At the Federal Reserve, It's Lonely at the Top

Tuesday, 16 November 2010 08:36 By Paul Krugman, Krugman & Co. | Op-Ed | name.

At the Federal Reserve, It
(Image: CartoonArts International / The New York Times Syndicate)

While people like me see the Federal Reserve’s recent actions as far too timid, there’s a substantial faction out there that thinks they will very soon bring about the end of Western civilization.

It has been quite interesting to read the commentary that has followed the Fed’s Nov. 3 announcement that it would pump $600 billion into the economy.

Take the Bloomberg article of Nov. 5 featuring investor Jim Rogers, the chairman of Rogers Holdings, who said that quantitative easing will be a “horrible disaster,” and that Fed chairman Ben S. Bernanke simply doesn’t understand economics. “His whole intellectual career has been based on the study of printing money,” Mr. Rogers said. “Give the guy a printing press, he’s going to run it as fast as he can.”

Inflationistas like Mr. Rogers have been wrong about absolutely every aspect of this economic cycle (and they were wrong about the last cycle, and the cycle before that).

But they have their devotees, which means that changes to monetary policy, our only real hope for kick-starting the United States’s economy at this point, must vault a wall of stupidity before there’s any chance they’ll be implemented.

Recently, I have been asked by various people what I would do if I were Mr. Bernanke, or what I would do if I were in charge of the Fed. Now, that is not the same thing: Mr. Bernanke is not a dictator. Evidence suggests that he would be substantially more aggressive in both action and rhetoric  if he weren’t constrained by the need to get his colleagues to agree with him. I don’t know what I would do in his place.

What I would do if I were in charge of the Fed is the same thing I suggested that Japanese officials do in 1998: announce a fairly high inflation target over an extended period and commit to meeting that target. As I have said before, when you’re up against the zero lower bound, it doesn’t matter how much money you print unless you credibly promise higher inflation.

What does this mean? Let’s say the Fed commits to achieving 5 percent annual inflation over the next five years — or, perhaps better, to hitting a price level 28 percent higher at the end of 2015 than today’s level. Crucially, this target cannot be called off if the economy recovers. Why? Because the point is to change expectations, and that means locking in the price rise.

The sad truth is, of course, that the chances of our achieving anything like this are no better than those for implementing an adequate fiscal stimulus — at least for now.

At best, the limited quantitative easing that was just announced will only provide mild mitigation of the country’s current problems. Perhaps when the reality that the United States is caught in a liquidity trap sinks in — as the fact that we’re doing worse than Japan starts to finally penetrate our arrogance (amazing how long that’s taking) — we will eventually get there.

But it is not likely to happen soon.

Backstory: Running Low On Options

In an unusual move, the United States Federal Reserve committed on Nov. 3 to buying $600 billion in Treasury securities by June, hoping that demand for the 30-year bonds will push up their value and depress long-term interest rates.

Lower long-term rates could encourage homeowners to refinance mortgages and corporations to release cash from their balance sheets, injecting much-needed liquidity into the capital markets.

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For the last two years, the Federal Reserve has kept short-term interest rates near zero in an attempt to stimulate growth in the United States, to little avail. The economy remains stalled, and unemployment has hovered around 9.6 percent for months.

But beyond adjusting short-term interest rates, the Fed has few options for encouraging economic growth, especially without accompanying fiscal stimulus measures.

One option is the monetary intervention the Fed announcedNov. 3 — what economists call quantitative easing.

The most cited example of a government’s use of this tactic is Japan’s injection of money into its economy between 2001 and 2006. Japan’s economic situation has not shown much improvement; it seems to be stuck in the sort of economic quagmire that American officials are trying to avoid.

The Fed’s foray into a new round of quantitative easing has not been welcomed by critics, who predict that the action will lead to dangerous inflation in the United States.

Joining them are officials from nations in Asia and Europe who have expressed worry that their markets will be flooded with foreign capital as investors seek higher returns, and that their currency values will rise, making their exports less competitive against American-made products.

“What the U.S. accuses China of doing, the U.S.A. is doing by different means,” said Germany’s finance minister, Wolfgang Schäuble.

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Paul Krugman joined The New York Times in 1999 as a columnist on the Op-Ed page and continues as a professor of economics and international affairs at Princeton University. He was awarded the Nobel in economic science in 2008.

Mr Krugman is the author or editor of 20 books and more than 200 papers in professional journals and edited volumes, including "The Return of Depression Economics" (2008) and "The Conscience of a Liberal" (2007).

Copyright 2010 The New York Times Company.

Last modified on Tuesday, 16 November 2010 15:47