Federal Reserve Board Chairman Ben Bernanke. REUTERS/Molly Riley
Washington is lost in a snarl of confusion, cowardice and wrongheaded ideological assumptions that threaten to keep the economy in a ditch for a long time. That prospect is not much discussed in the halls of Congress or the White House. It’s as though the crisis has been put on hold until after the presidential election.
As almost everyone understands, nothing substantial will be accomplished this year. President Obama is campaigning on warmed-over optimism and paper-thin policy proposals. Republicans propose to make things worse by drastically shrinking government spending, when the opposite is needed to foster a real recovery. The president, like the GOP, embraces large-scale deficit reduction. In these circumstances, it’s just as well that the two parties cannot reach agreement. After the election they may make a deal that splits the difference between bad and worse. In the worst case, they might inadvertently tip the economy back into recession.
In this sorry situation, there is really only one governing institution with the courage to dissent from the conventional wisdom—the Federal Reserve. The central bank declines to participate in the happy talk about recovery or in the righteous sermons attacking the deficit. In its muted manner, the Fed keeps explaining why the house is still on fire, why more aggressive action is needed, and is gently nudging the politicians who decide fiscal policy to step up. But its message is ignored by Congress and the president and viciously attacked by right-wing Republicans who say, Butt out.
The stakes in this elite dialogue are enormous. The outcome will be more meaningful for ordinary citizens than any other issue at play in this year’s campaign. If the Fed is right and politicians refuse to act, Americans may be condemned to a bitter slog through many years of stagnation.
Japan in the 1990s is the appropriate comparison. After its financial bubble burst, Japan saw its “lost decade” stretch into fifteen years of stunted growth. Its central bank responded hesitantly, and its monetary policy proved ineffective—rendered impotent by a “liquidity trap,” a condition identified by John Maynard Keynes. The United States experienced a similar fate in the Great Depression of the 1930s. As an economics professor, Fed chair Ben Bernanke is a scholar of that period. He is determined not to let it happen again. A decade ago, he scolded Japanese authorities for failing to be more imaginative and aggressive. They needed “the courage to abandon failed paradigms and to do what needed to be done,” Bernanke advised. His model was Franklin Roosevelt, whose “specific policy actions were, I think, less important than his willingness to be aggressive and to experiment—in short, to do whatever was necessary to get the country moving again.”
Maybe the Fed chair should give the same lecture to American politicians. But Bernanke is at risk of embarrassment himself: despite the Fed’s firepower, it has been unable to restart the economy. And monetary policy is running out of gas. Five years ago, in the heat of crisis, Bernanke’s response was awesome. The Fed created trillions of dollars and flooded the system with easy money—enough to stabilize financial markets and rescue wounded banks. It brought short-term interest rates down to near zero and long-term mortgage rates to bargain-basement levels. It provided a huge backstop for the dysfunctional housing sector, buying $1.25 trillion in mortgage-backed securities, nearly one-fourth of the market.
Flooding Wall Street with money saved the banks, but it didn’t work for the real economy, where most Americans live and toil. The housing sector kept falling. The Fed knows (even if politicians do not) the danger of sliding into a liquidity trap, which would utterly disarm its monetary tools (Charles Evans, president of the Chicago Federal Reserve Bank, thinks the trap has already closed). So the Fed wants Congress and the White House to borrow and spend more, which, when the private sector is stalled, only the government can do. To advance this cause, the central bank is promoting its recent white paper on housing, proposing, ever so gingerly, the heretical remedy of debt forgiveness for the millions of homeowners facing foreclosure.