US Federal Reserve Chairman Ben Bernanke has now given his Jackson Hole speech. Hints at what the Fed might do next first appeared almost coyly on page 15. “Notwithstanding these positive signs, the economic situation is obviously far from satisfactory."
The Fed Chairman concluded, “Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.” Many market participants thus see increased likelihood of further quantitative easing (or non-traditional monetary measures in Fed jargon) when the Federal Open Market Committee meets on 12–13 September.
This said, the large first part of Ben Bernanke’s speech deserves a closer look; it can be seen as both history and apology of the US monetary policy in the last five years.
Ben Bernanke starts with a counterfactual argument: “If we wouldn’t have done what we did, we would be in a much worse situation.” The problem here is that we will never be able to experience the “other” history, where the measures weren’t taken, to really assess whether Bernanke is right or wrong – unless we are in a Fringe episode.
Fringe is an ongoing, successful and entertaining US TV series, which follows the adventures of a team of FBI agents and an eccentric scientist, confronted with phenomena and crimes occurring at science’s borders. A recurring element in this series is a second parallel universe, like ours but not quite. In some episodes, the heroes can cross from one universe into the other.
If this parallel universe existed, one could imagine a counterpart to the former Fed Chairman Alan Greenspan, Alan Greespanother, who in 1998 and 1999 would not have feared deflation after the Asian crisis and hence would not have inflated a tech bubble. The same Alan Greenspanother would have learned his lesson after the tech bubble burst and hence would not have inflated again, leading to the housing bubble. Let’s assume, though, that until the cracks in the credit market five years ago, history would have been the same in both universes and we'll just focus on Ben Bernanke and Ben Bernalternate.
Possibly both versions of the Fed Chairman would have done the same from 2007 until the end of 2009. The financial markets back then were disrupted and forceful action was needed to provide liquidity and restore confidence.
But QE2 in November 2010 is a borderline case. The Fed justified it to “promote a stronger pace of economic recovery.” Ben Bernanke argues now in retrospect that thanks to this program and the following “Operation Twist,” 10-year Treasury yields are now 80–120 basis points lower. Moreover, “the level of output was raised by almost 3 percent and private payroll employment increased by more than 2 million jobs relative to what otherwise would have occurred.”
In the parallel universe, Ben Bernalternate decided to exit non-traditional monetary policy measures by the end of 2010 – instead of QE2. The yield curve in the other universe was much steeper in the last two years than in ours. At first, according to Fed econometric models (which did not see the financial crisis coming), this led to lower growth. But by now, thanks to higher revenues, parallel financial intermediaries are far more advanced in their balance sheet repair, and hence are eager to lend again. Moreover, the government was disciplined by higher interest rates. With a debt of 15 trillion US dollars, a 120 basis point higher interest rate means 180 billion US dollars more debt servicing per year – a strong incentive to tackle public deficits.
This thought experiment shows that counterfactual history runs both ways, so it shouldn’t be used as an argument. Better to stick to fundamental economic laws.
Fringe’s twisted standards of physics have yet to challenge the impossibility of perpetual motion. The impossibility of creating wealth by printing money should not be challenged either.