What To Do About the Fed Toolkit?

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Historians of the 1913 Federal Reserve Act should find out who was most responsible for Section 13(3), giving the central bank authority to lend broadly in “unusual and exigent circumstances”. The person is a hero. 13(3) provided the legal basis for the Fed’s successful effort to halt and reverse the 2008-09 collapse in total nominal spending. The unsung prescience played an essential role in preventing a 21st-century depression, the cost of which would have made the 1930’s collapse look like a walk in the park.

The central lesson implicit in Ben Bernanke’s virtuoso management of the 2008-09 crisis is obvious, important, and remains difficult for legislators, media, and the public to grasp. The central bank’s stabilization toolkit must be made as potent as possible. Most critically, tools enabling effective intervention in total spending must be readily available if and when the Fed again confronts the devastating broad market failure associated with nonstationary demand contractions. (Chapter 10) Further strengthening the argument, the GEM Project has identified investor/lender confidence in the credibility of the Fed’s toolkit to itself be a powerful bulwark against extreme instability. (Chapter 6)

Wrong-headed approach. It is deeply disturbing that Congressional action in the aftermath of the Great Recession has sought to restrict, not enhance, the power of the Fed to effectively intervene in total spending. A frequently heard reason for that push is that 2008-09 demonstrated the Fed to have too much power. That assessment is partly rooted in the curious notion that the outcome of the crisis, i.e., no depression occurred, shows that central-bank intervention was unnecessarily excessive. The urge to restrict the Fed is also rooted in the substantial public perception that big banks’ greed caused the Great Recession and that the purpose of the Fed’s intervention was to line the pockets of the bankers. Congress knows that punishing banks and their friends at the central bank garners votes. MoveOn.org captured the country’s post-crisis mood: “Fed Chair Ben Bernanke spent trillions to bail-out Wall Street, but he’s turning a blind eye to regular Americans.” It is embarrassing that mainstream macroeconomists have so little to say about the validity of those stubbornly held perceptions about Bernanke’s performance.

On-going efforts to truncate the capacity of the Fed to intervene in total spending should greatly concern macroeconomists. It is shocking that there is not more economic analysis and vocal communication about it. I believe the inattention of leading theorists has two interrelated causes. First, they know that, if the profession is to speak with one voice on the crucial Fed-powers issue, macroeconomists must first agree on a stabilization model that supports their conclusions. Second, they know that the coherent market-centric consensus DSGE theory falls well short of being stabilization relevant. How can mainstream macroeconomists credibly comment on limiting Fed authority to intervene in total spending when what they teach graduate students cannot coherently accommodate a causal link from demand disturbances to recognizable changes in employment and output? There is general reluctance to draw attention to the nonexistence, in modern consensus thinking, of involuntary job loss. In discussion with legislators, framing the debate about Fed authority to stabilize the economy with what is taught in our best graduate schools would be met, justifiably, with incredulity and scorn.

Being useless with respect to the most important macro issues was not always the case. When Early Keynesians dominated consensus thinking, they were a powerful force in shaping what was reasonable in public-policy debates. The media, Congress, and Administrations paid attention to what the leaders of the profession, from Samuelson to Friedman, had to say. If they had remained dominant, the Early Keynesians would have approved of the Fed performance in the Great Recession, aggressively and convincingly explaining their support. The post-crisis debate would have played out much more sensibly.

What should be done? The GEM project demonstrates that effective policy reform would focus on making stabilization authorities’ toolkits more formidable. (Chapter 10) In particular, modern monetary intervention into total spending must be explicitly authorized to go beyond Walter Bagehot’s liquidity lending, which generalized-exchange modeling has shown to be overwhelmed by the acute-instability macrodynamics of the Great Recession. Counter-cyclical bank regulatory policies, including variable required capital, should also be reaffirmed as should the capacity to cooperate with central banks in other nations. In circumstances of adverse nonstationary demand disturbances, the Fed should be able to use its balance sheet to recapitalize financial and relevant nonfinancial institutions as well as to guarantee assets/credit of relevant institutions. Emergency measures should also include well-designed Fed purchases on asset markets, including equities. The central bank should be authorized, if push comes to shove, to finance well-designed public dividends, perhaps along the lines of a special tax cut.

None of the expanded-powers ideas is new. Milton Friedman suggested a “helicopter drop” of cash as an inherent stabilization power of the monetary authority. Stanley Fischer (2013, p.2), the respected macro theorist and now Vice Chair of the Fed, recently recalled some ambitious toolkit advice from a great economist: “James Tobin in 1963 asked in which assets the central bank should conduct open market operations. His answer was the market for capital – namely, the stock market – since that way it could have the most direct effect on the cost of capital, later known as Tobin’s q, which he saw as the main price through which the central bank could affect economic activity.” The GEM Project provides the coherent macroeconomics that broadly microfounds the expansion of the Fed’s toolkit and the increased stabilization credibility that would result. Nonstationary demand disturbances, the causal force in extreme instability, cannot coexist with robust credibility of the trend real-side objective of the Federal Reserve.

Blog Type: Policy/Topical Saint Joseph, Michigan

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