Bernanke’s Little Depression

The Telegraph’s Ambrose Evans-Pritchard discusses Bernanke’s Little Depression in his latest column:
Fed chair Ben Bernanke kept policy far too tight after the US economy buckled in early to mid 2008. He allowed a collapse in the money supply to run unchecked, causing avoidable disasters at Fannie, Freddie, Lehman, and AIG later that year.

Call it the “Bernanke Depression” if you want, a term gaining traction in elite circles. The indictment is a little unfair. The European Central Bank was worse. It raised rates into a deflationary oil shock in August 2008, and worsened a run on the dollar that constrained Fed actions.

There was little that Bernanke could do about the deeper causes of the crisis, whether the `Savings Glut’ of Asia and North Europe, the `China Effect’, the $10 trillion reserve accumulation by the world’s rising powers.

Yet three heavyweight books now lay the blame squarely on the Fed: the ‘Great Recession’ by Robert Hetzel, a top insider at the Richmond Fed; ‘Money in a Free Society’ by Tim Congdon from International Monetary Research; and ‘Boom and Bust Banking: The Causes and Cures of the Great Recession’ by David Beckworth from Western Kentucky University.

To be clear, the Market Monetarist’s view is not that the Fed deliberately caused the Little Depression, but rather that the Fed failed to fully respond to a number of developments over the past four years that significantly raised the demand for money: the U.S. collapse in 2008-2009, the Eurozone Crisis of 2010-present, and the debt ceiling crisis of 2011. We don’t see these events dramatically changing the productive capacity of the U.S. economy over this time, but we do see them increasing the demand for money and other safe assets because of the economic uncertainty they created. The Fed could have met this spike in demand for liquidity by better managing expectations about future nominal income. The Fed’s failure to do so amounts to what we call a passive tightening of monetary policy and is why we view this as Bernanke’s Little Depression.

So naturally, we were pleased to see the FOMC decide to do QE3, its latest round of large scale asset purchases, on a conditional basis. Doing so signals to the public that the Fed will restore nominal incomes regardless of how many asset purchases it takes. Knowing this, the public should reduce its money and safe asset holdings and in the process catalyze a robust recovery. The problem, however, is that the FOMC’s definition for recovery under QE3 is loosely tied to labor market conditions. If this means stabilizing nominal wages (i.e. nominal GDP per capita) around some growth path that would be fine. But if it means explicitly targeting a real variable like the unemployment rate than QE3 has the potential to turn out badly, a point noted by Evans-Pritchard:

Modern monetarists — or market monetarists as they call themselves — have achieved a bittersweet victory. They have been calling for QE3 all year. They are widely credited with forcing the Fed to capitulate. Their influence is now extraordinary.

Yet the Fed is dressing up its policy shift in dubious terms. Instead of adopting a “pure” monetarist target — say a 5pc trend growth rate for nominal GDP — the Fed is implicitly arguing that a little more inflation is a worthwhile trade-off if it creates more jobs.

Bill Woolsey from Monetary Freedom says we are back edging back towards the `Phillips Curve’ temptations of the 1960s and 1970s, which ended with stagflation and the misery index.

“Targeting real variables is a potential disaster. Expansionary monetary policy seeking an unfeasible target for unemployment was the key error that generated the Great Inflation of the Seventies,” he said.

Bernanke’s attempt to push down borrowing costs is at odds with monetarist orthodoxy. Woolsey argues that successful QE should cause rates to rise — not fall — because the goal of such policy should be to put money into the hands of businesses that then invest, spending on machinery and real expansion.

The Fed is barking up the wrong tree with its doctrine of credit yield manipulation, or “creditism”, straying far from the quantity theory of money… So back the Fed’s QE3 with a clothes-peg on your nose.

Evans-Pritchard is absolutely right. On one hand, QE3 could turn out to be an important turning point in the Fed’s journey to NGDP level targeting. On the other hand, it could turn out bad if QE3 puts the Fed on the road to explicitly targeting the unemployment rate, as some Fed officials now want. Granted, these officials want to do so in the in the context of price stability, which for them may just be Fedspeak for saying the FOMC really needs to target the level of NGDP. But in its current form, QE3 allows enough wiggle room to make me uncomfortable. So come on FOMC, take the full plunge and adopt a NGDP level target already!