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.