Must-Read: Ryan Avent: Ben Bernanke’s Big Blunder

Must-Read: I find myself thinking about six things:

  1. The failure of the Bernanke Fed to focus on the unwinding housing bubble and learn about the outstanding sources of systemic risk in 2006 and 2007.
  2. The decision by the Bernanke Fed in September 2008 that it was time to demonstrate that it did not guarantee the debt of money-center shadow banks, step aside, and allow the uncontrolled bankruptcy of Lehman Brothers.
  3. In fact, the earlier decision by the Bernanke Fed to stand by rather than to handle the situation when, in the summer of 2008, Lehman Brothers crossed the line from solvent to insolvent and thus the Federal Reserve arguably lost the legal power to handle a Lehman-centered crisis.
  4. The failure of the Bernanke Fed to commit to a policy of catching-up to 2%/year inflation should prices fall below its inflation target.
  5. The failure of the Bernanke Fed to choose a more appropriate, higher inflation target than 2%/year.
  6. The failure of the Bernanke Fed to admit that the 2%/year inflation target had proved to be a mistake, and shift to a more sensible nominal GDP target.

These are six major failures of technocratic rationality in monetary policy. Is there anything to offset them, other than “we stopped another Great Depression from happening”?

Ryan Avent: Ben Bernanke’s Big Blunder: “Two weeks ago, The Economist repeated its endorsement of a change in the Fed’s monetary policy target…

…from an inflation rate to a growth rate for nominal GDP (NGDP): or total spending and income in an economy in dollar terms. In November of 2011, during Mr Bernanke’s chairmanship of the Fed, the monetary-policy committee considered a change to an NGDP target, but opted to stay with the old, inflation-focused framework. Mr Bernanke writes:

For nominal GDP targeting to work, it had to be credible. That is, people would have to be convinced that the Fed, after spending most of the 1980s and 1990s trying to quash inflation, had suddenly decided it was willing to tolerate higher inflation, possibly for many years.
And so in January of 2012 the Fed reiterated its inflation-targeting stance and officially designated a 2% rate of inflation, as measured by the price index for personal consumption expenditures, as the target.

We all know what happened next. Since then, the Fed has spectacularly undershot its inflation target…. Markets suspect rates might not rise to 0.5% until well into 2016, and most Fed members think rates will never get any higher than 3.5%. Treasury prices suggest that inflation will be closer to 1% than 2% over the next five years. There is good reason to believe that Mr Bernanke’s Fed made a big mistake, in other words. An NGDP target would have worked out better… helped the Fed choose policy more appropriately at a tricky time in the recovery. In 2011 high oil prices drove headline inflation above 2%… the central bank sensibly shrugged aside calls to raise rates in response to rising prices. Yet it also took no additional action to boost the economy. The recovery subsequently lost pace, inflation fell, and by the end of 2012 the Fed was forced to restart QE. Had the Fed instead focused its attention on NGDP, it would have been forced to react to an economy that was well below an appropriate level of output and which was growing too slowly…. Instead it took the costly choice to dither.

Just as importantly, a switch to an NGDP target would have sent a strong signal about Fed priorities…. Mr Bernanke notes that the Fed spent the 1980s and 1990s trying to quash inflation. It did not arrive at that policy strategy passively…. Paul Volcker… [did not say] that the Fed couldn’t possibly rein in double-digit inflation because it lacked credibility as an inflation-fighter after a decade of neglecting the problem. Instead, he used the tools available to him to demonstrate the Fed’s credibility. Mr Bernanke’s Fed could have, and should have, taken similarly bold action….

Instead, it made itself a prisoner of its own complacency. As a result, inflation and interest rates will spend most of the 2010s at dangerously low levels, leaving the American economy disconcertingly vulnerable to new economic shocks. The book, by the way, is titled The Courage to Act

October 7, 2015


Brad DeLong
Connect with us!

Explore the Equitable Growth network of experts around the country and get answers to today's most pressing questions!

Get in Touch