its commitment to spend and its willingness to impose taxes to pay for that spending. Recognizing this inherent and structurally inflationary impulse, Congress wisely delegated operational independence to the Federal Reserve, effectively saying “stop ourselves from ourselves.”