The Ironies Keep Piling Up

by: Scott Sumner

Ryan Avent asks a pretty good question:

And if you think the Fed can't raise inflation, then it would still seem to make sense to urge the Fed to buy as much government debt as it possibly can. If one could entirely monetise the debt with no inflationary consequences, why not do it?

Ben Bernanke should be praised for his effort to inject more transparency into Fed operations. This has actually made his life much more difficult, as compared to the more dictatorial approach of Volcker / Greenspan. For instance, Bernanke keeps insisting that the Fed is never really out of ammo. I know that some people think he's lying, but he also passionately believed that as an academic. And he's very smart. And it's obviously true. So why should I assume he's lying in saying something that's true, and that he unquestionably used to actually believe?

Nevertheless, the transparency has put him in an awkward position. The Fed's newly transparent forecasts make it quite clear that we will fall short of almost anyone's definition of a desirable level of demand growth over the next few years. And yet the Fed holds back from doing more. Reporters are beginning to probe this inconsistency at press conferences. He answers the queries the only way he can—mysterious "costs and risks" of aggressive unconventional stimulus. That basically means that if they bought up a large chunk of the national debt, they might have to sell it later at a loss.

Does Bernanke actually believe these costs and risks are more important than millions of unemployed? Based on his work on Japan as an academic, almost certainly not. But other people at the Fed certainly do worry about this, and he must speak for the entire Fed at the press conferences. What else could he say?

While revising my Depression manuscript (which is finally back at the publisher, thank God!) I was reminded of a similar problem in the Great Depression. This is New York Fed President Harrison in 1932 testifying in front of Congress (in the days when Congressmen did understand monetary policy, indeed he's being questioned by Congressman Goldsborough who has an excellent discussion of the distinction between temporary and permanent currency injections at the zero bound, an idea rediscovered by Krugman in 1998.)

HARRISON: [W]e have bought since the crash in the stock market approximately $800,000,000 to $850,000,000 of additional government securities . . . [H]owever, when after all the huge withdrawals of currency for hoarding purposes . . . we had in the system a relatively small proportion of free gold . . . [W]hile I would have liked to proceed further and faster last year, I was adverse to doing so till we had the protection of the Glass Steagall bill. . . . Perhaps we could have gone a little faster without clogging the banks by giving them too much excess reserve. [from Hetzel's new book, p. 42.]

Harrison is sort of like Bernanke, someone who got more cautious as he got closer to power. That's a very Bernanke-like statement. We did a lot. Perhaps we should have done a bit more. But there were costs and risks (of gold outflows.) And, of course, we know exactly what Bernanke thinks of Fed behavior in the Depression, it was disgracefully timid. They needed "Rooseveltian resolve."

Here I discuss Richard Timberlake's excellent analysis of the gold problem:

In fact, Timberlake (1993, p. 272) pointed out that "In the true sense of Walter Bagehot's prescriptions, all the Fed banks' gold was excess." Meltzer (2003, p 276) makes a similar point and also observes that the Fed was well aware of the techniques used by the Bank of England during the nineteenth century to protect its gold holdings during a panic [Meltzer (p. 276) points out that the Bank of England "had suspended the gold reserve requirement and relaxed restrictions on eligible paper for discount" during panics].

And it's hard to argue with Timberlake's maxim (p. 273) that "A proper central bank does not fail because it loses all its gold in a banking crisis. It only fails if it does not." It is difficult to imagine a more shocking indictment ofU.S. monetary policy than the fact that on the day FDR took theU.S. off the gold standard it still held over 37 percent of the world's monetary gold stock.

That's from my manuscript. Here's how I'd translate that. If a murderous maniac is trying to rape your wife, there is no shame in shooting at him and failing to stop him. What would be shameful is if you failed to stop him and still had unfired bullets in your revolver. The U.S. still had the world's largest gold reserves in 1933 when they threw in the towel and devalued. Just think of the irony. They were so cautious in monetary stimulus that NGDP fell in half, and therefore, we eventually abandoned the gold standard. And why were they so cautious? They were afraid of running out of ammo . . . I mean gold. And when they finally gave up in 1933, we discovered that the Fed had been so timid that we still had far more gold than any other country on Earth! I'm quite certain that Bernanke agrees with Timberlake and me . . . about 1933.

I bet you're thinking that it doesn't get any more ironic than that. Unfortunately it does. The Fed's not worried about gold outflows, they're worried about losses on their portfolio of securities. And can you blame them? It's not like Fed profits in recent years have more than doubled, soaring to the highest levels ever earned by any corporation in the history of the universe. Oh wait . . .

Click to enlarge

And 2011 profits were about the same as 2010 profits. That's triple the amount Apple (NASDAQ:AAPL) earned in 2011. Two hundred billion dollars in 3 years! Folks, that's a huge, gigantic, vast, enormous, mammoth, tremendous, titanic, humongous, immense, colossal, gargantuan, stupendous amount of money. Yes, they might lose some money in the future if rates rise. But consider:

1. Any losses from faster NGDP growth would be more than offset by gains to the Treasury. When you are in a Great Depression you don't worry about gold outflows. And when you are in a Great Recession, you sure as hell don't worry about the possible (though unlikely) need for future accounting transfers within the Federal government.

2. According to the EMH, expected gains or losses from future purchases of securities are roughly zero, as sellers of T-bond's will price them based on the expected effect of any stimulus the Fed happens to announce.

3. Given the announcement effect, it's unlikely that the Fed would actually have to buy all that much if they sincerely went for faster NGDP growth, level targeting. In other words, the Fed's current (ultra-cautious) path is actually the riskiest, the one associated with the largest demand for base money.

To summarize, the costs and risks argument isn't just weak, it's laughably weak, especially when set against the scale of the (now global) AD crisis. But the Fed has been forced to make this pathetic argument because of three factors:

1. Bernanke's decision to promote transparency.

2. Bernanke's obvious reluctance to start lying, and claim they are out of ammo. That would be wrong and would make him look like a complete fool, as he wouldn't be able to provide any concrete facts that would explain why he had abandoned his previous academic view.

3. Bernanke's reluctance to tell Congress; "We have no AD problem; we are right where we want to be folks."

Bernanke's in a box with no way out. And the screws are only going to get tighter and tighter over time.

PS. And remember that the press corps still hasn't asked him about his 2003 claim that money and interest rates are unreliable policy indicators, and that only NGDP growth and inflation provide a reliable indicator of the stance of policy. And that those two indicators (averaged) show the tightest money since Herbert Hoover over the past 4 years, when high unemployment would call for easy money (dual mandate.) He still hasn't been asked that question! The box is only going to get hotter.

PPS. I still like Bernanke, I hope the two new Board members will show some initiative and encourage him to follow his instincts.