What Can the Fed Do?

In his column today, Paul Krugman excoriates the Federal Reserve System, and especially Ben Bernanke, for “inventing reasons to dither in the face of mass unemployment.” Why? Because the Fed is not creating enough inflation, which Krugman claims will give the economy “traction.”

Krugman writes:

America’s current economic troubles aren’t exactly identical to those of Japan in 1999-2000: Japan was experiencing outright deflation, while we aren’t — yet. But inflation is well below the Fed’s target of around 2 percent, and it is continuing to slide. And Americans face a level of unemployment, and sheer human misery, far worse than anything Japan went through.

Yet the Fed is doing almost nothing to confront these troubles.

However, Krugman also suggests a “solution,” and it is here that I think we need a discussion. He says:

What could the Fed be doing? Back when, Mr. Bernanke suggested, among other things, that the Bank of Japan could get traction by buying large quantities of “nonstandard” assets — that is, assets other than the short-term government debt central banks normally hold. The Fed actually put that idea into practice during the most acute phase of the financial crisis, acquiring, in particular, large amounts of mortgage-backed securities. However, it stopped those purchases in March.

Since then, the economic news has grown steadily worse. And earlier this week, the Fed changed course — but barely. It now says that it will reinvest the proceeds from maturing securities in long-term government bonds. That’s a trivial change, basically the least the Fed could get away with without facing a firestorm of criticism — and far short of the major asset-purchase program the Fed should be undertaking.

So, once again we see the post hoc ergo propter hoc fallacy at work. Why is the economy now in the tank? The Fed isn’t buying enough assets, as though the economy was doing well in March.

Not surprisingly, Krugman blames those dastardly regional Fed chairmen for this plight, declaring:

What’s going on here? Has Mr. Bernanke been intellectually assimilated by the Fed Borg? I prefer to believe that he’s being political, unwilling to engage in open confrontation with other Fed officials — especially those regional Fed presidents who fear inflation, even with deflation the clear and present danger, and are evidently unmoved by the plight of the unemployed.

And in fairness to Mr. Bernanke, discord among senior officials also makes it difficult for policy to change expectations: it would be hard to credibly commit to higher inflation if this commitment were constantly being undercut by speeches out of the Richmond or Dallas Feds. In fact, I’d argue that loose talk by some Fed officials is already having a negative economic impact. But while Mr. Bernanke doesn’t have the authority to stop that loose talk, he could make it clear that it doesn’t represent overall Fed policy.

Yeah, its the rhetoric. If only we had all members of the Fed declaring that what this country needs is a good bout of inflation, then everything would be fine and the economy would be gaining “traction” toward recovery. However, there is a problem here, and it is NOT that President Obama waited until recently to fill 16 Fed slots, regardless of what Krugman claims.

No, the problem is that Krugman confuses the paper purchase of assets deemed worthless in the markets with the creation of real wealth. I have said before that Krugman really does confuse paper money with wealth, a fallacy that Adam Smith and others exploded more than two centuries ago, yet lives on in the hallowed halls of Ivy League institutions.

Like the Supply-Siders that claim that the real problem is that the government has not cut tax rates low enough (although that does help), Krugman’s answer always is that there is not enough inflation. In Krugman’s view, there really is no “real” economy; instead, it is a combination of paper and rhetoric, as though capital and other factors of production are simple putty to be molded in the hands of the “experts” in Washington.

The economy is not tanking because of any alleged “dithering” at the Fed. It is tanking because the government insists upon strangling those firms that still are healthy (“wicked profiteers”) and propping up the politically-connected firms (i.e. Government Motors) or forcing taxpayers to ante up to pay for assets that cannot ever be profitable in a real economy (i.e. “Green Energy”). The Keynesian prescription – inflate, inflate, inflate – is what is intellectually and morally bankrupt, and as long as that mentality rules, we will have a moribund and depressed economy.

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