What Lies Ahead

In an article in the Washington Post, Simon Johnson and James Kwak express fears about what the Federal Reserve is doing to "fix" the economic crisis. What they foresee is pretty scary:

Bernanke initially maintained Greenspan's hands-off approach to the emerging housing bubble. As the financial crisis deepened in late 2007 and early 2008, however, the Fed began expanding its lending efforts to financial institutions that couldn't raise money in private markets. This was Bernanke's first departure from the Greenspan school, in which tweaking interest rates was the instrument that mattered.

Then, in 2008, Bernanke became sucked into the firestorms that threatened to engulf the financial sector: Bear Stearns, AIG, the money markets and Citigroup, among others. In these interventions, the Fed brought the money. It extended loans to newly created entities and accepted dodgy collateral in return; lent money directly to non-financial institutions; or guaranteed the value of toxic assets -- a series of reactive, chaotic and non-transparent transactions that seem to have enriched Wall Street and have attracted congressional concern.

The theory at the time was that the financial sector was facing a liquidity crisis, with banks unable to raise enough money to pay off their short-term debts. In response, the Fed would provide enough cash for banks to "deleverage in a more orderly manner," as Bernanke explained last August. By late 2008, the Fed was providing $1.5 trillion of liquidity to the economy through these programs -- an amount roughly equal to half of the 2008 federal budget -- prompting John Cassidy of the New Yorker, in a perceptive essay, to note that Bernanke had begun to "intervene on Wall Street in ways never before contemplated by the Fed."

Since late last year, however, Bernanke has signaled that even these efforts are not enough. In a January speech, Bernanke acknowledged the limits of liquidity and outlined a broader strategy in which the Fed would do everything in its power to increase credit. ...

...Bernanke is making the biggest bet placed by a U.S. central banker in decades, wagering that he can pull the economy out of a deep crisis by creating money without unleashing high and long-lasting inflation. In a speech Friday, Bernanke admitted that his efforts are "rather unconventional programs for a central bank to undertake," but added that they are "justified by the extraordinary circumstances in which we find ourselves."

Will it work? In a normal advanced economy, creating hundreds of billions of dollars in new money would not foster runaway inflation. As long as the economy is underperforming -- for example, with high unemployment -- stimulating the economy will only cause that "slack" to be taken up, the theory goes. Only when unemployment is low again can workers demand higher wages, forcing companies to raise prices.

But is the United States really a normal advanced economy anymore? We seem to have taken on some features of so-called emerging markets, including a bloated (and contracting) financial sector, overly indebted consumers, and firms that are trying hard to save cash by investing less. In emerging markets there is no meaningful idea of "slack;" there can be high inflation even when the economy is contracting or when growth is considerably lower than in the recent past.