Ric Mishkin writes:
How to Get The Fed Out Of Its 'Box': When the Federal Open Market Committee meets this Tuesday and Wednesday, the Federal Reserve will face a serious dilemma. Since the last committee meeting six weeks ago, the 10-year U.S. Treasury yield has risen by around 70 basis points (0.70%), with the result that the interest rate on 30-year mortgages has risen by a similar amount. The rise in long-term interest rates is particularly worrisome, because it has the potential to choke off economic recovery and lead to further deterioration in the housing market. That would put an already weakened financial system under stress. Does the situation call for the Fed to expand its purchases of Treasury bonds to lower long-term interest rates?
To answer this question, we need to look at why long-term interest rates have risen. Here, there is good news and bad news. One cause of the rise in long-term rates is the more positive economic news of the past couple of months, particularly in financial markets. The bad news is that long-term interest rates are higher because of concerns about the deteriorating fiscal situation, with massive budget deficits expected for the indefinite future. To fund these budget deficits, the Treasury has to sell large quantities of bonds both now and in the future, causing bond prices to fall and interest rates to rise. The increased supply of Treasury debt puts pressure on the Fed to buy it up.... The Fed is boxed in. The slack in the economy that is likely to persist for a very long time suggests the need for stimulative monetary policy to lower long-term interest rates through the purchase of Treasurys. The fiscal situation argues against this policy action, because it would weaken the Fed's inflation-fighting credibility.
How can the Fed get out of the box and pursue the expansionary monetary policy that is needed right now? The answer is that the Obama administration and Congress have to get serious about long-run fiscal sustainability. Large budget deficits naturally occur during severe recessions when tax revenue undergoes a substantial decline. In addition, fiscal stimulus to promote economic recovery when the economy is in a severe recession is a sensible prescription. However, the failure to take steps to get future budgets under control is a recipe for disaster.... [I]t may even make the fiscal stimulus package less effective... if you know that the government is issuing a lot of debt that has to be paid back someday you can expect to pay much higher taxes in the future. With the prospect of higher taxes, you will be less likely to spend today.
How can the Obama administration and Congress help the Fed do its job and help the fiscal stimulus package work? It needs to address exploding spending on entitlements -- Social Security and particularly Medicare -- which are causing future deficit projections to be so bleak. One possibility is to establish a nonpartisan commission on entitlement reform, along the lines of the National Commission on Social Security in the early 1980s.... Another is taxing health-care benefits as part of any package to reform health care.... There are surely many other ways to promote more fiscal responsibility. The Fed can assist this process. It could indicate that implementing measures that would promote fiscal sustainability will be rewarded with Federal Reserve actions to bring long-term Treasury rates down. Deals like this have been successfully made in the past. In the current extremely difficult economic environment, we surely need such a deal now.
I think pieces like Ric Mishkin's are much less useful than they could be, because Mishkin talks in a peculiar kind of code:
When Mishkin writes: "[t]he Fed... could indicate that implementing measures that would promote fiscal sustainability will be rewarded with Federal Reserve actions to bring long-term Treasury rates down. Deals like this have been successfully made in the past..." he means: "Alan Greenspan and Bill Clinton and the Democratic Party did a very good thing back in 1993 when--over unanimous Republican opposition--they coordinated action to raise taxes, cut the future growth path of spending, and ease monetary policy."
When Mishkin writes: "nonpartisan commission on entitlement reform, along the lines of the National Commission on Social Security in the early 1980s..." he means: "the Democratic Party then did a good thing in giving Republican President Ronald Reagan bipartisan cover to raise taxes and so reduce the damage to long run fiscal stability that he had done in his first year..."
When Mishkin writes: "budget deficits naturally occur during severe recessions when tax revenue undergoes a substantial decline... fiscal stimulus to promote economic recovery when the economy is in a severe recession is a sensible prescription..." he means: "Republican root-and-branch opposition to Obama's stimulus plan is stupid and harmful to the country..."
Everyone who was around in 1982, or 1993, or 2001-3 (when Republicans were welcoming and expanding deficits as recession-fighting measures understands the code that Mishkin is talking in: that Republican politicians behaved badly and Democratic politicians behaved well, and it would be good for the country if the Democratic politicians were to step up to the plate and once again do the right thing for the country. But for some reason Mishkin won't say that in anything but the most elliptical of implicatory sentences.
It matters, I think, because until senior Republican presidential appointees like Ric Mishkin will call Republican politicians on their misdeeds--and cross the aisle in response--Republican politicians will continue to misbehave. And it is not clear the country can afford that.