Fed Ready to Dig Deeper to Aid Growth, Chief Says by Sewell Chen

Title should be "Economy Weakens as Bernanke says Fed Ready to Step in if Economy Weakens."

From the piece:

Mr. Bernanke said he saw "no support" on the committee for setting a higher inflation target, as some economists have suggested. He called the strategy "inappropriate for the United States in current circumstances."

Goody gumdrops! And yet Bernanke saw much support on the committee for years of high unemployment. The Federal Reserve Bank of America - many of whose decision makers are appointed by private sector banks* - is losing legitimacy by the day.

Bernanke passes the buck to the do-nothing Senate, which has already lost its legitimacy:

Mr. Bernanke made clear that while the Fed could take various steps, including large purchases of government debt, "central bankers alone cannot solve the world’s economic problems." Speaking at the Fed’s annual symposium here, he hinted broadly that political leaders had to take steps to tackle the deficit and the trade imbalance.

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* Imagine the outcry, say, if half the decision makers on the National Labor Relations Boards were appointed by labor unions.

History Repeating

via DeLong:

Christina Romer, CEA Chair, March 9, 2009:

http://www.brookings.edu/~/media/files/events/2009/0309_lessons/0309_lessons_romer.pdf: [M]onetary policy was very expansionary in the mid- 1930s. Fiscal policy, though less expansionary, was also helpful.... And the economy responded. Growth was very rapid in the mid-1930s. Real GDP increased 11% in 1934, 9% in 1935, and 13% in 1936. Because the economy was beginning at such a low level, even these growth rates were not enough to bring it all the way back to normal. Industrial production finally surpassed its July 1929 peak in December 1936, but was still well below the level predicted by the pre-Depression trend. Unemployment had fallen by close to 10 percentage points -- but was still over 15%. The economy was on the road to recovery, but still precarious and not yet at a point where private demand was ready to carry the full load of generating growth.

In this fragile environment, fiscal policy turned sharply contractionary. The one- time veterans’ bonus ended, and Social Security taxes were collected for the first time in 1937. As a result, the deficit was reduced by roughly 21⁄2% of GDP. Monetary policy also turned inadvertently contractionary. The Federal Reserve was becoming increasingly concerned about inflation in 1936. It was also concerned that, because banks were holding such large quantities of excess reserves, open-market operations would merely cause banks to substitute government bonds for excess reserves and would have no impact on lending. In an effort to put themselves in a position where they could tighten if they needed to, the Federal Reserve doubled reserve requirements in three steps in 1936 and 1937. Unfortunately, banks, shaken by the bank runs of just a few years before, scrambled to build reserves above the new higher required levels. As a result, interest rates rose and lending plummeted.

The results of the fiscal and monetary double whammy in the precarious environment were disastrous. GDP rose by only 5% in 1937 and then fell by 3% in 1938, and unemployment rose dramatically, reaching 19% in 1938. Policymakers soon reversed course and the strong recovery resumed, but taking the wrong turn in 1937 effectively added two years to the Depression.

The 1937 episode is an important cautionary tale for modern policymakers. At some point, recovery will take on a life of its own, as rising output generates rising investment and inventory demand through accelerator effects, and confidence and optimism replace caution and pessimism. But, we will need to monitor the economy closely to be sure that the private sector is back in the saddle before government takes away its crucial lifeline...

Christina Romer, CEA Chair, June 18, 2009:

Economics focus: The lessons of 1937: [I]t hit me that I should have told the story of 1937. The recovery from the Depression is often described as slow because America did not return to full employment until after the outbreak of the second world war. But the truth is the recovery in the four years after Franklin Roosevelt took office in 1933 was incredibly rapid.... However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19%... an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy.... According to a classic study of the Depression by Milton Friedman and Anna Schwartz... monetary contraction was a central cause of the 1937-38 recession.

The 1937 episode provides a cautionary tale. The urge to declare victory and get back to normal policy after an economic crisis is strong. That urge needs to be resisted until the economy is again approaching full employment. Financial crises, in particular, tend to leave scars that make financial institutions, households and firms behave differently. If the government withdraws support too early, a return to economic decline or even panic could follow. In this regard, not only should we not prematurely stop Recovery Act spending, we need to plan carefully for its expiration. According to the Congressional Budget Office, the Recovery Act will provide nearly $400 billion of stimulus in the 2010 fiscal year, but just over $130 billion in 2011. This implies a fiscal contraction of about 2% of GDP. If all goes well, private demand will have increased enough by then to fill the gap. If that is not the case, broad policy support may need to be sustained somewhat longer.

Perhaps a more fundamental lesson is that policymakers should find constructive ways to respond to the natural pressure to cut back on stimulus.... Granting [the Fed]... additional tools now could provide confidence that the Fed will be able to respond to inflationary pressures, without it having to create that confidence by actually tightening prematurely.

Now is also the time to think about our long-run fiscal situation.... To switch to austerity in the immediate future would surely set back recovery and risk a 1937-like recession-within-a-recession. But many are legitimately concerned about the longer-term budget situation.... The fundamental source of long-run deficits is rising health-care expenditures. By coupling the expansion of coverage with reforms that significantly slow the growth of health-care costs, we can dramatically improve the long-run fiscal situation without tightening prematurely.

As someone who has written somewhat critically of the short-sightedness of policymakers in the late 1930s, I feel new humility. I can see that the pressures they were under were probably enormous. Policymakers today need to learn from their experiences and respond to the same pressures constructively, without derailing the recovery before it has even begun...

Hopefully she'll become President of the San Francisco Fed.

Dean Baker wonders why David Brooks is wrong all the time.

This time Brooks asserts that Germany is doing better than America because it has followed conservative economic/austerity policies.

Krugman points out how this is wrong. Basically Germany had more Keynesian fiscal stimulus than the U.S. since the 50 state governments' austerity policies negated much of the American federal government's Keynesian fiscal stimulus.

To be fair to Brooks, it is kind of confusing that the European Central Bank President's Trichet is talking austerity and scolding spendthrift governments, while Bernake is talking loose monetary policy, while not doing enough as the economy weakens.

Sewell Chen reports on the two central bankers.

The Dark Side
New York Times editorial on terrorist suspects and torture.

In 2008, the Supreme Court ruled that Guantánamo prisoners could challenge their detention as enemy combatants in federal court, under the constitutional right of habeas corpus. Since then, the government has lost 37 of the 53 habeas cases that have been decided, largely because it could not prove the prisoners were terrorists.

In the 15 cases where prisoners have alleged coercive interrogations, according to the ProPublica report, judges have sided with the prisoners eight times. (There are probably more cases than these, but the judges’ opinions have been too heavily redacted by the government to tell.) Only three detainees in habeas cases have actually been let go.

In one compelling example, Judge Gladys Kessler of the United States District Court for the District of Columbia in November threw out the case against Farhi Saeed bin Mohammed, captured in Pakistan in 2001. The government described Mr. Mohammed as a fighter for Al Qaeda, and Judge Kessler acknowledged there was some evidence he had associated with terrorists.

But the main evidence that he was an active terrorist was supplied by another prisoner, Binyam Mohamed, who Judge Kessler said was repeatedly tortured for two years while being held in Pakistan and Morocco at the behest of the United States. His genitals were mutilated; he was deprived of sleep and food; he was held in stress positions and forced to listen to piercingly loud music.

Because the government did not dispute Binyam Mohamed’s torture -- and could not otherwise prove that Farhi Mohammed was actively engaged in fighting for Al Qaeda or the Taliban -- she ordered him released. The government is appealing.

At least 50 other Guantánamo prisoners have filed habeas lawsuits. Torture could also affect the trial, if there is one, of Khalid Shaikh Mohammed, who planned the 9/11 attack.

...

The decisions speak well of the federal judges who are adhering to civilized legal standards even when the decision to release prisoners is difficult. We hope this demonstrated respect for due process will help repair this country’s battered reputation. Had Bush-era interrogators held to similar standards, there would be fewer dubious detention cases at Guantánamo, and the government would have a much stronger case against those prisoners who are there legitimately.

Bernanke gave a speech in Jackson Hole today:

Despite this recent slowing, however, it is reasonable to expect some pickup in growth in 2011 and in subsequent years. Broad financial conditions, including monetary policy, are supportive of growth, and banks appear to have become somewhat more willing to lend. Importantly, households may have made more progress than we had earlier thought in repairing their balance sheets, allowing them more flexibility to increase their spending as conditions improve. And as the expansion strengthens, firms should become more willing to hire. Inflation should remain subdued for some time, with low risks of either a significant increase or decrease from current levels.

No helicopter drop incoming. Next FOMC meeting is September 21st. According to the June minutes the Fed expects:

3.5 to 4.2 percent growth for 2011 and unemployment of 8.7 to 8.3 percent. They need higher inflation. Seems to me that the Federal Reserve Bank is going to lose its legitimacy.

Second quarter growth was revised down to 1.6 percent. I'd bet we come under 3.2 percent GDP growth for 2010.

Sewell Chan speculates on the planned Bernanke statement at Jackson Hole, Wyoming tomorrow.

Former Wyoming Senator Alan Simpson is co-chair of the debt cat food commission. After Simpson compared Social Security to a " milk cow with 310 million tits," Krugman rightly calls for him to be fired.

Krugman makes a prediction about the Jackson Hole pow-wow:

Something I wanted to put up before the Jackson Hole extravaganza: let’s watch and see how many Fed officials declare that expectations of future inflation are "well-anchored" (which is the favorite formulation). Because, you know, they’re not.

Dean Baker fisks Matt Bai on Social Security.

Why are we even discussing Social Security?

Matt Bai:

The party’s liberal activists rejected Mr. Muskie’s argument. They reacted with the same disdain 20 years later, when President Bill Clinton declared an end to the "era of big government." They opposed the creation of Mr. Obama’s debt panel for the same reason.

Yes Bill Clinton partnered with Republicans to deregulate a financial system whose recent collapse wrecked the economy. Big government saved us from a second Great Depression.

Matt Bai:

But at a time when the nation faces its second straight budget deficit of more than $1 trillion under their watch, some Democrats in Congress may be more inclined to accept the proposition that budget reform is essential to the endurance of liberal government.

The deficit was caused by Big Government bailing out the private sector after the financial crisis. Also, tax revenues declined because of the recession. Once the economy grows again we can pay down the debt, just as Bill Clinton did ten years ago.

Krugman on bubblenomics:

Consider the stock bubble of the late 1990s. It was crazy, and when it popped U.S. households suffered a capital loss of about $5 trillion. This was bad, and helped cause a recession. But it never rose to the level of economic catastrophe.

Then came the housing bubble, after which households suffered a capital loss of about $8 billion. Yes, they also suffered a big loss as stocks plunged -- but that was because the housing bust, unlike the stock bust, had a huge impact on the financial system and the economy as a whole.
What was the difference? First, a lot of financial institutions -- which are highly leveraged -- were holding securities whose value was highly sensitive to the state of the housing market. There was nothing comparable in the case of stocks. So the housing bust undermined the financial system in a way the stock bust never did.

Second, households also leveraged themselves up in the housing boom, in a way they for the most part didn’t with stocks (yes, there were people buying dotcoms on margin, but they were not typical). So the housing bust created a balance-sheet crisis for the household sector in a way that the dotcom bust didn’t.

The moral for right now is that even if you believe that there are bubbles inflating or about to inflate, they’re only a big concern if they are leading to leveraged positions for key players. The alleged carry trade bubble sorta kinda mighta have met that criterion, although I never found the warnings all that persuasive. But other stuff -- bubbles in BRIC equities, or gold, or whatever, don’t make the grade.

Anyway, my point is not so much about current events as a more general observation: the bubbles we should fear are those that lead to leverage, and set us up for a Minsky moment.

So he's revising what he had said about the carry trade bubble? I don't understand this stuff completely but I would bet against there being a bond bubble. Krugman seems to think it's in the realm of possibility.

I do remember Long Term Capital Management being over-leveraged in 1998.  At that time the Fed didn't bail them out but instead got all of their creditors to join together and "foam the runway."

I always thought James Ledbetter had a good take on things and had the critical thinking skill necessary to be a quality journalist, but I guess was wrong.

Headmaster DeLong takes him to school:

All this in the decline from 137.83 million people employed in July 2007 to 129.95 million people employed in July 2010--a 7.88 million decline in employment during a period in which the adult population has grown by 6 million.

I see employment growth in (a) internet, (b) health care, and (c) logging and mining. I see employment declines everywhere else.

That does not look like a story of "mismatch" unemployment--in which demand shifts in a direction that the existing labor force cannot cope with, and the result is structural unemployment in declining sectors and occupations and boom times and rising wages and prices in those sectors and occupations to which demand has shifted. That does not look like that at all.

One shouldn't cheat on the Swedish model.

Two Letters in the NYTimes

To the Editor:
Re "German Growth Bolsters Its Stance on Recession" (front page, Aug. 14), about Germany’s remarkable recovery in the midst of global recession:

German capitalism is an almost entirely different creature from the one that American workers have to contend with. Germany has about 60 percent unionization. And German workers have fully 50 percent representation on corporate boards. Then there are the works councils, in which German labor sets many of the basic rules of employment, not to mention cheap, superior and universal health care.

All in all, the German model of fully empowered labor cooperation with management has produced a far more robust, rational and moral economy than the one we have, in which labor has little say, firing employees is cause for celebration and lavish bonuses are given in the executive suites. The only worker satisfaction to be had here is to grab a couple of beers and pull the escape cord Steven Slater-style.

Gary Borg
Chicago, Aug. 14, 2010

To the Editor:
As I read the article describing Germany’s impressive economic growth this past quarter, the obvious question for us is: Why aren’t we following this path, too?

Loose credit and excessive spending got us into the mess we’re still in. So I don’t understand why the solution both the Fed and the Treasury are pushing is easy credit to stimulate more consumer spending. This is a sure recipe for another bubble and crash.

We should be growing our economy by increasing our productivity and exports and not stimulating more spending, which just runs up our debt.

James P. Tuthill
Lafayette, Calif., Aug. 15, 2010

The Hangover Theory by Krugman

Lovers in Japan (Osaka version)

Krugman on the ratings agencies.

One thing you sometimes hear is that the game will be up when the ratings agencies downgrade U.S. debt. I wonder how many of the people saying this know that Moody’s and S&P downgraded Japanese debt in 2002, with Moody’s actually putting it below Botswana and Estonia.

And 8 years later, Japan can still borrow at less than 1 percent.

And didn't those same ratings agencies bestow crappy mortgage-backed securities with AAA ratings?

Yglesias discusses how appropriate government policies can work and did work in Japan in the face of a liquidity trap.

No, We're Not Turning Into Japan by James Ledbetter

Pressed to Act, Bank of Japan Sees Few Ways to Lift Demand by Hiroko Tabuchi