POLITICS SEPTEMBER 22, 2011
It’s hard to interpret the letter that Congressional Republicans sent on Tuesday evening to Ben Bernanke as anything other than an attempt to politically influence the monetary policy set by the Federal Reserve. Democrats have correctly recognized this as a rare breach of the central bank’s independence. But rather than complaining about conservatives’ fervor for monetary issues, liberals should be seeking to emulate them.
For most policymakers and commentators on the left, aggressive monetary policy and inflation has long taken a backseat to fiscal and financial sector issues when it comes to discussing how to return our economy to its full potential. That has allowed the conservative movement and the financial sector to dominate the monetary discussion throughout our current recession—and their focus, as we have seen in recent weeks, is a perpetual fear about imminent hyperinflation. But liberals should be addressing monetary policy head-on, and they should do so by challenging conservatives’ definition of the term “credibility” as it applies to our central bank.
Conservatives have shaped the consensus view of monetary credibility as a perpetual effort by central bankers to combat inflation, and to prevent it from spiraling out of control. And that has clearly influenced the actions of the Federal Reserve over the past three decades: Ever since Paul Volcker became its chairman in the late 1970s, the Fed has consistently sought to keep inflation low, stable and predictable, steadily reducing inflation rates from the double-digits of the late 1970s, to the 4 percent rate of the 1980s, to the 3 percent of the 1990s, to the 2 percent of the 2000s.
There is no doubt that predictable price levels are a necessary aspect of monetary credibility. But for many on the right, low inflation is not a matter of good policy, but an ideological dogma: inflation must always be fought, regardless of the state of the economy, and regardless what the data tell us. As Dallas Federal Reserve President and CEO Richard Fisher described it last summer, he was “committed to keeping inflation low and maintaining the credibility gained so painstakingly by former Fed Chairman Paul Volcker. I will remain steadfast in my resolve to keeping inflation low and stable.” This was in the face of an unemployment rate near 10 percent and concerns that financial markets were stagnating because of deflation. The word “credibility” no longer seems appropriate here.
Liberals should offer an alternative, pragmatic definition of monetary credibility, according to which credibility works like capital—you build it up in good times so you can spend it in bad times. This is the logic of many professional economists who are ordinarily inflation hawks, but now are arguing for the logic of higher inflation. Harvard economist and former Federal Reserve economist Kenneth Rogoff explicitly used this logic when he called for a period of sustained, higher inflation of 4 to 5 percent. He notes that the credibility the Federal Reserve has built as an inflation fighter over the past several decades should be used to now fight the current recession. As he told the Washington Post’s Ezra Klein, “This is a once-every-75-years great contraction where you spend your credibility. This is what that credibility is for.”
If the Federal Reserve were allowed to deploy its credibility, higher inflation would take care of several of the major problems that are currently impacting our economy. We suffer from a deficiency in demand, a severe debt overhang, and a large amount of capital that is sitting on the sidelines, not being put towards more productive uses. Inflation impacts all three of these obstacles: It generates demand, reduces the burden of debt, and pushes those who hold capital to put it into the economy.
There is a large amount of work that argues that we are stuck in a “balance-sheet recession”, one in which consumers, deleveraging from large amounts of bad debts, drag on the larger economy. In a way, this is inflation redistributed from creditors to debtors. A higher period of inflation would reduce this burden of debt in a cleaner, broader way than more cumbersome legal procedures. Until now, most of the large-scale debt reduction in housing has taken place through foreclosures, which is a particularly painful way to lower the amount of debt in our economy. Foreclosures have spillover effects that reduce the value of neighboring properties, putting those homeowners even more underwater, and in turn increasing the need to reduce their debts as well. This process can spiral out of control; inflation can help reign it back in to a more steady deleveraging process.
In producing a sustained period of higher inflation, the Federal Reserve needn’t abandon the inflation-fighting aspects of monetary credibility. It can commit to being responsibly irresponsible, showing that it will tolerate higher inflation as part of the path to full employment and catch-up growth, without introducing permanent changes to its mission. One way it could do this would be to target a particular growth rate or an unemployment level, and accept the higher-rate of inflation that would come with it. As Chicago Federal Reserve President Charles Evans recently pointed out, the Federal Reserve could "make a simple conditional statement of policy accommodation relative to our dual mandate responsibilities." We might even call this the Evans Rule: the Federal Reserve could simply agree to keep interest rates at zero and tolerate 3 percent average inflation until unemployment was down to 7 percent.
Maintaining expectations in this way should be Bernanke’s primary task in nursing the economy back to health. When a country is in this kind of recession, it is more important than ever that the Federal Reserve make a straightforward explanation of what it plans to do. This has been the problem with the Fed’s program of Quantitative Easing so far. Nothing about QE has shown the markets where the central bank wants to end up. By explicitly making targets, either of GDP growth, inflation and unemployment, or others, the Federal Reserve can put its credibility to good use—and even maintain it.
It is important that liberals engage conservatives on monetary debates. Since the 1970s, liberals have entirely ceded this aspect of the economic agenda. Even now, calls from the left for more monetary action gain only a fraction of the support of arguments for fiscal stimulus. But the left needs to realize that there is no neutral position in monetary policy—even if President Obama’s jobs plan is passed, its effects can easily be canceled out if the Federal Reserve caves to the singular pressure being applied to it by inflation hawks.
To whatever extent the Obama administration’s fiscal proposals might “Win the Future,” without taking monetary policy into consideration, they are unfortunately destined to lose the present. Because the present is a battle over low demand, high debt and people hoarding capital—three things that only a short period of sustained inflation will cure.
Mike Konczal is a fellow at the Roosevelt Institute. He blogs at Rortybomb.