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Democracy & Technology Blog Bernanke’s Gaps

Ben Bernanke, President Bush’s nominee to succeed Alan Greenspan as chairman of the Fed, is the John Roberts of monetary policy. He is intelligent, erudite, apolitical, pleasant, and prepared. Credentialed at the best schools and immersed in the theory and practice of monetary policy for the last several decades, Bernanke, says supply-sider Arthur Laffer, is “the right person at the right time.”

It’s true President Bush could have done far worse. But I worry. You see, Bernanke is worried about gaps. He’s worried about trade gaps — he thinks the U.S. trade gap is caused by a global savings glut. And he worries about something called the output gap — a variant of the Phillips Curve, which supposes a trade-off between unemployment and inflation. But the Phillips curve really gets the relationship backward. As economist Mike Darda wrote this week:

I don’t like this model because the empirical linkage between growth and inflation is non-existent, or inverse, while the relationship between unemployment and inflation is significant and positive. The data clearly show that inflation raises unemployment with a lag, precisely the opposite of the original precept of the Phillips curve. Wage pressures and capacity constraints can result from excess liquidity and thus be positively associated with inflation, but on their own they have no power to raise the dollar price level without the accomplice of excess money.
Inflation is a monetary phenomenon, not a cost-push event.

Bernanke was perhaps the first member of the Fed to acknowledge the possibility of deflation in the U.S. when he joined the central bank in 2002. Bernanke had studied the world’s rare deflationary events and gave major speeches on the topic when the U.S. was still reeling from market crash and recession/stagnation. Bernanke gets some credit for grasping the concept and verbalizing it — something no other Fed member, and few other economists, were able or willing to do. But Bernanke was too late. The dollar had already experienced a five-year deflationary event and was even then, in the fall of 2002, already reflating. Deflation wasn’t a remote possibility in the future. It had just happened. The ultra-strong deflationary dollar crashed Asia in 1997-98, then bankrupted Russia, Turkey, and Argentina, and finally made it’s way to the strongest, most flexible, least vulnerable, least commodity-based economy in the world, the U.S. The result was zero profit growth from 1997-2001, a stock crash, a recession, and record corporate defaults, especially in the debt-laden telecom sector. Bernanke himself has written that deflation is hardest on debtors, but bankruptcy across the globe did not seem to tip him off. Chairman Greenspan’s liquidity injection after the 9/11 attacks of 2001 had begun the process of relieving the deflation that had already occurred.

Bernanke was the key force in bringing the Fed Funds rate to 1% and leaving it there for, well, for too long. Today’s inflationary environment, in fact, is a perfect example of the backward looking nature of Bernanke’s favored mechanism of “inflation targeting.” By targeting conventional measures of inflation, like the CPI (consumer price index) or the PCE deflator, one necessarily must look “in the rear view mirror.” Today’s CPI tells you what monetary policy was like 18 months or two years ago. Thus the Fed’s tendency to overshoot on either side. Tighten to squelch inflation. But by the time the CPI is under control, you’ve tightened too much and have caused a recession. Then you loosen to relieve recession, leaving the Funds rate at 1% as long as the CPI looks tame. Meantime, real-time prices of traded commodities have gone through the roof, the dollar has severely weakened, and American politicians are complaining that the dollar-linked Chinese yuan is too weak. Hey, guys, the value of the yuan depends completely on the value of the dollar. Is it Beijing you are worried about, or the Fed?

Which brings us to China. Bernanke’s real test will be China and all international monetary and trade relationships. Greenspan has acquiesced to Sec. John Snow’s calls for a strong yuan and a weak dollar, though the Fed chairman publicly persuaded Sens. Chuck Schumer and Lindsey Graham to pull their China tariff bill. Will Bernanke go a step further and explain the importance of international currency stability? We have no indication that Bernanke looks at the value of the dollar, or at foreign exchange rates, in his inflation targeting model. George Gilder and I met with National Economic Council director Al Hubbard at the White House last week, talking China and currencies, and hold out hope the Administration could make an intellectual breakthrough. But whether Bernanke fills in those gaps — trade, output, intellectual, and otherwise — remains to be seen.

-Bret Swanson

Bret Swanson

Bret Swanson is a Senior Fellow at Seattle's Discovery Institute, where he researches technology and economics and contributes to the Disco-Tech blog. He is currently writing a book on the abundance of the world economy, focusing on the Chinese boom and developing a new concept linking economics and information theory. Swanson writes frequently for the editorial page of The Wall Street Journal on topics ranging from broadband communications to monetary policy.