Ben Bernanke
Federal Reserve Board Chairman Ben Bernanke testifies before the Joint Economic Committee on Capitol Hill June 7, 2012 in Washington, DC.

Playing Chicken With Congress

What is the point that Federal Reserve Chairman Ben Bernanke is really trying to get across during during his last appearance before the Joint Economic Committee of Congress?

Regarding policy, in his written submission and oral responses to questions, El-Erian notes that Bernanke appears to be trying to shift the focus from monetary policy to other areas  – particularly fiscal. He commented that he would feel much more comfortable if Congress were to take some of the policy burden off the Fed.

This might mean that Chairman Bernanke is following the example of European Central Bank president  Mario Draghi, who been vocal about the need for politicians in Europe to do their part and deliver on their policy responsibilities.

There is a view in academic and policy circles, also expressed by voices at the Fed that central bank activism is becoming less effective. Bernanke covered this in one of his responses.

 Bernanke Not Quite Assimilated By the Borg

Economist Paul Krugman recently criticized Chairman Bernanke as having been “assimilated by the Borg” (ie. that he had changed the activist stance that he formerly took as an academic.) However, Chairman Bernanke has now confirmed at a hearing of Congress’s Joint Economic Committee  that

“[The Fed] stands ready to do whatever is necessary to protect our financial system,”

We now see a more  nuanced position. Chairman Bernake is telling us that he is indeed willing and able to do more if conditions deteriorate, even if the policy instruments are limited and less effective than in the past. However, rather than risk raising inflation above a targeted level as a result, he would prefer that Congress first do its share to stimulate the economy.

Cliff Hanger

Bernanke warned about the so-called fiscal cliff — a reference to the expiration of middle class tax cuts on Dec. 31 and the imposition of automatic spending reductions on Jan. 1. The U.S. economy could see an unprecedented fiscal hit of as much as $720 billion if the slated changes take effect.

The cliff includes two elements that would adversely affect the economy:

  1. An end to the temporary tax cuts enacted during the George W. Bush administration and to temporary Obama administration payroll tax cut, which is saving the typical worker about $1,000 this year,  could have a negative impact on the economy by adversely impacting the purchasing power of middle class consumers.
  2. Automatic spending cuts on federal programs which were negotiated as part of last summer’s pact to raise the debt ceiling would automatically go into effect if a better budget agreement is not reached, including federal extended unemployment benefits. Austerity measures like these have been disastrous in Europe and would have a devastating impact on the US economy if allowed to go into effect.

If Congress can’t compromise on a new budget, automatic cuts will take effect under the so-called sequester outlined in the Budget Control Act. For defense, for instance, the 10% elimination would shave about $53 billion from the budget, to $472 billion.

Economists at Bank of America in a report summarized the effect that this would have:

“As the cliff approaches, we expect first firms and then households to start postponing decisions, weakening the economy in advance of the cliff. When you are approaching a cliff, in a deep fog of uncertainty, you slow down.”

There is already abundant evidence that this is exactly what some employers are doing.

“You First”

Still, despite the weakening U.S. job market, Chairman Bernanke gave no clear signal that the central bank was about to provide more monetary stimulus to prop up the economy and bring down the unemployment rate, which inched up to 8.2% in May. Instead, he called on lawmakers to do more, “to take some of this burden from us,” reminding them of what happened last year when the debt ceiling debacle took the country to the brink of default.

“The brinkmanship last summer over the debt limit had very significant adverse effects for financial markets and for our economy…. It really knocked down consumer confidence quite noticeably,” Bernanke said. “I urge Congress to come to agreement on that well in advance so as not to push us to the 12th hour.”

A general consensus among economists is that an intractable partisan House of Representatives has stood in the way of the kind of stimulus that has lifted the economy out of such conditions in the past, and that the lessons of the conditions created by austerity measures in Europe have been lost in a cloud of partisan rhetoric and polarization.

The Fed chairman added that, even as Congress tries to avoid squeezing the economy in the short run, lawmakers also need to set credible plans to control budget deficits over the next decade or more.

What More Can the Fed Do?

Quantitative Easing!

Bernanke has now said the Fed would examine at its next policy meeting, scheduled for June 19 and 20, is a new round of “quantitative easing” – bond purchases by the Fed (which is precisely what Paul Krugman called for.)

With short-term interest rates already near zero percent, buying long-term Treasury bonds is a strategy by which the Fed has tried to reduce long-term interest rates and encourage investors to buy other assets such as stocks. Bernanke said past rounds of quantitative easing have worked, partly by buoying the stock market. Still, with long-term Treasury yields already near record lows, Bernanke acknowledged that some financial analysts see “diminishing returns” from such efforts.

What To Do About Europe?

Some questions at the hearing focused on what the Fed could do if events in Europe caused financial-market distress. Bernanke said the “main tool” would be to support banks by standing ready to make emergency loans to solvent banks against collateral they provide, which could help prevent a financial panic from spreading, based on fears that a recession in Europe would ripple through the global banking system and cause a credit freeze-up. He also said the Fed is keeping careful watch on US banks, monitoring their exposure to Europe.

Bernanke said European nations have ample economic resources to resolve concerns about large government debts. The big hurdle, he said, is the political challenge of agreeing on debt-control and growth strategies among 17 disparate nations in the currency union.

A Proper Balance

In other words, Congress needs to keep inflation stable while maximizing employment – growth plus budget relief. So far, political polarization and grandstanding have prevented Congress from establishing such a balanced solution here.

As the Fed’s policy committee prepares to meet, inflation appears fairly tame, but the pace of job creation has cooled. Bernanke said that an earlier spurt of job growth may have reflected “catchup” as employers made up for the outsized layoffs that occurred during the recession. He said that if such a catchup period is now over, then future job gains may be harder to come by unless economic growth speeds up.

In other words, Congress, get your House in order.

Snap! principle of economic stimulus:

You’ve got to grow your way to economic strength, not just cut spending.