Economist Paul Krugman is among those questioning the Fed (Chip East/REUTERS)
Back in December, Paul Krugman, the Nobel Prize winning economist and NYT columnist, wrote an Op-Ed saying the Federal Reserve can and should do more to boost employment. Krugman’s prescription was for the Fed to spend trillions of dollars buying long-term bonds.
The most specific, persuasive case I’ve seen for more Fed action comes from Joseph Gagnon, a former Fed staffer now at the Peterson Institute for International Economics. Basing his analysis on the prior work of none other than Mr. Bernanke himself, in his previous incarnation as an economic researcher, Mr. Gagnon urges the Fed to expand credit by buying a further $2 trillion in assets. Such a program could do a lot to promote faster growth, while having hardly any downside.
The Fed may soon do just that. On Tuesday and Wednesday, Ben Bernanke and the rest of his policy making committee will meet to decide what to do next to boost the flailing economy. The problem is short-term interest rates, which is what the Fed normally lowers to boost economic growth, can’t go any further south. The Fed has already set them close to zero. So Bernanke has signaled over the past month or so that the Fed may soon use government money to buy bonds to drive down long-term interest rates as well. If companies can borrow money for less, for longer periods of time say 5 or 10 or 20 years, not just overnight or for a few months, which is the rates the Fed normally sets, maybe those companies will borrow more. And some of that money might be used to build factories or buy equipment. And that should boost the economy and create jobs. Or so the thinking goes.
But in the past few weeks, more and more economists have been coming out against the plan saying it won’t boost employment. One of the people who now thinks Krugman’s no-downside prescription to boost the economy is a bad move: Krugman himself. Here’s why:
The main reason is probably because the economy looks to be in worse shape than it was a few months ago. Krugman has repeatedly, perhaps correctly, hammered President Obama for not seeing that the economy was worse than it was and for ordering up less stimulus than was needed. Obama needed to spend $2 trillion not nearly $800 billion, in Krugman’s mind and others. But Krugman looks to have made the same mistake, at least in late 2009. Back then he thought lower interest rates would be enough to boost employment. Now, not so much. Here’s what Krugman wrote about the Fed’s plan to buy bonds, called quantitative easing, a little over a week ago:
But with all the talk about further quantitative easing by the Fed — QE2, for quantitative easing, the sequel — I think it’s worth sharing one way of thinking about what’s on the table — and why you shouldn’t be too optimistic about its effects.
And Krugman’s not the only one. Last week, Christopher Pissarides said he, too, thought the Fed’s plan would do little to boost employment. Pissarides argument is that interest rates are already low enough to allow companies to do all the borrowing they want. There is plenty of liquidity, he said, just not enough spending.
But it’s not just the spending of US companies and US consumers that drives or economy. Exports are a big part of our economy as well. And if the Fed’s plan to buy bonds increases inflation, which is one of the goals, and drives down the value of the dollar that could get more foreigners to buy our goods, creating jobs. Right? Not so. Says another Nobel prize winning economist Joseph Stiglitz:
The upside of QE is limited. The money simply won’t go to where it’s needed, and the wealth effects are too small. The downside is a risk of global volatility, a currency war, and a global financial market that is increasingly fragmented and distorted. If the U.S. wins the battle of competitive devaluation, it may prove to be a pyrrhic victory, as our gains come at the expense of others—including those to whom we hope to export.
Stiglitz’s point is that any thing we do to make our goods more attractive will only hurt the economies of those that would buy our goods. So even if their dollars go farther in our markets, they will have less of them to spend. Even Bernanke appears to be questioning just how much he can do on his own. Reportedly he privately has advocated for another round of government stimulus spending, but isn’t willing to push for it in public.
To be fair, there are a number of economists who think the Fed’s plan is the right move, and will create jobs, if only modestly. A recent forum of top Wall Street economists in China (no irony here) said that the US economy will improve after the Fed’s moves. David Greenlaw of Morgan Stanley predicted unemployment will fall by an additonal 0.3% in 2011 and 0.5% in 2012 just because of the Fed’s bond buying plan. Considering unemployment is near 10% that’s not nearly enough to solve the problem, but hey if you are part of that 0.8% that gets a job, it matter.
My thinking is that the Fed’s move could help if it is able to moderately boost inflation. The threat of higher prices gets people to spend now because they are afraid they will have to spend more later for the same good. It’s why we stretch to buy houses and cars and vacations and many other large purchases before we may be ready. And if banks are diligent in decided which of those purchases to fund that can be a good thing. But I agree that the Fed is playing with fire. Consumers are correctly reluctant to spend. And they may need more than the threat of inflation to get them to pull out their wallets. If the Fed only boosts prices and not the economy, then we could end up being in a worse place than we are in now.