Helicopter Ben Confronts the Challenge of a Lifetime

Desmond Lachman responds to Martin Wolf's December 17, 2008 post on FT.com.

Resident Fellow
Desmond Lachman
Martin Wolf is certainly right in asserting that the ruthless use of the Federal Reserve's printing press will succeed in eliminating deflation.

However, posing the issue in this way overlooks the fact that the Federal Reserve's legal mandate requires not simply that the Federal Reserve avoid deflation but rather that it seek to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

By aggressively resorting to the printing press to finance large budget deficits and by indiscriminately lending to the private sector, the Federal Reserve risks compromising the country's longer-term economic growth and employment prospects as well as the prospects for moderate long-term interest rates.

A major impediment to any economic recovery right now is not that official interest rates are too low but rather that the money multiplier has collapsed.

As Martin notes, it does so in part through heightening the risk of a burst in inflation once an economic recovery gets underway. However, it also does so by facilitating the crowding out of future investment, by undermining the efficient functioning of the capital market, and by increasing the risk of a dollar crisis.

A major impediment to any economic recovery right now is not that official interest rates are too low but rather that the money multiplier has collapsed due to the very deep problems in the US financial system.

Despite the literally hundreds of billions of dollars in liquidity injections by the Federal Reserve, and despite the disbursement of around US$300 billion under the TARP program, the US financial system today is practically as dysfunctional as it has been at any time over the past 18 months. The banks are not lending, the securitisation process has all but dried up, and the interest rate spreads over US Treasuries that even the best rated of corporations are paying have widened to highly onerous levels.

One has to hope that amongst the very first priorities of the new US Administration will be a radical rethinking of the TARP program in an effort to restore the US financial system to a semblance of normality. For in the absence of a normally functioning financial system that makes credit more readily available, efforts to revive the economy through fiscal stimulus and unorthodox monetary policy measures will prove to be short-lived and will not be without serious longer-run costs.

In rethinking the TARP, the new administration would do well to take a close look at the successful Swedish bank support program of the early 1990s, which quickly restored the Swedish banking system to normality. In contrast to the Japanese approach, that program made the vital distinction between solvent and insolvent financial institutions. It also used a "good bank"/ "bad bank" approach to rehabilitate insolvent institutions so that they could quickly resume lending.

One also has to hope that Mr. Bernanke supplements the historic steps that the FOMC took earlier this week by adopting two further measures to leave little doubt that the FOMC is serious about combating deflation.

The first measure, which Mr. Bernanke himself proposed in his famous 2003 helicopter speech, would be for the FOMC to provide the public with a quantitative working definition of price stability. That definition might be in the form of a range with the lower bound of that range a safe distance from zero. The main purpose of such quantification would be to provide the public and the markets with some guidance as they try to forecast FOMC behaviour.

The second measure might be for the Federal Reserve to purchase government inflation linked bonds (TIPS) as the clearest of indications that the Fed truly believed that it would avoid deflation. At present, on looking at the upward sloping oil price futures curve, one finds that 5-year TIPS are implying that core inflation will be a negative 5 percent over the next five years. This would seem to offer the US taxpayer a good bet if the Federal Reserve is indeed to prove successful in its task of defeating deflation.

Desmond Lachman is a resident fellow at AEI.

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