The president and the Federal Reserve chair were a trifle premature last year when they congratulated themselves for saving the country from a depression. The Fed has now put that claim on hold. Ben Bernanke conceded as much when he dropped the Fed’s $600 billion love bomb on the economy, hoping to blow away the negative forces threatening Big D, which stands for deflation and depression. Bernanke announced this dramatic move with his usual bland understatement and the opaque technical label "quantitative easing." QE stands for scared central bankers. The government’s fiscal policy is paralyzed: Democrats belatedly realize they did not do nearly enough to stimulate the economy, but do-nothing Republicans, abetted by some spineless Dems, are insisting on spending cuts and budget balancing. Barack Obama, characteristically, says he wants to do some of both.
So the Fed decided it has to act alone. It intends to repeat what it did two years ago at the height of the financial crisis: pump up the money supply in order to head off a dangerous spiral of deflationary forces—falling prices that lead to more defaulting debts, more unemployment, more lost output. That same destructive cycle is what led to the Great Depression after the financial collapse of 1929. Bernanke says it can’t happen again. Just in case he’s wrong, he has turned on the fire hose with a massive purchase of long-term Treasury bonds. The Fed says it will keep pumping easy money into the economic system until it works—lowering long-term interest rates to encourage big-ticket consumption and new investment while weakening the dollar’s value to boost US exports. The central bank did not find funny money under the mattress. It is creating this $600 billion for a compelling public purpose—averting catastrophe (again). Bernanke says he will buy still more Treasuries with the interest collected on mortgage securities, which will push the overall injection to nearly $900 billion—bigger than TARP.
The right is attacking him, but I would offer two muted cheers for the Fed—at least it is doing something. But the problem is, it probably won’t succeed. Flooding the financial markets with a surfeit of money should, in theory, prevent a catastrophic monetary deflation, but it is not so clear that this will revive the stalled economic engine. Pumping tons of new money into the banking system and financial markets will definitely make bankers and big-time investors feel better—stock markets and commodity traders are already bubbling with hope. But this will not do much for business enterprise, not to mention unemployed workers and families facing foreclosure.
Bernanke is an orthodox monetary conservative, adhering to scripture taught by Milton Friedman, not John Maynard Keynes. As Keynes taught, what excites the "animal spirits" of businesspeople is the sight of willing customers with money to spend, eager to buy stuff. But consumer demand is exactly what bankers and business guys can’t see at present. The economic problem is located on the demand side. Alas, the country is still governed by policy-makers enthralled by supply-side theory.
The Federal Reserve’s solution essentially takes the long way around the barn. It will be funneling the $600 billion through banks already flush with trillions they are reluctant to lend. Why lend to companies to build new factories when they can’t sell the stuff they already make?
I propose a more direct solution, if people in government have the nerve and imagination to try it. The Fed could skip over the banks and, instead of buying Treasuries with its newly created money, pump it directly into the real economy of consumers and producers, where it would finance new demand and rejuvenate the economic activity needed for genuine recovery. That direct action is a no-no to central bankers and orthodox monetary economists, but Lincoln did it during the Civil War, and his greenback currency helped save the Union.
Fed governors will claim they are forbidden by law from directly supporting nonfinancial enterprises, but the Fed has already lost its virginity on that question. During the financial bailouts, the Fed pumped billions into AIG—an insurance company, not a bank—and in effect became its owner. In any case, the Fed’s legal authority to lend is deliberately vague. It can lend to nearly anyone, even local governments, if it finds "unusual and exigent circumstances." Congress can authorize the Fed to pump its $600 billion into building infrastructure, creating employment and stimulating consumer demand, assuming proper safeguards.
One obvious solution is for Congress to create the federal Recovery and Reconstruction Bank some are advocating. The new bank would be given a list of well-defined projects and appropriations, but its financing would rely mainly on money borrowed by selling bonds to investors. The Federal Reserve’s new money would be interest-free and governed by special performance bonds—the reconstruction bank would have to pay the money back only if it failed to deliver the promised projects. That would impose discipline on the new bank and on Congress. The Fed could hold the infrastructure bonds in its own portfolio, where it already holds $1.1 trillion in mortgage-backed securities created by the reckless banking industry. The government would, in effect, be able to borrow huge sums interest-free and pay off the long-term loans over many years, much like corporate bonds or home mortgages. The money, once expended on construction and other projects, would immediately circulate through the regular banking system, indistinguishable from any other money, instead of sitting idle as bank reserves.
Of course, the bankers will scream because they will be cut out of the money-creation chain that is so profitable for them, in which the Fed hands them free money as reserves, with the banks lending it out and collecting interest from the borrowers. Most monetary economists will denounce the idea of a Fed-financed infrastructure bank as heresy. They prefer that the Fed remain an oddly cloistered and unaccountable institution of government, independent of all outside influence except that of the bankers.
The real obstacle to direct Fed stimulus is primarily the political community. It is largely composed of clueless senators and representatives intimidated by the financiers and bankers, who lead them around by the nose. But the country is mired in a historic crisis. Where are leaders with the imagination and guts to break some eggs and make an omelet?