No, Mr. Krugman, Bernanke’s Conundrum is Completely Different

By Pavlina R. Tcherneva

Our mainstream colleagues keep banging their heads against the wall. “Why, oh why wouldn’t Chairman Bernanke do more to rescue the economy?” Today Paul Krugman took on this question again, arguing that Chairman Bernanke should listen to Professor Bernanke who had far more sensible ideas about rescuing an economy from a deflationary environment, as seen in his research on Japan during the 90s.

Krugman revisits a 2000 paper by then professor Bernanke, which many of us have scrutinized before, titled “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” Krugman faults Bernanke for not following his own advice arguing that what he should do instead is 1) change expectations about the future by declaring and sticking to an explicit inflation target and 2) intervene even more aggressively in financial markets through alternative open market operations to deal with the nation’s massive unemployment problem.

Why Bernanke doesn’t do what he prescribed for Japan baffles Krugman who points to one of two explanations. The first was provided by his colleague Larry Ball, who recently claimed that Bernanke has become a victim of “groupthink” and has lost the ability to think for himself. The second is that the power lobby at the Fed and the political bullies in Congress are far too strong for the mild-mannered and soft-spoken Chairman, undermining his ability to act more aggressively.

In 2010, I wrote a paper Bernanke’s Paradox (JPKE version, April 2011) which examines his monetary policy prescriptions for Japan in detail. I have been asking myself the same question: why isn’t Bernanke following his own advice? But the answer I give is that it’s because he cannot, literally. Whatever policy options he believes to be genuinely effective actually depend on Congress and not on him.

The difference is that, unlike Paul Krugman, I actually read Bernanke’s paper from start to finish. See, what Krugman is missing is that Bernanke did not prescribe two policy options to deal with deflations (1. stick to an inflation target and 2. engage in alternative OMOs), but four.

I have discussed these in the paper above and in shorter blogs here and here. Here are the four options Bernanke recommends:

  1. Commit to an inflation target and a long-term low interest rate environment; 
  2. Depreciate the currency through open market purchases of foreign currency; 
  3. Engage in non-traditional OMOs – including purchases of long term government securities and other private sector liabilities such as non-performing loans, commercial paper, corporate bonds, asset-backed securities and other; 
  4. Last but not least, finance various fiscal transfers (e.g., tax cuts) to boost consumption demand 

Take the time to read Bernanke’s Japan paper and you will find that indeed he did follow this prescription as closely as he could, but he could not do so 100% because the core of the recipe lies in what Bernanke calls the fiscal components of monetary policy. Such fiscal components can be found in the Fed’s actions to depreciate the currency, purchase private sector assets, or finance tax rebates, all of which require an act of Congress or approval of the Treasury for the Fed to execute. 

Of the four policy options above, Bernanke clearly prefers the latter – money financed tax cuts. Only the money drops that occur from deficit spending (e.g. via tax rebates) financed by the Fed are able to increase net financial wealth in the private economy, help with faster deleveraging, and hopefully boost aggregate demand.

So much ink has been spilled on Bernanke’s research on Japan and I am still amazed that the mainstream refuses to discuss the importance of these fiscal components in Bernanke’s work. They are the essence of monetary policy effectiveness, as Bernanke understands it.

Fiscal components of monetary policy, of course are a euphemism for fiscal policy proper. The reason why Bernanke calls them “components” of monetary policy and why the mainstream refuses to acknowledge them is because they are still blindly wedded to the idea that monetary policy is omnipotent in rescuing the economy from recessions. Well, it’s time to give up this old notion. How many years of low interest rates, aggressive QE1, QE2, Operations Twists, swaps, and $trillions and $trillions of lending do we need to recognize that these policy actions do not provide proper channels for dealing with the unemployment problem? In fact, in 2000 the Professor thought that:

Nonstandard open market operations with a fiscal component, even if legal, would be correctly viewed as an end run around the authority of the legislature, and so are better left in the realm of theoretical curiosities” (Bernanke 2000, p. 164)

But in the absence of Congressional action to fund aggressive fiscal transfers to the real economy, Bernanke left the ‘realm of theoretical curiosities’ and engaged in as many nontraditional OMOs as he could, some of which were of questionable legality.

Monetary policy just can’t do it alone. Fiscal policy must come to the rescue. Professor Bernanke understood this. Why he prefers tax cuts as opposed to any other type of fiscal policy is a function of his ideological preferences. But the bottom line is this—the way to rescue the economy is through aggressive fiscal stimulus where the Federal Reserve stands ready to finance it. That’s the substance of Professor Bernanke’s message, which has clearly eluded Paul Krugman and Larry Ball.

I titled my paper Bernanke’s Paradox, because I did see a conundrum in Bernanke’s writings, a different conundrum from the one Krugman suggests (that Bernanke seems to believe one thing as an academic but implements another as a policy maker). No, the conundrum is much deeper, much more important than what Krugman identifies.

Bernanke understands well that for monetary policy to be effective, fiscal policy must be aggressive (which the Fed always finances). Without bold Congressional action and a large fiscal stimulus package to boost demand and employment, nominal GDP cannot and will not rise to desired levels, no matter what the Fed does. Bernanke knows that despite his commitment to low interest rates and alternative OMOs, what he really needs is big fiscal components, but those can only come from Congress, not the Fed. Bernanke also knows that the US has infinite ability to finance these fiscal components, that there is no solvency issue and that the policy rate and both ends of the yield curve are under the direct control of the Fed. All of this is clear both from his academic writings and policy actions.

What I find absolutely paradoxical is that, despite all this, he still appears before Congress and makes ominous statements about the unsustainability of the US debts and deficits and their upward pressure on interest rates, failing to distinguish between nations like Greece which do not have their own currency and those like the US and Japan which do.

Having a large and increasing level of government debt relative to national income runs the risk of serious economic consequences. Over the longer term, the current trajectory of federal debt threatens to crowd out private capital formation and thus reduce productivity growth. To the extent that increasing debt is financed by borrowing from abroad, a growing share of our future income would be devoted to interest payments on foreign-held federal debt. High levels of debt also impair the ability of policymakers to respond effectively to future economic shocks and other adverse events.

Even the prospect of unsustainable deficits has costs, including an increased possibility of a sudden fiscal crisis. As we have seen in a number of countries recently, interest rates can soar quickly if investors lose confidence in the ability of a government to manage its fiscal policy. Although historical experience and economic theory do not indicate the exact threshold at which the perceived risks associated with the U.S. public debt would increase markedly, we can be sure that, without corrective action, our fiscal trajectory will move the nation ever closer to that point. (Bernanke, Congressional Testimony, February 2, 2012) 

This is the conundrum: either he believes (as indicated by his research of the late 90s and early 2000s) that deficits are sustainable and cause a crowding in effect where the policy rate is under the direct control of the Fed, or he believes that they are not (as in his Congressional testimonies). Bernanke simply cannot argue it both ways. And we know well that in practice the operational reality is the former. In sovereign currency nations as in the US, deficits are infinitely sustainable, do not crowd out, and do not put upward pressure on interest rates. 

So yes, I too have been unable to resolve Bernanke’s paradox. How is it possible for someone to hold two completely incongruent intellectual positions? Either he has been intellectually dishonest when appearing before Congress fueling the deficit phobia of policy makers, or he has become intellectually lazy and has not taken the time to rethink the crowding out dogma he has learned in grad school in the face of his later academic work and practical experience, which point all evidence to the contrary.

23 Responses to No, Mr. Krugman, Bernanke’s Conundrum is Completely Different

  1. Either way Mr. Bernanke is guilty. If he doesn’t understand what is going on, he is just committing manslaughter.

    If he does understand and at the same time gives wrong advices to Congress, he is committing predetermined murder.

  2. Perhaps he is like a modern day Galileo, forced (implicitly) to “recant” that which he knows to be true every time he speaks before Congress… effectively telling them what they “want” to hear. I’m being kind… I know… :)

  3. Someone needs to read Bernanke the Riot Act in a respectful way. Does the Times intend to give you the space to do this? That certainly would be “news that’s fit to print.” They could use an “outside opinion” for real.

  4. Perhaps Bernake’s paradox can be resolved in the following way:

    When one is attempting to predict a trend based upon a set of variables as givens, one tends to hold the independent variables in the theory constant. In a way, Bernake is right when he complains that there are serious economic consequences of running large public deficits or having large public debts relative to national income or national wealth. That is, he would be right so long as the current fiscal picture remains unchanged. That is, running large public debts while the fiscal policy remains either neutral to the current distribution of fiscal resources, or continues to redistribute fiscal resources from wage-earners/producers/consumers to banks/financiers/rentiers, will eventually cause public debt to crowd out private debt, in the sense that the banks would come to prefer to lend to the public, rather than lend to any private producer/consumer.

    In his Japan paper, he’s being more explicit that the fiscal policy has to be appropriately targeted and redistributionary. What I take to be the resolution of the paradox implied by the “large and increasing level of government debt relative to national income” statement is the fact that appropriately redistributive fiscal policy combined with a coordinated monetary policy doesn’t necessarily imply large and increasing public debt levels.

  5. I think he is simply disengenuous. He can’t hold these two opposed opinions at once without being hypocritical. I think he is playing to the PTB. If he actually told them the truth he may be fearful they would run him out of town on a rail. There is his career to consider and life at a cushy Koch institution after his fifteen minutes of fame. But, hey, that’s just my opinion. No theory about variables of any kind other than self interest. I think a good part of the world is like that. Consider austerity for example. But don’t get me started on that.

  6. Scott Fullwiler

    Great post, Pavlina.

    As I like to say, a deficit dove is just a deficit hawk that’s not in as much of a hurry.

  7. I agree with Marley. Heads of central banks are always in a difficult position. They aren’t supposed to be political. So (in the case of the U.S.) the head of the Fed can’t tell Congress to spend more (and/or cut taxes), because that is seen as political. So to understand what heads of central banks are saying, you always have to read between the lines.

    The solution to this problem is to get a more logical distinction between economics and politics. I.e. the question as to how much stimulus (or deflation) to implement, whether monetary or fiscal, is a strictly economic decision, and should be in the hands of a committee of economists.

    In contrast, the decisions as to what proportion of GDP is allocated to public spending, and how that is split as between education, defence, etc etc are legitimate POLITICAL decisions, and should be left to the electorate and politicians.

  8. Great post, Pavlina. I always find it so amazing that people can read phrases like “helicopter drop” over and over and over think its only about central bank policy.

    I’m thinking that Bernanke just gave up. His monthly statements used to contain calls for fiscal expansion, but he probably concluded that if he can’t get either party to call for fiscal expansion and exhibit any real leadership, then to hell with them.

  9. If I understand P R Tcherneva’s analysis, Fed Chief Bernake very likely understands that the current crisis situation calls for fiscal rather than monetary policy actions. However, he suffers from the same affliction that almost all main-stream economists seem to – namely, he would rather please the PTB than to explain them (+ their lackey economists/politicial hacks) and to the American public that they are likely incapable of understanding his previously espoused views on economics.

    Were he to resign, he might then take that opportunity to provide an explanation for his actions by employing words that average (non-economist/non-politician) type American citizens might comprehend. The consequences might then include the possibility that he could become an American hero by explaining how MMT could work to solve both a sovereign nation’s economic and unemployment problems. [One can dream!]

  10. Pavlina R. Tcherneva

    Thanks for the comments, everyone. I think most of you are giving Bernanke an easy pass.

    Nathan, you could make an interpretation in terms of the distributional impact of fiscal policy, but that is not at all what Bernanke does—first his research just doesn’t deal with distributional issues and second all of his deficit comments are couched in sustainability/crowding out/interest rate effects. Actually, in his congressional testimonies he is using the “deficit is a problem” argument to say that entitlements must be reformed. If anything, his implicit ‘distributional’ policy is precisely the opposite of what you suggest we need.

    Dan, I don’t think he just gave up. This has been an ongoing problem for him. Even back in his 2009 testimonies, he was raising the specter of government debts (which is why I wrote the 2010 paper). At that time we didn’t have the divided congress we have now. He softened his stance slightly during the 2011 debt ceiling debacle, but he still argued that deficits are unsustainable and should be reduced, except not right away.

    Yes, being a policy maker requires you to walk a fine line, but we’ve had people in government like Ruml, Hopkins, Eccles and many others, who fought the political establishment tooth and nail to launch policies based on their convictions. What ARE Bernanke’s convictions?

    I personally think that his conflicting views are due to the enormous power of indoctrination. I suppose you don’t just one day wake up at the age of 58 and say, hmm that crowding out argument really doesn’t make sense, when it has been one of your main analytical tools all your life. But at the same time, the mainstream has been talking about sovereign currencies for a while. Woodford, Sims, Loyo (all colleagues of Bernanke, Woodford even edited a book with him) have all written on how the govt is an entity that pays in its own liability and thus cannot go bankrupt. (This is what permits them to put govt debt in their DSGE models—there is no default!!—which does not hold for private debts and hence there is no private money in DSGE…but I digress).

    What I am saying is that the New Consensus has recognized for a while that govts like in the US do not go bankrupt (Sims specifically differentiates between Europe and the US on those terms –I wrote a paper on this in 2008 at ), but WHERE are those voices from the mainstream… nowhere to be found, because they just don’t know what to do with this knowledge. MMT by contrast tells you the implication of this salient fact. So Bernanke and his friends have written on how the government does not go bankrupt, yet he still keeps talking about funding constraints??

    How could it be? The only way I can reconcile this paradox is that he believes that in normal times the govt funds itself by borrowing from private agents, whereas in recessions it funds itself through the Fed. If that’s the case, this means that even as the head of the Fed, he doesn’t understand how his bank operates in relation to the Treasury.

    • Pavlina, I think what we have going on is a battle for the preservation of elite economic power. The ability to terrify people with nightmare images of public bankruptcy, hyperinflation and rampaging bond vigilantes is the chief tool of the financial oligarchs for retaining control over the society and keeping democratic governments weak and under their thumbs. Bernanke works for the oligarchs, as does the leadership of both parties. The oligarchs are desperately trying to prevent people from understanding how the predatory financial industry actually works to keep people living in neo-feudal dependence on society’s landlords and to keep the parasitical flow of rents going. They also want to prevent people from realizing that they are actually the rightful owners and operators of the nation’s financial system . Bernanke is not going to tell the truth even if he knows it. Nor will Bowles, Simpson, Romney, Obama, Geithner, Mankiw, Draghi, Merkel, Cameron and all of the other soldiers of the global status quo.

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  12. Fiscal policy where art thou?
    It seems to me that monetary policy seeks to stimulate the economy by the creation of new debt in the private sector whereas fiscal policy seeks to stimulate the economy by increasing aggregate demand in the private sector by reducing taxes or by investing in the future of a nation by investing in public infrastructure, education or health. Debt which has utility into the future such as spending on infrastructure, health and education make sense now when labour cost are cheap due to high unemployment and the benefits to society will be spread over several generations.
    It would seem to me that monetary policy is driven by business interests whereas fiscal policy is driven by the political process. The lack of action on the part of government to employ fiscal policy to address issues of debt and unemployment in the economy points to the impotence of the democratic process and the disillusionment of the 99%.

  13. Dan: Finally. Exactly right. That is the essence of the bamboozlement that characterizes our system. Your post should be pasted on the screen of every commentator before they start writing.

  14. “What I find absolutely paradoxical is that, despite all this, he still appears before Congress and makes ominous statements about the unsustainability of the US debts and deficits and their upward pressure on interest rates, failing to distinguish between nations like Greece which do not have their own currency and those like the US and Japan which do.”
    Congress prohibits direct monetary financing and as long as it does, the Bernanke view is correct.

  15. @jck: I’m afraid you need to read this post again, as well as Dan’s comment. What you are saying is precisely their point; there’s nothing paradoxical at all about it; it’s precisely the stratagem they use.

  16. jck,

    “Congress prohibits direct monetary financing and as long as it does, the Bernanke view is correct.”

    Strange you think the United States is like Greece. The Greek government has absolutely no chance of using central bank overdrafts in its lifetime – as long as it remains in the Euro Area. Any borrowing – even from official sources – comes with harsh conditions imposed by the creditors. It’s amazing to me that “experts” in financial markets do not yet understand this distinction.

    This is from Ben Bernanke:

    “… A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields …”

    Can the Bank of Greece do so? Only if the European Central Bank allows it. If the ECB allows, it may be under a condition of a “fiscal compact” or something similar.

    It’s also strange to me that recently so many people have been writing about EA nations having to surrender sovereignty in recent times. Actually they did so long back – by signing the Maastricht Treaty.

    The point of the article is that fiscal policy -via expansion – has a tremendous role to play, if we were/want to grow. Your comment seems to suggest otherwise.

  17. @Ramanan:
    Indeed, the Greek government has absolutely no chance of using central bank overdrafts unless the statutes of the ECB are amended, and that’s exactly the same position for the US: the US government has absolutely no chance of using central bank overdrafts unless Congress changes the prohibition on direct monetary financing.

  18. jck,

    Because the US government has the power *with itself* to make a draft at the Federal Reserve and the fact that the Federal Reserve has the power itself to set the whole yield curve, United States is not Greece. And because the markets know this, the situation of bond markets panicking is avoided.

    Greece cannot unilaterally amend the statutes of the ESCB.

    The issue is that of sovereignty.

  19. Scott Fullwiler


    It doesn’t matter because US debt already arbitrages with current and expected fed funds rate (for long-term rates–and note that it is a choice for the Tsy to even issue lt bonds–the arbitrage can be set easily via swaps). The lowest rate the Tsy could pay even with an overdraft is the fed funds rate (or the rate the Fed pays on reverse repos, time deposits, or term reverse repos should it choose to drain the reserve balances created by the overdrafts on Tsy deficits) since the Fed would have to pay interest to hit a positive fed funds target and this would reduce the Fed’s profits returned to the Tsy. So, effectively, with overdrafts as a possibility the Tsy has the option of an overdraft at the fed funds rate or issuing debt at roughly the fed funds rate, and thus if the option of the overdraft is prohibited via self-imposed constraint, as now, there is virtually no economically meaningful difference from when it isn’t prohibited.

  20. Scott Fullwiler

    And Ramanan at 5:51am explains why this arbitrage works as it does.

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  22. i have listened to bernanke several times as he testified before congress. i notice no paradox at all. this article completely ignores the “time” factor even though the quoted text of his 2/12 congressional testimony makes it clear, testimony which i watched. he is clearly concerned with long term debt persistent accumulation, not debt per se. he is an advocate for short term increased debt as a stimulation agent, but wants to see a plan (i.e. budegtray commitments) that weens debt from from our routine governmental life, i.e the legislated end to gravy trains. I see the “Bush tax cuts” as an excellent example. they were funded by incurring debt but targeted for 10 years and at the 10 year date extended on top of a mountain of additional date. that is short term stimulus that turned into long term unsustainable debt. that so simple a concept is completely ignored or missed by a Ph.D(s) is both alarming and telling.