Magazine article The American Conservative

Prophet & Loss

Magazine article The American Conservative

Prophet & Loss

Article excerpt

Ben Bernanke's bad predictions should preclude his reappointment.

IF THERE WAS ANY DOUBT that the Greenspan era was over, Ben Bernanke's rough day on June 25 dispelled it. The Federal Reserve chairman endured hours of grilling by the House Oversight and Government Reform Committee, a stunning contrast to the deferential treatment long accorded to his predecessor. With Bernanke's four-year term winding down, the debate over whether President Obama will reappoint him is getting a lot louder.

The committee's sharp questions focused on the role the Federal Reserve played in Bank of America's takeover of Merrill Lynch last year. But Fed watchers have recently been focusing on important new evidence of Bernanke's actions in the early part of the decade. The Federal Open Market Committee (FOMC) meets eight times a year to plan various aspects of monetary policy, including interest rates. It releases verbatim transcripts after a five-year lag. Fed members often make speeches and give interviews, but the transcripts show exactly what goes on behind closed doors.

2003 was a pivotal early bubble year. The war drums had been beating for months, which suppressed economic activity in the early part of the year. But by the middle of 2003, Iraq was an apparent success. With "Mission Accomplished" as the national mantra and Saddam in the market for spider holes, American consumers let out a collective sigh of relief. Third quarter GDP growth was a stunning 7.5 percent. The fiscal and monetary jets were on full blast. George W. Bush's tax cuts passed that May, and in June the Fed cut the fed funds rate to 1 percent and kept it there for the next year. The great national binge was underway.

But the FOMC transcripts show that Bernanke, then a Fed governor, was feeling a bit grumpy. With the economy gathering speed and the fed funds rate already at a historic low, he searched for reasons to cut interest rates even further. The text of the meeting on Aug. 12, 2003 evidences his concern:

Despite the good news, I think it's premature to conclude that we should not consider further rate cuts, if not at this meeting then at some time in the near future depending on how the dataplay out. My concern is focused on the behavior of inflation both in the short term and in the long term. Regarding the short term, though I can see that output gaps are extremely hard to measure, the most reasonable guess is that the current gap remains substantial. Moreover, because of rapid productivity growth, the gap may close very slowly in coming quarters even if output growth is quite strong. That's bad news for workers, and it poses some risks to consumer spending. More to the point, a persistent output gap implies that additional disinflation over the next year remains a distinct possibility. Even if we consider actual deflation to be too remote to worry about, further disinflation poses important risks.

Bernanke's caveat about output gaps was appropriate. The output gap is the difference between the actual output of an economy and the output it could achieve at full capacity. As economic statistics go, it is notoriously unreliable. Actual GDP is hard enough to measure and is habitually revised. One can imagine the pitfalls of a group of statisticians in Washington trying to estimate the collective potential of the entire U.S. economy. Beyond that, some larger dynamics affect the utility of the output gap as a statistic. If Detroit makes cars that consumers don't want, leaving large parts of the automobile industry and its associated national supply chain fallow, the output gap will reflect that. So too if a U.S. company outsources manufacturing to China or India. These are longterm, structural changes in the economy, influenced by forces such as globalization, demographics, and consumer preferences. They cannot be solved through monetary policy.

But Bernanke's solution is to monetize them. And using the output gap to predict inflation, as he did in that 2003 meeting, is particularly risky when it justifies easy monetary policy. …

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