Can the Fed Stimulate Growth or Only Inflation?

Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of the coming book “The Benefit and the Burden.”

Many economists, myself included, believe that a more aggressive Federal Reserve policy is needed to turn the economy around. Additional fiscal stimulus would also help. As the chairman of the Federal Reserve Board, Ben Bernanke put it at a Nov. 2 news conference, “It would be helpful if we could get assistance from some other parts of the government to work with us to create jobs.”

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However, such assistance will not be coming. President Obama’s jobs package has been blocked by Republicans in Congress, and the order of the day is fiscal tightening, with the Joint Select Committee on Deficit Reduction poised to offer recommendations for $1.5 trillion in additional deficit reduction by Nov. 23.

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With fiscal stimulus off the table, monetary stimulus is all that is available. But the Republican view is that monetary policy is incapable of stimulating real growth – that it will stimulate only inflation. This view is regularly enforced by The Wall Street Journal editorial page, which establishes the ideological line for Republicans on Fed policy.

In an editorial on Feb. 29, 2008, The Journal said it was certain that higher inflation was on the way, calling it the “Bernanke reinflation.” An editorial on June 9, 2008, warned that easy money and Keynesian stimulus “is taking us down the road to stagflation.” On Feb. 6, 2009, the Journal editorial writer George Melloan said the inevitable result of economic stimulus would be inflation. On June 10, 2009, the economist Arthur Laffer wrote on the Journal editorial page that the increase in the Fed’s monetary base was “a surefire recipe for inflation and higher interest rates.”

Echoing the party line, Representative Paul Ryan of Wisconsin, in a New York Times op-ed article on Feb. 14, 2009, said it was a virtual certainty that 1970s-style stagflation was coming back. In The New York Times on May 4, 2009, the conservative economist Allan Meltzer wrote that enormous budget deficits, rapid growth in the money supply and a sustained currency devaluation were “harbingers of inflation.”

More than two years later, none of those predictions has come to pass. According to the Federal Reserve Bank of Cleveland, inflationary expectations have been falling for years and continue to fall. Indeed, recent reports from Reuters and CNNMoney found that deflation – falling prices – is a growing problem.

Although the anticipated inflation rate is falling and the “risk premium” — the difference between a bond that doesn’t adjust for inflation and one that does, in the same maturity — has scarcely changed, conservatives continue to warn that inflation is right around the corner, especially if the Fed were to adopt a new operating procedure called nominal gross domestic product targeting.

This is an idea supported by Christina Romer of the University of California, Berkeley, economists at Goldman Sachs and others. The idea is to permit a period of catch-up inflation to get nominal G.D.P. back to its prerecession trend, which would increase incomes, employment and household balance sheets.

But conservatives want nothing to do with N.G.D.P. targeting. Amity Shlaes, a columnist with Bloomberg News and a former Wall Street Journal editorial writer, denounced the idea in a Nov. 2 column, calling it “a license to inflate.”

Her view is that if a recession causes growth to fall, unemployment to rise and home prices to crash, people should just suck it up and learn to live with it. Allowing prices to rise from wherever they are, even if there has been a deflation that caused them to fall, opens the door to stagflation and even hyperinflation. It’s a risk too great to take. The risk of continuing the status quo is, apparently, nothing to be concerned about.

It’s tiresome to read such rationalizations for doing nothing about the second-greatest economic crisis in our history, especially from someone like Ms. Shlaes, who is well versed in the history of the Great Depression.

Then, too, there were those just like her, like Henry Hazlitt, an editorial writer for The New York Times, and Benjamin M. Anderson, an economist with Chase National Bank, who also said people should just suck it up, that unemployment was only caused by excessive wages and greedy workers and that inflation was a cure worse than the disease, even as the price level fell 25 percent from 1929 to 1933.

With fiscal stimulus off the table and Republicans gambling that continued economic stagnation will hurt Democrats more than them, the Federal Reserve is the only institution with the freedom of action and power to stimulate growth. But it is constrained by conservatives who charge that it is fostering inflation whenever it tries to provide monetary stimulus.

The fact that conservatives have consistently been wrong about this for the last three years has done nothing to diminish their confidence. They are like the French Bourbons, who learned nothing and forgot nothing.

Of course, no one wants to go back to the 1970s, when we had both rising inflation and rising unemployment. But the risk of inflation is now as low as it’s been since the 1950s, while slow growth and high unemployment impose a crushing burden on a huge portion of the population. If the Fed believes it can help, it has a responsibility to do so.

Recovering From a Balance-Sheet Recession

Laura D’Andrea Tyson is a professor at the Haas School of Business at the University of California, Berkeley, and served as chairwoman of the Council of Economic Advisers under President Clinton.

Unprecedented volatility on global capital markets and a sharp correction in global equity prices are warning signs that the United States, Europe and Japan are teetering on the brink of a double-dip recession.

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In the United States, growth in the first half of the year was far slower than predicted, and forecasts for the full year have been marked down. Even if the economy does not slip back into recession, the jobs crisis will persist, because growth will be barely enough to absorb the flow of new entrants into the labor force and certainly not enough to make a significant dent in the unemployment rate.

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To develop cures to ease the jobs crisis, its causes must be diagnosed correctly. The fundamental cause is the drastic breakdown in private-sector demand brought on by the 2008 financial crisis that burst the debt-financed housing and spending boom preceding it.

This boom displayed all of the features of a major financial crisis in the making — asset price inflation, rising leverage, a large current account deficit and slowing growth. And the recession that followed had all of the features of what Richard Koo called a “balance-sheet” recession — a sharp decline in output and employment caused by a collapse of demand resulting from vast wealth destruction and painful de-leveraging by the private sector.

The economy is now mired in an anemic balance-sheet recovery in which many consumers and businesses continue to curtail their spending relative to their income, increase their saving and reduce their debt even though interest rates are near zero. And the process of de-leveraging is only beginning.

Real per-capita net worth in the United States is back at its 1999 level. The real per-capita value of housing equity has fallen to its 1978 level, and housing prices are still slipping in many parts of the country.

Household debt has come down to about 115 percent of disposable income, largely as a result of foreclosures, 15 percentage points below its peak of 130 percent in 2007 but significantly higher than its 1970-2000 average of 75 percent. Household saving has risen to about 5 percent of disposable income, far above the 2005 low of 1.2 percent but far short of the 1970-2000 average of 8 percent.

Consumption is the major driver of aggregate demand in the United States economy, and since early 2008 it has grown at an average rate of 0.5 percent in real terms. Not since before World War II has consumption growth been this weak for such an extended period.

Despite misleading claims by Republican members of Congress and by Republican candidates on the presidential campaign trail that the size of government, regulation and excessive taxation have caused the jobs problem, business surveys repeatedly have identified weak demand as the primary constraint on job creation.

As one small-business owner told The Los Angeles Times, “If you don’t have the demand, you don’t hire the people.” And the majority of economists agree on this diagnosis. They also agree that the recovery from a balance-sheet recession can be agonizingly long, with significantly slower growth and a significantly higher unemployment rate for at least a decade.

Recent data indicate that the United States is on such a course, and many economists are now drawing comparisons between it and Japan during the two “lost decades” following Japan’s 1989-90 financial crisis and ensuing balance-sheet recession.

A recent study by the economist Robert Gordon confirmed that the shortfall in private-sector demand, especially the demand for consumer services, residential and commercial construction, and consumer durables, is the primary cause of shortfalls in production and jobs.

He also found that strong net exports, in response to growing aggregate demand abroad, has reduced the jobs gap by about one million jobs, but these gains have been offset by cutbacks in domestic spending, including spending by state and local governments.

In other recoveries during the last 50 years, public-sector employment increased. This time it is falling: during the last year the private sector added 1.8 million jobs while the public sector cut 550,000.

What should policy makers do to combat the large and lingering job losses that result from a financial crisis and balance-sheet recession? Mr. Koo, whose book on Japan’s experience should be required reading for members of Congress, showed that when the private sector is curtailing spending, fiscal stimulus to increase growth and reduce unemployment is the most effective way to reduce the private-sector debt overhang choking private spending.

When the Japanese government tried fiscal consolidation to slow the growth of government debt in response to International Monetary Fund advice in 1997, the results were economic contraction and an increase in the government deficit. In contrast, when the Japanese government increased government spending, the pace of recovery strengthened and the deficit as a share of gross domestic product declined.

The credit rating agencies gave Japan a lower credit rating than Botswana, but this had no impact on the yield on Japanese government bonds. Contrary to the rating “experts,” investors were worried about a prolonged stagnation, not about the ability of Japan’s government to roll over its debt — and they were willing to buy this debt with their growing savings surplus. (Richard Koo, “U.S. Credit Rating Finally Downgraded,” Nomura Equity Research Report, Aug. 9, 2011)

Investors have had a similar response to the downgrade of United States government debt by Standard & Poor’s. To investors, the downgrade signaled the possibility of premature austerity and heightened the risk of a double-dip recession, and this drove the yield on 10-year government debt to levels not seen since the 1950s.

The market understands that the most important driver of the fiscal deficit in the short to medium run is weak tax revenues, reflecting slow growth and high unemployment, and that additional fiscal measures to put people back to work are the most effective way to reduce the deficit.

Every one percentage point of growth adds about $2.5 trillion in government revenue. An extra percentage point of growth over the next five years would do more to reduce the deficit during that period than any of the spending cuts currently under discussion. And faster growth would make it easier for the private sector to reduce its debt burden.

But what about the growth of public-sector debt that would result from more fiscal stimulus? Some economists worry that the growing government debt will itself become a constraint on growth. But that certainly is not the case now — with weak private-sector demand and a huge output gap, spending and borrowing by the government are not crowding out spending and borrowing by the private sector.

What about the fact that by some estimates the debt-to-gross domestic product ratio is approaching the 90 percent threshold identified by Carmen Reinhart and Kenneth Rogoff as likely to reduce growth by a percentage point a year? As Robert Shiller has pointed out, the causality between this ratio and growth runs in reverse when the economy has lots of slack as it has now.

Under these conditions, slow growth leads to a higher debt ratio, not vice versa.

The United States government can currently borrow funds and repay less than it borrows in constant dollars. Surely there are many job-creating investment projects in education, research and infrastructure that would earn a higher rate of return. I argued in favor of more government spending on such projects and the introduction of a capital budget in my previous Economix post.

Even Professor Rogoff acknowledged in a recent interview that he would support more government spending on infrastructure, and there is widespread bipartisan support for infrastructure investment in the Congress and in the business and labor communities.

Unfortunately, the current extension of the highway trust fund and surface transportation bill expires on Sept. 30, as does the authorization of the federal gasoline tax and highway user fees to finance them. Now there are signs that Republicans in Congress, egged on by Tea Party attacks on the size of government, may block both measures, precipitating more than 100,000 job losses a month.

In a balance-sheet recession caused by too much private-sector debt, the government should also use its resources to catalyze debt workouts and debt reductions.

In the United States, where mortgages account for most of the private debt overhang, the federal government should enact stronger measures to reduce principal balances on troubled mortgages and to make refinancing easier. These measures would help stabilize the housing market, would prevent future defaults and would free money for borrowers to use to pay down their debt or increase their spending.

This would translate into stronger private-sector demand and more jobs. Many economists, including me, warned in 2008 that the economy would not recover until the housing market recovered, and the housing market won’t recover until the debt overhang from the housing bubble is reduced through programs that shift some of the burden to creditors from debtors.

Increases in public spending along with housing relief and expansionary monetary policy helped the economy recover from the Great Depression in the 1930s. The same combination of policies can help the United States recover from the Great Recession now.

At the end of World War II, the federal debt-to-G.D.P. ratio was 109 percent, one and a half times what it is today. Yet after the war the economy thrived, and no one questioned the government’s ability to pay its debt over time.

We should now be fighting a war against unemployment and the waste of resources, poverty, inequality and the hopelessness it causes.

Government debt may rise as a result of this war effort, but no one will question the government’s ability to pay its debt provided Congress and the president commit now to a balanced multiyear plan to reduce the long-run deficit once the war against unemployment has been won and Americans are back at work.

A Second Great Depression, or Worse?

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

With the United States and European economies having slowed markedly according to the latest data, and with global growth continuing to disappoint, a reasonable question increasingly arises: Are we in another Great Depression?

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The easy answer is “no” — the main features of the Great Depression have not yet manifested themselves and still seem unlikely. But it is increasingly likely that we will find ourselves in the midst of something nearly as traumatic, a long slump of the kind seen with some regularity in the 19th century, particularly if presidential election-year politics continue to head in a dangerous direction.

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The Great Depression had three main characteristics, seen in the United States and most other countries that were severely affected. None of these have been part of our collective experience since 2007.

First, output dropped sharply after 1929, by over 25 percent in real terms in the United States (using the Bureau of Economic Analysis data, from its Web site, for real gross domestic product, using chained 1937 dollars). In contrast, the United States had a relatively small decline in G.D.P. after the latest boom peaked. According to the bureau’s most recent online data, G.D.P. peaked in the second quarter of 2008 at $14.4155 trillion and bottomed out in the second quarter of 2009 at $13.8541 trillion, a decline of about 4 percent.

Second, unemployment rose above 20 percent in the United States during the 1930s and stayed there. In the latest downturn, we experienced record job losses for the postwar United States, with around eight million jobs lost. But unemployment only briefly touched 10 percent (in the fourth quarter of 2009; see the Bureau of Labor Statistics Web site).

Even by the highest estimates — which include people discouraged from looking for a job, thus not registered as unemployed — the jobless rate reached around 16 to 17 percent. It’s a jobs disaster, to be sure, but not the same scale as the Great Depression.

Third, in the 1930s the credit system shrank sharply. In large part this is because banks failed in an uncontrolled manner — largely in panics that led retail depositors to take out their funds. The creation of the Federal Deposit Insurance Corporation put an end to that kind of run and, despite everything, the agency has continued to play a calming role. (I’m on the F.D.I.C.’s newly created systemic resolution advisory committee, but I don’t have anything to do with how the agency handles small and medium-size banks.)

But the experience at the end of the 19th century was also quite different from the 1930s — not as horrendous, yet very traumatic for many Americans. The heavily leveraged sector more than 100 years ago was not housing but rather agriculture — a different play on real estate.

There were booming new technologies in that day, including the stories we know well about the rapid development of transportation, telephones, electricity and steel. But falling agricultural prices kept getting in the way for many Americans. With large debt burdens, farmers were vulnerable to deflation (a lower price level in general or just for their products). And before the big migration into cities, farmers were a mainstay of consumption.

According to the National Bureau of Economic Research, falling from peak to trough in each cycle took 11 months between 1945 and 2009 but twice that length of time between 1854 and 1919. The longest decline on record, according to this methodology, was not during the 1930s but rather from October 1873 to March 1879, more than five years of economic decline.

In this context, it is quite striking — and deeply alarming — to hear a prominent Republican presidential candidate attack Ben Bernanke, the Federal Reserve chairman, for his efforts to prevent deflation. Specifically, Gov. Rick Perry of Texas said earlier this week, referring to Mr. Bernanke: “If this guy prints more money between now and the election, I don’t know what y’all would do to him in Iowa but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost treacherous — er, treasonous, in my opinion.”

In the 19th century the agricultural sector, particularly in the West, favored higher prices and effectively looser monetary policy. This was the background for William Jennings Bryan’s famous “Cross of Gold” speech in 1896; the “gold” to which he referred was the gold standard, the bastion of hard money — and tendency toward deflation — favored by the East Coast financial establishment.

Populism in the 19th century was, broadly speaking, from the left. But now the rising populists are from the right of the political spectrum, and they seem intent on intimidating monetary policy makers into inaction. We see this push both on the campaign trail and on Capitol Hill — for example, in interactions between the House Financial Services Committee, where Representative Ron Paul of Texas is chairman of the monetary policy subcommittee, and the Federal Reserve.

The relative decline of agriculture and the rise of industry and services over a century ago were long believed to have made the economy more stable, as it moved away from cycles based on the weather and global swings in supply and demand for commodities. But financial development creates its own vulnerability as more people have access to credit for their personal and business decisions. Add to that the rise of a financial sector that has proved brilliant at extracting subsidies that protect against downside risk, and hence encourage excessive risk-taking. The result is an economy that is at least as prone to big boom-bust cycles as what existed at the end of the 19th century.

The rise of the Tea Party has taken fiscal policy off the table as a potential countercyclical instrument; the next fiscal moves will be contractionary (probably more spending cuts), whether jobs start to come back or not. In this situation, monetary policy matters a great deal, and Mr. Bernanke’s focus on avoiding deflation and hence limiting the problems for debtors does not seem inappropriate (for more on Mr. Bernanke, his motivations and actions, see David Wessel’s book, “In Fed We Trust“).

Mr. Bernanke has his flaws, to be sure. Under his leadership, the Fed has been reluctant to take on regulatory issues, continuing to see the incentive distortions of “too big to fail” banks as somehow separate from monetary policy, its primary concern. And his team has consistently pushed for capital requirements that are too low relative to the shocks we now face.

And the Federal Reserve itself is to blame for some of the damage to its reputation, although it did get a major assist from Treasury in 2008-9. There were too many bailouts rushed over weekends, with terms that were too generous to incumbent management and not sufficiently advantageous to the public purse.

But to accuse Mr. Bernanke of treason for worrying about deflation is worse than dangerous politics. It risks returning us to the long slump of the late 1870s.

On Debt Talks, a Lose-Lose-Lose-Lose Situation

1:07 p.m. | Updated with a fifth (less likely) scenario.

Almost whatever happens this week with Washington’s debt talks, the economy will most likely be worse off.

As Dean Maki, the chief United States economist at Barclays Capital, put it: “The basic issue is that the U.S. is on an unsustainable fiscal track, which is pretty widely agreed upon. From that point, none of the choices are fun.”

CATHERINE RAMPELL

Dollars to doughnuts.

Here are the likely scenarios I see:

Dollars to doughnuts.

1) Held up by disputes over how to reduce deficits, Washington doesn’t raise the debt ceiling in time. As a result, the Treasury stops paying debts it owes.

If that happens, the rating agencies downgrade the United States’ debt. The cost of borrowing for the United States government shoots up, since lenders demand higher interest rates from borrowers that are less trustworthy. Many other interest rates are pegged to the cost for the United States to borrow, making interest rates on all sorts of other loans, like mortgages, rise too. Credit markets freeze up, crushing an already-feeble economic recovery.

Macroeconomic Advisers predicts that failing to raise the debt ceiling in time — even if the delay is only one month — will very likely result in a new recession. And because it’s more expensive for the United States to borrow, the United States debt gets even larger, the exact opposite effect from what fiscal hawks are hoping for.

2) Held up by disputes over how to reduce deficits, Washington doesn’t raise the debt ceiling in time. But rather than default on its debt, it diverts money from other spending into paying back bondholders.

That could mean that Social Security checks are not sent, soldiers in Afghanistan and Iraq are not paid, and all sorts of other consequences.

In addition, bond markets might still freak out because the threat of default remains, so interest rates could rise anyway and cause all the terrible consequences in Scenario No. 1 (potential second recession and even bigger federal debt).

3) Washington comes up with a deal to raise the debt ceiling, but it amounts to less than $4 trillion in savings.

Standard & Poor’s has said that just raising the debt ceiling is not enough; without a “credible” plan for at least $4 trillion in savings, the United States might still have its credit rating downgraded. That could, again, mean higher interest rates and all the other terrible consequences of Scenario No. 1.

4) Washington comes up with a deal to raise the debt ceiling that amounts to more than $4 trillion in savings over a near-term horizon.

The credit rating agencies are appeased, but such severe austerity measures put the fragile economic recovery at risk. The states in particular are anxious about what major spending cuts mean for them and for the many social safety net services they provide with federal support.

As Bruce Bartlett and others have written, similar fiscal tightening during a fragile economy happened in 1937. Those actions resulted in a severe second recession and prolonging of the Great Depression, partly because it was coincident with monetary tightening as well. While a sharp, sudden monetary tightening seems unlikely, the Fed is at the very least pulling back on its easy monetary policy with the end of its second round of quantitative easing.

As The Wall Street Journal’s Kelly Evans observed, Japan had a similar experience in 1998, when austerity measures were followed by a recession and a widespread sell-off of Japanese bonds.

And even if these likely American austerity measures don’t result in an outright recession, job growth is already so feeble that most Americans still think we’re in recession.

Imagine how terrible things would feel if the economy slowed down even further.

5) Washington comes up with a deal to raise the debt ceiling that amounts to more than $4 trillion in savings, but over a longer-term horizon.

This is the best-case scenario: It deals with the long-term unsustainability of the country’s fiscal arrangements — which is good for growth in the long run — but doesn’t rock the boat in the current economic recovery.

Unfortunately, it also seems to be the scenario that is least likely to be pulled off effectively.

Economists want spending cuts and/or tax increases that come after 2012, when the economy is expected to be stronger. But to use Standard & Poor’s lingo, cuts that take effect in 2012 may not be fully “credible.” Committing to future cuts/tax increases is just another way of kicking the can down the road, as Washington has been doing for decades now. Almost every time Congress promises painful fiscal measures at some future date, later politicians jump in to dismantle them just before they take effect.

“We do seem to have a time-consistency problem,” Mr. Maki said. “There does never seem to be a good time for major cuts, and they’re not going to be more popular five years from now versus now.”

He says that Congress must come up with a way to prove that these are cuts that will actually happen, versus something that’s on the drawing board and is therefore erasable.

Unfortunately, he says, “There is no way to completely tie the hands of future legislators.”