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.”

Today’s Economist

Perspectives from expert contributors.

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.

Perspectives from expert contributors.

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.

Volcker is right: a little inflation is a dangerous thing

Paul Volcker, chairman of the Federal Reserve

Ouch! It's even worse than we thought – or perhaps that should read what forecasters thought. For most of us, news that CPI inflation last month reached 5.2pc won't come as much of a surprise; it's been obvious from our utility bills and shopping baskets for some time now. The older, RPI measure of inflation is worse still, at 5.6pc.

And still the Bank of England likes to pretend it's trying to meet the inflation target. More monetary stimulus in the form of a further £75bn of "quantitative easing", with the inflation rate at 5.6pc? If the economic bind the country finds itself in were not so serious, it would be almost laughable.

Everyone expects inflation to come down sharply over the next year, as the current round of fuel price increases and the January hike in VAT work their way out of the index, but then the Bank, the Government and most City analysts have consistently underestimated inflation for the best past of the last three years. What reason do we have to believe them now?

Sir Mervyn King, Governor of the Bank of England, has long argued that to have taken the action necessary to keep inflation on target would have meant inducing a recession and therefore well below target inflation further out. The elevated inflation we are enduring now is framed as part of a necessary adjustment to living standards as the country adapts to its plainly more straitened circumstances.

It is also sometimes argued in justification for the present "blind eye" approach to inflation, though not by the Bank itself, that it provides a way of gently inflating away the country's debt burden. The first argument may hold more water than the second, but both look questionable.

The problem with inflation, repeated historical experience has demonstrated, is that once out of the bag, it is extremely difficult to put back in. There is only so much wage erosion through inflation that people will take before they start to demand compensating pay rises. True enough, fear of unemployment has been sufficient to deter widespread inflationary pay increases so far, but there have been a number of instances of key worker groups managing to obtain them. The danger is that relatively high inflation creates a kind of wage apartheid of those who are able to keep up with inflation and those who can't – mainly the unskilled and those who live off their savings.

It is also impossible to believe that the almost unprecedented amounts of liquidity that have been provided by central banks to western economies over the past three years – and continues to be so – will not in time prove highly inflationary. And even if in the fullness of time it has demonstrably proved only mildly inflationary, as its supporters claim it will, it doesn't necesssarily vindicate the policy.

Here's Paul Volcker, the Federal Reserve chairman credited with finally exorcising the inflation of the 1970s and early 80s from the US economy, writing recently in the New York Times.

My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

No, inflation is never an economic panacea. Nor does it even help with the debt burden. If wages aren't matching inflation, then it is of no help in eroding the nominal value of household debt, and if taxes aren't keeping pace with inflation, then the same goes for government debt. Worse, many forms of government spending, most notably the bulk of benefit entitlements, are linked to inflation, so that we now have the absurdity of benefit claimants being better protected against price increases than wage earners.

These figures are not just uncomfortable for the Bank of England and the Government. They are a disaster. It took twenty years finally to exorcise the ghost of Britain's post war inflationary past, and to win credibility as a stable, low inflation economy. All that work is in danger of being thrown away

Volcker is right; a little inflation is a dangerous thing

Ouch! It's even worse than we thought – or perhaps that should read what forecasters thought. For most of us, news that CPI inflation last month reached 5.2pc won't come as much of a surprise; it's been obvious from our utility bills and shopping baskets for some time now. The older, RPI measure of inflation is worse still, at 5.6pc.

And still the Bank of England likes to pretend it's trying to meet the inflation target. More monetary stimulus in the form of a further £75bn of "quantitative easing", with the inflation rate at 5.6pc? If the economic bind the country finds itself in were not so serious, it would be almost laughable.

Everyone expects inflation to come down sharply over the next year, as the current round of fuel price increases and the January hike in VAT work their way out of the index, but then the Bank, the Government and most City analysts have consistently underestimated inflation for the best past of the last three years. What reason do we have to believe them now?

Sir Mervyn King, Governor of the Bank of England, has long argued that to have taken the action necessary to keep inflation on target would have meant inducing a recession and therefore well below target inflation further out. The elevated inflation we are enduring now is framed as part of a necessary adjustment to living standards as the country adapts to its plainly more straitened circumstances.

It is also sometimes argued in justification for the present "blind eye" approach to inflation, though not by the Bank itself, that it provides a way of gently inflating away the country's debt burden. The first argument may hold more water than the second, but both look questionable.

The problem with inflation, repeated historical experience has demonstrated, is that once out of the bag, it is extremely difficult to put back in. There is only so much wage erosion through inflation that people will take before they start to demand compensating pay rises. True enough, fear of unemployment has been sufficient to deter widespread inflationary pay increases so far, but there have been a number of instances of key worker groups managing to obtain them. The danger is that relatively high inflation creates a kind of wage apartheid of those who are able to keep up with inflation and those who can't – mainly the unskilled and those who live off their savings.

It is also impossible to believe that the almost unprecedented amounts of liquidity that have been provided by central banks to western economies over the past three years – and continues to be so – will not in time prove highly inflationary. And even if in the fullness of time it has demonstrably proved only mildly inflationary, as its supporters claim it will, it doesn't necesssarily vindicate the policy.

Here's Paul Volker, the Federal Reserve chairman credited with finally exorcising the inflation of the 1970s and early 80s from the US economy, writing recently in the New York Times.

My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

No, inflation is never an economic panacea. Nor does it even help with the debt burden. If wages aren't matching inflation, then it is of no help in eroding the nominal value of household debt, and if taxes aren't keeping pace with inflation, then the same goes for government debt. Worse, many forms of government spending, most notably the bulk of benefit entitlements, are linked to inflation, so that we now have the absurdity of benefit claimants being better protected against price increases than wage earners.

These figures are not just uncomfortable for the Bank of England and the Government. They are a disaster. It took twenty years finally to exorcise the ghost of Britain's post war inflationary past, and to win credibility as a stable, low inflation economy. All that work is in danger of being thrown away

Why the squeeze in living standards is very welcome

Austerity isn't all bad news (Picture: Howard McWilliam)

OK, so the headline was written to provoke, but from a macro-economic point of view, there is a sense in which the Institute for Fiscal Studies' finding of the longest slump in household finances on record is actually a quite positive development.

How come? It can surely never be a good thing for living standards to be falling in the way they are. Of course not, but if the relatively high level that living standards reaching in the run up to the crisis was unsustainable, then the present adjustment, painful though it undoubtedly is for many households, was both inevitable and necessary, the latter because it helps to make the UK a competitive economy once more.

This is how it works. If the cost of the things we buy – fuel, food, commodities, imported goods, and so on – is going up, then one way or another we will be forced to pay for it with a corresponding fall in real wages. This can happen in two ways, through inflation or through cuts in nominal wages. In the UK, the Bank of England has chosen the former route; in the eurozone, policymakers are enforcing the latter approach on uncompetitive periphery nations.

The Bank of England could have stopped the inflationary impact on living standards, but only by driving up unemployment to such a degree that workers would be prepared to accept no wage increases or even outright cuts in nominal earnings in order to stay in employment. The choice was between higher inflation, or a deeper rececession. The point is arguable, but the Bank's approach would seem to be the least worst from a social perspective. Certainly, it looks preferable to the depression economics being applied to the eurozone periphery.

In time, this external devaluation ought to make the UK more competitive again, so that companies choose to locate their production in the UK rather than overseas. So far, there's not much sign of this happening, but it takes time for businesses to absorb these relative shifts in competitiveness.

In any case, relative labour costs are improving quite markedly right now when compared with much of Europe and even some emerging markets. If the UK does the right things on supply side reform, ten years from now, it could actually be a model economy once more.

With inflation approaching 5pc, do we really want more QE?

The Bank has announced 75 billion more QE (Photo: PA)

On the basis that inflation is better than depression, I suppose it is just about possible to go along with the Monetary Policy Committee's decision to increase "quantitative easing" by a further £75bn.

But I worry about it. I worry both that it will be ineffective in terms of stimulating investment and growth, I worry that it is going to be very difficult for the Bank of England to unwind these now vast holdings of government debt, I worry that we are now perilously close to outright monetisation of the deficit (a policy approach which all economic history shows ends in abject disaster), and I worry that ultimately, it's bound to be inflationary.

In a speech two or three weeks back, Adam Posen, until recently an outrider on the MPC in demanding more QE, said that such fears were "unfounded" and "unwarranted", but answer me this. How's the further plunge in the value of the pound that greeted this announcement not inflationary? Even the Bank of England's own analysis of the effect of QE to date, which is based on quite questionable methodology, estimates that it has added 0.75 to 1.5 percentage points to CPI inflation for a maximum gain in real GDP of 2pc. That doesn't seem to me to be a particularly good trade off.

And you cannot help but think that the long term impact of all this money printing is almost bound to be highly inflationary. Already, the Bank of England has bought up around 20pc of the national debt, equal to some 14pc of GDP. This will expand it to close to 30pc.

Since a fair old chunk of this debt is in the form of inflation protected gilts, which have not been part of the asset purchase programme, the proportion of the conventional gilts market that will be sitting on the Bank of England's balance sheet by the end of the latest batch of purchases is going to be rather more than a half. When something looks mad, it generally is. Yields on ten year gilts are already at historic lows at less than 3pc. Is it really sensible to be driving them even lower?

In his speech, Mr Posen said "we will know that monetary policy has done enough for long enough when long term interest rates rise due to demand for capital from our private sector taking on risk and making investments". But why would they rise when there's the open cheque book of the Bank of England willing to buy up almost anything that comes onto the market? And if they do rise, it's much more likely to be because investors expect inflation than than a sudden return to rampant business investment.

Despite these concerns, I guess it's just about possible to support what the Bank of England is doing given the extreme downside risks to the economy that have swept in from the Continent over the last month or so. With all this talk of coordinated action, we have to assume that other central banks are poised to follow suit, though I'll believe it when I see it as far as the European Central Bank is concerned. Jean-Claude Trichet is holding his monthly press conference shortly, so there may be more to say on this later.

But it's a disappointment that the Bank's statement made no mention of the "credit easing" flagged by George Osborne, the Chancellor, in his conference speech. This is an idea worth pursuing – a way of getting the newly released funds to the bits of the economy that really need it and stimulating some much needed business investment.

As it is, I fear that it will again be the investment bankers who are the major beneficiaries. QE is like a drug; once hooked, it's very difficult to wean yourself off. Just how many fixes are required before you realise you are an addict?

What's more, as every addict knows, to get the same effect, you have to keep increasing and repeating the dose. The way things are going, the entire gilts market will end up in the hands of the Bank of England. I'm sorry, but I fail to see the difference between such an extreme position and outright monetisation of the deficit, the sort of thing they got up to in Weimar Germany. In that case, the end result was not just the destruction of middle class savings, but the currency itself.

Never mind the cost of living; have you seen what it costs to die around here?

"That'll be £1,270, please, sir. Coffins are extra."

Never mind today’s increase in the cost of living – have you seen what it costs to die around here? Inflation does not stop with the last breath, and basic burial costs vary more than house prices from one part of Britain to another.

The cheapest are as low as £50 but the most expensive hit an eye-watering £1,270. Nor is the division on a simple north/south basis, as is the trend with house prices.

Strangely, two of the 10 cheapest places to be buried are in the constituencies of former Chancellors of the Exchequer. Nigel Lawson’s former seat at Blaby, Leicestershire, came in with a rock bottom quote of £50 for a basic interment, while John Major’s former seat at Huntingdonshire, Cambridgeshire, was fourth cheapest of 255 local authorities surveyed with a charge of £115.

By contrast, the most expensive place for a basic burial was Lichfield, Staffordshire, which charged £1,270 – or more than 25 times as much as Blaby – while Elmbridge, Surrey, was not far behind with costs of £1,138 according to funeral plan provider Avalon.

Bear in mind these figures do not include additional costs such as having a vicar, priest or other religious representative in attendance and you can see why some chose to save up for the dread event. Recent research by Mintel suggests a basic funeral now costs more than £2,600 but a church service and flowers would push this above £3,000.

Before the Welfare State set out to care for people from cradle to grave, saving up for a decent send off was the basis of many life companies’ business. But soaring taxation and the death of the savings habit put an end to that.

Now former Norwich Union manager Mike Cooper, managing director of Avalon, reckons there may be a gap in the market. Fewer than three in 10 of the people who die in Britain are now buried – and rising costs are a major factor in families choosing cremation.

He said: “As space dwindles and fees grow, the number of burials is expected to decrease rapidly. It seems that dying has become a very expensive business.

“While the traditional funeral is still part of our cultural fabric, burials are now out of reach for many of the population. It’s no surprise that cremation is by far the most popular choice for funerals.”

No wonder more people have started saving again toward paying for one of life’s few certainties. As rising inflation and taxation, coupled with frozen or falling earnings continue to squeeze living standards, relying on the children to do you proud could prove a mistake.

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.

Today’s Economist

Perspectives from expert contributors.

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.

Perspectives from expert contributors.

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.

How Much More Can the Fed Help the Economy?

With the risk of another recession on the horizon, many economists and investment analysts are hoping that Ben S. Bernanke will signal on Friday that the Federal Reserve is ready to step in once again and save the economy from disaster. After all, Congress seems wholly unwilling to engage in fiscal stimulus, and instead is planning further fiscal tightening.

But there are reasons to believe the Fed’s remaining tools may be losing their potency.

Monetary policy works best when the Fed cuts interest rates, giving banks a good opportunity to extend more loans. If more loans go out to people and companies, those people and companies can buy more goods and services, creating more demand and eventually more jobs.

CATHERINE RAMPELL

Dollars to doughnuts.

Interest rates are already at zero, though (and have been for a while), so the Fed cannot lower them any further. That’s why the Fed has engaged in more unusual — in some cases, unprecedented — measures.

Dollars to doughnuts.

Twice now the Fed has engaged in large-scale asset purchasing, a process known as quantitative easing. (Hence the nicknames QE1 and QE2.) This is meant to lower long-term interest rates, which should, in theory, stimulate economic growth in two ways.

First, it should encourage more borrowing, so companies and consumers will have more money to spend.

Second, lower long-term interest rates could encourage investment in riskier assets, like stocks. Why? Because if long-term Treasuries don’t offer much in the way of returns, investors will seek higher yields elsewhere. If investors do start buying up riskier assets, those asset prices rise. Consumers then see that their portfolios are worth more, causing them to feel richer and so more comfortable with spending. This is known as the wealth effect.

But this two-pronged attack is probably less powerful today than it was three years ago.

After two rounds of quantitative easing, long-term interest rates are already quite low. It is not clear that lowering them further with a third round of quantitative easing (QE3) would do a whole lot more to encourage investment in riskier assets, or to increase lending. Many companies are choosing not to borrow primarily because demand is so weak, and not because credit is expensive.

Additionally, if investors do start increasing their investments in assets with higher yields, they may pour more money into commodities like oil. And commodity prices are already higher today than they were a year ago; pushing energy and food prices further up could actually discourage consumers from spending.

And many economists are still debating whether the last round of quantitative easing was terribly useful.

“It’s hard to make the argument that QE2 was a rousing success or we wouldn’t be on the verge of seeing QE3,” the economists at RBC Capital Markets wrote in a client note. “The market may very well get what it seems to desire, but we believe there is no magic bullet here.”

There are other measures the Fed could take besides quantitative easing. These include changing the composition, rather than the size, of the assets already on its balance sheet so that they have longer maturities. Like quantitative easing, this could lower long-term interest rates, with many of the same pros and cons. There would probably be less political resistance to reconfiguring, rather than expanding, the central bank’s debt holdings.

The Fed could also lower the interest rate it pays banks on their reserves. Maybe this would encourage them to hold less cash and increase their lending. There is some debate about how effective this measure would be. If demand for credit remains low, encouraging banks to lend more may not be helpful.

Many economists have suggested that the most powerful tool the Fed might employ would be an announcement that it is raising its medium-term target for inflation.

If prices are expected to rise, banks, businesses and consumers will be more eager to spend their money before it loses value. That could have positive effects throughout the economy, since spending means more demand for goods and services, which means companies need to hire more employees, which means more spending, and so on. That is the much-sought-after virtuous cycle.

The problem, though, is that inflation has some major downsides too — especially if coupled with sluggish growth, as seen during the “stagflation” of the 1970s. Not having a good sense of how much your next gallon of milk or gas will cost is stressful, particularly if your wages aren’t rising to match the higher prices.

Today inflation is pretty low, but it’s higher than it was a year ago when the Fed last engaged in quantitative easing. Already the more hawkish members of the Federal Open Market Committee are getting antsy. Since Mr. Bernanke cannot unilaterally carry out any of these stimulus strategies, the chances that the Fed will increase its inflation target in the near future seem low.

But hey, the Fed has surprised people before.

Sustained above-target inflation reduces the value of your money

In 2008/9, CPI inflation was more than one per cent above the government’s 2 per cent target between May 2008 and February 2009.  During that period, inflation in the actual cost of living (i.e. the RPI index, rather than the target variable, CPI, which is not a measure of the cost of living – contrary to much confused commentary – but a policy index (like the old RPIX)) peaked at 5 percent in September 2008.  But the episode was short-lived and followed immediately by deflation.  So in fact the cost of living in October 2009 was less than that in June 2008.

The policy index CPI measure of inflation went more than one per cent above target again in January 2010, and has stayed there ever since.  During this 2010/11 period of elevated inflation, by contrast to the brief 2008/9 episode, the cost of living (RPI) has risen by 7.7 per cent.  If RPI has risen at the old RPIX target of 2.5 per cent per annum, then over the period the cost of living would have risen by 4 per cent.  (If RPI had been 2.8 per cent, roughly equivalent to the CPI target of 2 per cent, then the cost of living would have risen by about 4.5 per cent.)

So that means that the period of sustained well-above-target inflation has meant a rise in the cost of living some 3.1-3.5 per cent more than if inflation had been kept to target.  Sustained above-target inflation is a sustained eroder of wealth.

That does not, of course, mean that temporary spikes are irrelevant, either.  In May 1978 annual RPI inflation was 7.7 per cent – not really so terribly far above the 5 per cent of the past twelve months.  In May 1980, less than two years later, it was 21.9 per cent.  In May 1983 it was down to 3.7 per cent.  Yet no-one (outside the outer fringes of Thatcher-hating-dom) thinks we should ”look through” the “temporary” spike in inflation of 1979/80.

But it does mean that the inflation of 2010/11 has already been a lot worse than that of 2008/9.  And that is before we find out whether it will really magically vanish when the economy recovers, as the Bank of England and others hope-against-hope.

Inflation: pensioners are biggest victims of RPI/CPI double-dealing

Millions of rail commuters – not to mention their student offspring – are entitled to feel the Government is not playing fair with its double-dealing measurements of inflation. But pensioners are the biggest losers from the way the real value of money is falling.

Rail fares and student loans are uprated in line with the Retail Prices Index (RPI) which is consistently higher than the Consumer Prices Index (CPI), which is applied to things that cost the Government money – such as pensions.

If that sounds like a dry technicality, then beware that new calculations from Saga show that inflation has robbed many older people of nearly a fifth of the purchasing power of their pension since the credit crisis began.

How you measure the rate of inflation depends on what you put in your sample or shopping basket. Excluding mortgage costs and council tax helps keep CPI more than 10pc lower than RPI. The respective  annual rates of increase were announced by the Office for National Statistics today as 4.4pc and 5pc respectively.

But even the RPI does not adequately reflect the way pensioners’ cost of living is rising because they tend to spend more of their money on food and fuel – where commodity inflation makes double digit increases common – and less of their money on electronic goods where prices are falling.

Ros Altmann, director general of Saga said: “Since the credit crisis began four years ago, the effect of RPI has been to reduce the purchasing power of money by 13.9pc – which may surprise some people, as they tend not to notice the cumulative effect of inflation.

“But we calculate the cumulative effect of inflation over the same period on those aged between 65 and 74 has been 18.8pc. If you are living on a fixed annuity, that’s money you will never recover. They have lost nearly a fifth of their purchasing power in four years.”

The Bank of England’s policy of keeping base rates much lower than any measure of inflation has transferred wealth from savers to borrowers by eroding the value of savings and debts. The idea is to prevent higher insolvencies, unemployment and repossessions; all of vital importance to people of working age.

Taking these factors into account, while commuters and students may feel it is unfair that their rail fares and loans are linked to RPI, their standard of living is unlikely to have fallen as much as pensioners’.

Everybody is going to suffer in this financial crisis, according to no less an authority than the Governor of the Bank of England, but older people who must live off their savings and can do little to protect themselves are being hit hardest.

Growth, real terms growth, and inflation

Click to enlarge

In this figure I show you three things. The red line is the standard rate of annual inflation in the cost of living – the all-items retail prices index. The green line tells us how the real value of quarterly output of the economy compared with the real value of output in the same quarter a year earlier (so, for example, real output in the second three months of 2011 is 0.8 percent higher than real output was in the second three months of 2010). I’ll call this “yearly real GDP growth”. The blue line tells us what happened to quarterly output in cash terms – when there is inflation, a rise in cash terms will be greater than the rise in real terms. I’ll call this “yearly money GDP growth”.

We can see that during most of the period 2000-2006, yearly money GDP growth was usually around 5 per cent, real GDP growth around 2.5 percent, and inflation around 2.5 percent. The first major departure comes in 2006, when money GDP growth goes well above 6 percent. Then inflation goes well above 4 percent (reaching 5 percent). Then we see all three series plummet during the 2008-9 recession. But then look at what happens after the recession. Money GDP growth returns to 5 percent, back to its pre-recession norm. There have been those (most notably Sir Samuel Brittan for many years, and more recently Giles Wilkes) who have argued that monetary policy should target money GDP growth instead of inflation. Indeed, some implicit variant of this is very probably an element in the Monetary Policy Committee’s thinking for 2009 onwards (it certainly was in mine). Well, the period after the recession should make Sir Samuel and the MPC happy – since the year following the commencement of quantitative easing (i.e. in our data, since the second quarter of 2010), yearly money GDP growth has been remarkably stable.

Now, if inflation had been around 2.5 percent, then 5 percent yearly money GDP growth would have meant about 2.5 percent real growth – as many hoped. But, in fact, inflation has been much higher than forecast, so real growth has been correspondingly lower. That extra cash the economy has produced just isn’t worth as much stuff. I suspect that is partly because the capacity for the economy to grow isn’t as high as we’d previously thought.

But now ponder this: what will happen if the economy does start to accelerate? If even the paltry growth of the past nine months has been associated with a rise in inflation, what might be the impact on inflation if the economy really starts to motor? The happy path would be if money GDP growth stayed pretty much where it is, but inflation fell back, so real growth accelerated. That is what the Bank of England hopes will happen. The other possibility is that when real growth accelerates, we will see a larger rise in money GDP growth, so inflation will accelerate even further. That’s what I expect.