Hard Money
In trying to prevent inflation and deflation, Ben Bernanke treads a perilous path.


Ramesh Ponnuru

The U.S. economy is at risk of falling into either an inflationary or a deflationary spiral, which is a consequence of the Federal Reserve’s having been either too loose or too tight. The only point of consensus among economists and financial journalists seems to be that Fed policy is dangerously wrong.

Federal Reserve chairman Ben Bernanke has been on both sides of the debate within the last few months. In late August he said that “falling into deflation is not a significant risk for the United States at this time.” In mid-October he said that “the risk of deflation is higher than desirable.” The Fed is expected to engage in another round of “quantitative easing”: creating money and using it to buy assets from banks. The banks will then use their increased reserves to lend more, thus stimulating the economy and easing deflationary pressures. That’s Bernanke’s plan, anyway. Executing it — and then beating a retreat before inflation begins, as the Fed also promises to do — will require the technocrat to exercise a kind of statesmanship.

Bernanke’s shift probably reflects a change in economic indicators, but may also be a response to pressures from inside and outside the Fed. Several members of the Fed board believe that the economy needs easier money. Charles Evans, head of the Chicago Fed, believes that the inflation rate should average 2 percent per year over time. Since we have undershot that mark recently, we should have a higher inflation rate for a while to catch up. William Dudley, Tim Geithner’s successor at the New York Fed, says that “very low interest rates can help smooth the adjustment process by supporting asset valuations, including making housing more affordable and by allowing some borrowers to reduce debt interest payments.”

Many academic and journalistic commentators agree. Columbia University economist Michael Woodford backs Evans’s contention. Paul Krugman is looking for stimulus anywhere he can get it. Martin Wolf, an influential columnist at the Financial Times, is worried about deflation.

Debates over monetary policy typically have a left-right dimension. Conservatives have traditionally worried that an excessively loose Fed policy would generate inflation, while liberals have been more concerned that overly tight policy would increase unemployment. (Congress has given the Fed the dual mandate of pursuing price stability and fighting unemployment.) That pattern is evident in this debate as well. The Wall Street Journal’s editorial page is regularly running commentary critical of the Fed for debasing the dollar, and Fox News is running plenty of ads encouraging people to buy gold as a hedge against inflation.

But some analysts are playing against type. John Makin, an economist at the conservative American Enterprise Institute, is worried about deflation. Greg Mankiw, who chaired President Bush’s Council of Economic Advisers, has called for “significant” inflation so as to create negative real interest rates and thus spur borrowing. But Joseph Stiglitz, a Nobel Prize–winning economist who has been a favorite of the Left over the last decade, joins with supply-sider Lawrence Kudlow in thinking that the chief effect of quantitative easing will be to cause “chaos” (Stiglitz’s word) in foreign-exchange markets.

Different people make different arguments for a looser monetary policy. For some of them, fear of deflation is the primary concern. The Treasury sells five-year bonds both with and without inflation protections. Comparing their yields results in one measure of the market’s expectations of inflation over the period. Those expectations have been low and dropping for most of the year, although they have started to bounce back now that quantitative easing is under discussion.

Fear of deflation is rooted in the experience of the early years of the Great Depression, when the money supply cratered. A falling price level increases the burden of debt and discourages spending (since a dollar will buy more tomorrow than it does today). Thus it can make recovery difficult, or even impossible. Bernanke is a student of the Depression and agrees with the late Milton Friedman that the Fed’s excessive tightness caused it. He has vowed that the Fed will not make the same mistake again, even if it means printing money and tossing it out of helicopters.