By any reasonable standard, the great failing of economic policy over the past 5 years — monetary and fiscal both — is that it has done too little. Output lies far below reasonable estimates of potential, meaning trillions of dollars of wasted resources; unemployment remains at levels that amount to personal, social, and possibly political catastrophe; inflation has been below target, and there are good reasons to believe that the targets are too low.
Yet the most virulent criticism of policy makers has come from those insisting that they are doing too much — that deficits are a terrible threat (somehow unperceived by the bond market), that the actions of central banks are excessive, even insane. So Martin Wolf finds himself compelled to defend Ben Bernanke, not against charges that he has failed to exhibit the “Rooseveltian resolve” he himself once demanded of the Bank of Japan, but against hedge fund types who accuse him of somehow perverting financial markets.
This makes me think that it might be time for a restatement of the case for unconventional Fed policy — not the case that it’s a panacea or even that it will necessarily work, but simply that it should be tried.
Start with the very simplest view of how Fed policy affects the economy: the Fed sets short-term interest rates, and other things equal a lower rate leads to higher output; the “natural rate” of interest — as explained in this SF Fed paper — is the rate at which output equals potential, that is, at which there are neither inflationary nor deflationary pressures:
Our problem now is that a severe negative shock to demand, originating from the bursting of the housing bubble and an overhang of household debt, has pushed the IS curve left to the point where the natural rate of interest is so low that it would take a negative nominal rate to get there:
What does this tell us? First of all, that there is nothing “artificial” or “unnatural” about low interest rates; they’re low because demand is low, and the Fed is responding appropriately. If anything, the “unnatural” situation is that rates are too high, because they’re constrained by the zero lower bound (rates can’t go below zero, except for some minor technical bobbles, because people can always just hold cash).
Second, the Fed’s inability to get rates as low as they should be justifies a search for policies that can fill this policy gap. Fiscal stimulus is one such policy; unconventional monetary policies of various kinds are another. Actually, the natural policy — natural in a Wicksellian sense, and also the one that in terms of standard economics should produce the least distortion — would be a credible commitment to higher inflation. Unfortunately, this is really hard to achieve, especially given the howling from the kind of people now attacking Bernanke.
My point, however, is that the extraordinary policies of recent years are responses — inadequate responses — to an extraordinary situation. And the real puzzle isn’t why Bernanke does what he does, but why so many supposedly knowledgeable people seem so determined to find reasons not to do the obvious, necessary thing.