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We Don't Understand Ben Bernanke...

James Kwak:

Ben Bernanke Doesn’t Get the Message: [I]n my opinion, Bernanke drew the wrong lessons…. He was very clear that the problem today is unemployment, not inflation…. He even said that we are in a situation where economics stimulus would improve the economy’s long-term performance…. But what is Bernanke going to do about it? He declined to offer any new efforts to reduce unemployment, saying only that the Fed “is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.” And mainly he relied on the political branches to solve the country’s problems, calling not only for “good, proactive housing policies” but also for policies that would improve K–12 education for underprivileged households and lower health care costs.

I don’t think it makes sense to criticize the political system for being dysfunctional and then rely on the political system to rescue the economy. I understand that traditional monetary policy tools don’t work that well in this environment: short-term rates can’t go any lower, and lowering long-term rates won’t make companies invest if they don’t think there is demand for their stuff. But there’s always, you know, dropping cash out of helicopters….

[T]he option of increasing the inflation target from 2 percent to 4 percent while simultaneously buying long-term bonds to keep nominal rates from rising too much…. [B]oth Ken Rogoff and Olivier Blanchard have argued for higher inflation, given current economic circumstances. As Blanchard says, “There was no very good reason to use 2% rather than 4%. Two percent doesn’t mean price stability. Between 2% and 4%, there isn’t much cost from inflation.”

I’m not sure it would work; maybe even raising the inflation target wouldn’t actually increase inflation. But doing nothing is be the wrong policy conclusion to draw from Bernanke’s observations, which seem spot-on.

Me:

Project Syndicate: [F]inancial markets were glued to the speech [Bernanke] gave in Jackson Hole, Wyoming on August 26.  What they heard was a bit of a muddle.

First of all, Bernanke did not propose any further easing of monetary policy to support the stalled recovery – or, rather, the non-recovery…. Finally, Bernanke claimed that “the growth fundamentals of the United States do not appear to have been permanently altered by the shocks of the past four years.”

Frankly, I do not understand how Bernanke can say any of these things right now. If he and the rest of the Federal Open Market Committee thought that the projected growth of nominal spending in the US was on an appropriate recovery path two months ago, they cannot believe that today. Two months of bad economic news, coupled with asset markets’ severe revaluations of the future – which also cause slower future growth, as falling asset prices lead firms to scale back investment – mean that a policy that was appropriate just 60 days ago is much too austere today.

[B]y the time this lesser depression is over, the US will have experienced an investment shortfall of at least $4 trillion. Until that investment shortfall is made up, the missing capital will serve to depress the level of real GDP in the US by two full percentage points. America’s growth trajectory will be 2% below what it would have been had the financial crisis been successfully finessed and the lesser depression avoided. There is more: state and local budget-cutting has slowed America’s pace of investment in human capital and infrastructure, adding a third percentage point to the downward shift in the country’s long-term growth trajectory.

After the Great Depression of the 1930’s, the vast wave of investment in industrial capacity during World War II made up the shortfall of the lost decade. As a result, the Depression did not cast a shadow on future growth – or, rather, the shadow was overwhelmed by the blinding floodlights of five years of mobilization for total war against Nazi Germany and Imperial Japan. There is no analogous set of floodlights being deployed to erase the shadow that is currently being cast by the lesser depression. On the contrary, the shadow is lengthening with each passing day, owing to the absence of effective policies to get the flow of economy-wide nominal spending back on its previous track.

Moreover, there is an additional source of drag. A powerful factor that diminished perceived risk and encouraged investment and enterprise in the post-WWII era was the so-called “Roosevelt put.” Industrial-country governments all around the world now took fighting depression to be their first and highest economic priority, so that savers and businesses had no reason to worry that the hard times that followed 1873, 1884, or 1929 would return.

That is no longer true. The world in the future will be a riskier place than we thought it was – not because government will no longer offer guarantees that it should never have offered in the first place, but rather because the real risk that one’s customers might vanish in a prolonged depression is back.

I do not know by how much this extra risk will impede the growth of the US and global economies. A back-of-the-envelope estimate suggests that a five-year lesser depression every 50 years that pushes the economy an extra 10% below its potential would reduce average investment returns and retard private investment by enough to shave two-tenths of a percentage point from economic growth every year. As a result, America would not just end this episode 3% poorer than it might have been; the gap would grow – to 7% by 2035 and 11% by 2055.

This is the shape of things to come if steps are not taken now to recover rapidly from this lesser depression, and then to implement policies to boost private capital, infrastructure, and education investment back up to trend. Perhaps that would be enough to reassure everyone that policymakers’ current acquiescence in a prolonged slump was a horrible mistake that will not be repeated.

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