The Bernanke/Paulson/Geithner/Bush/Obama response to the economic crisis has centered on a massive increase in the Fed balance sheet, large public investment in the financial sector (and select industrial sectors), and a large increase in debt-financed public spending generally. The goal is to avoid a repeat of the Great Depression, with massive deflation, a collapse in economic activity, the failure of much of the banking system, 20% unemployment, and so forth.
One risk this policy runs, as everybody involved understands, is that it won’t work – that nothing will be sufficient to keep the economy going. That wasn’t a strong argument against trying whatever had a chance of working and, moreover, there’s at least some evidence already for proponents to point to that the global economy is no longer falling off a cliff (whether because the policy worked or because some other response would have worked as well or better is something people will be debating for decades).
The more likely risk, again understood by everybody involved, is that it would work reasonably well – the economy would indeed stop falling off a cliff – but that it risked runaway inflation down the road, and, in the worst case, the potential for a collapse in international confidence in the dollar.
That hasn’t happened yet, of course. So far, the markets have reacted in a fairly orderly fashion to the problems being built in for the dollar. The US equity markets bottomed in early March; since then, their recovery has been highly correlated with the decline in the dollar against all major currencies (EUR most prominently, but also JPY, CAD, CHF, even – dramatically – GBP, in spite of the fact that sterling has the same kinds of problems that the dollar does, only worse), and with a rise in yields on the long bond. So long as this process remains orderly, the big trade our government is doing is likely to turn out well: we do know how to cure inflation, and even if we are slow to respond (as I expect we will be – nobody likes to take away the punchbowl) the results are still unlikely to be worse than a global depression. Moreover, if we use fiscal policy wisely in this period of fiscal expansion, we could take the opportunity to lay the foundation for more stable future growth, both by making smart public investments (e.g., in an upgraded electrical grid) and by reorganizing the tax system to encourage more productive investment (e.g., by eliminating the mortgage interest deduction, enacting 1986-style reform of the corporate income tax, replacing the payroll tax with a value-added tax). If we can raise our real growth rate through higher productivity, that gives us far greater flexibility to tackle inflation down the road while still being able to service our growing debt.
But if we get a true dollar crisis, that calculus no longer obtains. If the United States faces a situation at some point in the near future where we cannot finance our debts from abroad in our own currency, we would be forced into the kinds of austerity measures that created deep depressions in multiple emerging markets in the 1990s. To the extent that our current actions are retrospectively blamed for contributing to that crisis, we’ll regret them even more than we regret allowing the housing bubble to develop in the first place.
That housing bubble, remember, was principally a consequence of money being too easy for too long – i.e., Greenspan keeping interest rates too low for years after the economy began to recover in 2003. (I do want to stress: principally, not exclusively; there’s plenty of room for discussion of the other factors. But absent too much liquidity, those other factors couldn’t have caused the bubble; with too much liquidity, you were pretty much guaranteed to get a bubble somewhere.) There were many signs along the way that housing prices were getting crazy, but the Fed was very reluctant to set out to prick an asset bubble, and so its responses were consistently tamer than, in retrospect, we wish they had been.
Are we similarly going to see a dollar crisis developing slowly, and do nothing about it until it is upon us for fear of jeopardizing the gains we’ve already made through monetary and fiscal stimulus? How would we know whether, in fact, that was happening – now, for instance?
So here are my questions for Ben Bernanke as he looks at the possibility of a dollar crisis in the future:
- What signs are you looking for that such a crisis could be developing, if any? – If you don’t have any good forward-looking indicators, how is that shaping your policy response right now and your willingness to expand the Fed’s balance sheet seemingly without end? – If we find ourselves in the midst of a crisis of confidence in the dollar, what are the policy options open to you to respond and attempt to restore confidence? – Wouldn’t it make sense to give the market some indication of the seriousness with which you take the risk to confidence in the dollar by laying out these policy options in advance?