Politics & Policy

Bernanke’S Output Gaps

The Fed nominee might be Greenspan II -- but we could have done better.

President Bush has ended the suspense over who will replace Alan Greenspan with the nomination of CEA chairman Ben Bernanke. Those who were hoping for a reliable advocate of Bush’s broad economic policies of lower taxes and free trade should be mostly pleased.

Mostly is the appropriate modifier here because Bernanke does not appear to be a supply-sider. In a 2003 speech he made it clear that in his own economic model, “the consumer plays a central role as always.” In a July Wall Street Journal editorial, Bernanke expanded on this view when he noted that the “fiscal stimulus” from the 2003 tax cuts had “diminished in the past few quarters.” Conversely, the classical or supply-side view is that tax cuts continuously stimulate as they make productive work effort cost less. Still, in his speeches since becoming Fed governor, Bernanke has spoken positively about the affects of tax cuts — albeit from the demand side.

Of course, the job of Federal Reserve chairman is not to legislate tax policy. Management of the dollar is the chairman’s job, and that’s where Bernanke’s record suggests that he may fall short.

First of all, no one should expect Bernanke to lead the charge of redefining the dollar in terms of gold. The authors of a June 2005 New York Times article referenced a 2004 speech in which Bernanke spoke of a “gold standard orthodoxy” which led to “disastrous consequences” for the economy.

As for inflation, while defenders of this nominee laud his belief in inflation targets, such talk becomes irrelevant when you consider that Bernanke’s definition of inflation is rooted in output-gap theory. And to prove that Bernanke’s output-gap inflation theories are long-held, as opposed to being one-time slips-of-the-tongue, various speeches and editorials over the years make clear that in his model, neither inflation nor deflation are monetary events.

In a 2002 speech, as the 1997-2001 monetary deflation began to ease, Bernanke spoke of deflation in the future tense, saying, “I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small.” Clarifying what he deemed deflation in the same speech, Bernanke said, “Deflation is in almost all cases a side effect of a collapse of aggregate demand.”

In a 2003 talk, Bernanke spoke about the possibility of future inflation; specifically “the effective slack in the economy may be less than we now think, and inflationary pressures may emerge more quickly than we currently expect.” In another 2003 speech he downplayed inflation risks because the “amount of slack should lead to additional disinflation.” Moving to 2005, Bernanke wrote about employment in a Wall Street Journal op-ed, asserting that there is a “highest level of employment that can be sustained without creating inflationary pressure.”

These views on the nature of inflation should not be minimized during Bernanke’s confirmation process. This is the same output-gap theory that drove monetary policy in the late 1990s when Alan Greenspan stated that GDP could rise “in excess of trends of potential,” and that the economy would “eventually overheat, with inflation and interest rates moving up.” What followed was tragic. Instead of creating more money for a growing economy that required it, Greenspan tightened and a deflationary recession soon followed. The reverse of course occurred in the 1970s when the Fed loosened too much in an effort to expand a weak economy.

Returning to taxes, Bernanke’s supply-side-like commentary should be seen in light of how he defines inflation. Indeed, if inflation is in fact a demand phenomenon (supply-siders, of course, know it to be a monetary event), who’s to say where he’ll stand on tax cuts if they’re introduced when the economy is booming?

Stock markets rallied on Monday on the news of Bernanke’s nomination, and the consensus view was that the rally was a cheer from Wall Street. Perhaps it was. But an alternative theory could be that it was a relief rally — relief that Donald Kohn wasn’t the nominee. News accounts last week said Kohn, a Fed board member, was Greenspan’s choice, and as the Maestro’s views carry a lot of weight, the soft markets last week might have been discounting Kohn’s potential nomination.

In a recent Washington Times op-ed, Cato Institute senior fellow Alan Reynolds caustically referred to central banking as “the last refuge of central planning.” Kohn seems to embody the Reynolds quip. In a 2003 interview, Kohn lauded Fed rate cuts for keeping the equity markets “from falling quite as much as they might have.” He added that monetary policy had to “bolster household demand to make up for a lack of business demand.”

Additionally, Kohn shares the Bernanke thesis that too much growth is inflationary. Despite the myriad ways in which economic factors innovate around perceived labor and product shortages, Kohn noted in a speech this month that inflation “will still rise if central banks allow economies to run ‘too hot.’”

For those who were eager to see the Fed return to a price-rule definition of inflation, President Bush had a potential alternative nominee in Manuel H. Johnson. Johnson served as Fed vice chairman during some of Greenspan’s best years, and he has written a 293-page book on a transparent, market-oriented approach to currency titled, Monetary Policy, A Market Price Approach. Johnson’s model draws on the research of Swedish economist Knut Wicksell and the successful application of Wicksell’s monetary model at the Swedish (Riksbank) central bank in the 1930s.

Johnson’s model uses the value of the home currency against foreign monies, along with commodities and the yield curve, as a way to gauge and maintain currency stability. Unlike Alan Greenspan’s often-inscrutable commentary, Johnson’s approach, or one similar to his, could have been more easily read and analyzed by the markets.

The Fed ultimately exists at the service of the very people who toil to create the wealth in this country. That the Fed presently operates in relative secrecy in a way that affects American wealth is wrong, and is something that should be corrected. The nomination of a Fed chairman who would have enacted a price-rule approach would have been a huge step in a very transparent direction, and would have corrected a peculiar aspect of Fed policy today that says the management of the dollar should be done in secret, and with no clear policy in place.

Bernanke could very well follow sure-footedly in Greenspan’s steps, which isn’t a bad prospect at all. But just as we’re guessing now about Bernanke’s monetary bent, we’re sure to be guessing long after he assumes the chairmanship in February.

John Tamny is a writer in Washington, D.C. He can be contacted at jtamny@yahoo.com.


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