Editor’s Note: Unlike most central banks, the Federal Reserve has not one job, but two. It has a dual mandate to maintain stable prices and maximum employment. As New York Times columnist Paul Krugman told Paul Solman on Making Sen$e, the Fed’s not fulfilling either.
Balancing those two jobs “is harder than you’ll ever know,” Nashville money manager Jon Shayne (aka Merle Hazard) croons in his latest central bank ballad titled, appropriately enough, “Dual Mandate.”
But that dual mandate is not what’s giving the Fed trouble at the moment, says Krugman, who believes the Fed isn’t doing enough to maximize employment. He disagrees with the Fed’s decision to end their bond buying program, and he scoffs at conservatives’ cries about easy money leading to inflation.
The labor market is far from healthy, while inflation, Krugman argues, is nowhere close to getting out of hand; it’s comfortably below the Fed’s 2 percent target. And if it did start to rise, Krugman insists our central bank has the tools, and the will, to tamper it.
That’s not how Columbia University professor Charles Calomiris sees it. Watch that disagreement between Calomiris and Krugman play out in Paul’s broadcast segment, below, and read the conservative’s perspective on Making Sen$e.
Now, we return to Krugman, who argues deflation should actually be a much bigger concern for the Fed than inflation.
— Simone Pathe, Making Sen$e Editor
Why Deflation Is a Bigger Problem
Paul Krugman: Right now, the clear and present danger of a low inflation, maybe even deflation, trap seems a lot stronger than the risk of possibly overshooting on inflation for awhile.
Paul Solman: What’s wrong with deflation? I mean gas prices are now going down. That’s a good thing for consumers of gas.
Paul Krugman: But if the price of everything is going down, that’s going to include wages as well. People will have an incentive to sit on their cash and not spend it.
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Paul Solman: Because they think the cash is going to be worth more in the future?
Paul Krugman: Right. In Japan, for a couple of decades now, leaving your money under the mattress has been a very good investment compared with other stuff. It means that if people have debts, those debts are going to actually grow in terms of their real value, so whatever problems you have from debt are going to get worse. That’s going to deepen the downdraft on the economy.
Paul Solman: People won’t spend because their debts will be higher?
Paul Krugman: Right. And creditors will be richer, while debtors are in more trouble. So, it’s actually worsening the situation of the worst-off people, which in turn, is a bad thing for the economy.
Actually cutting the dollar amount is very, very hard. Always has been, always will be. It’s just not something that happens without extreme unemployment, so you’re creating a situation in which lots of people are supposed to have to take large wage cuts, and that’s very disruptive.
On multiple fronts, deflation is a really bad thing. You really don’t want to go there. And it’s very hard to get out of once it starts because you print money, and the money just sits there. So if at all possible, you want to steer well clear of deflation, which is why you should have some positive inflation in normal times.
Paul Solman: And that’s what the Fed’s doing wrong — not reacting sufficiently to the threat of deflation?
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Paul Krugman: They got behind the curve. They allowed it to slide to a point where we now have inflation that’s persistently below their own 2 percent target, which a lot of us now think was too low anyway.
Sometime in the 1990s, 2 percent became the safe conventional thing to target all around the world. But that was probably a mistake. Three would have been better.
People who are complaining about the Fed are people who’ve been predicting runaway inflation for five and six years, and it hasn’t happened.
Nobody wants to bring back 1979, 1980. Ten percent inflation is not a good thing. [But] we’re nowhere close to that. And right now, inflation is low, and jobs are still scarce. I keep seeing people searching for reasons why the Fed should pull back; searching for reasons why interest rates must go up. They’re inventing new theories on the fly, [with] this kind of visceral sense that easy money is a bad thing. Even if it is, lack of jobs is a worse thing, and that’s what we should be worrying about.
What About Bubbles, Though?
Paul Solman: We aren’t seeing inflation as it’s officially measured, but we’re seeing all this money go into various classes of investment, and so you had this huge run-up in the stock market — and in virtually everything else you can name, commodities, housing. Isn’t the Fed’s easy money policy actually expressing itself in these asset bubbles?
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Paul Krugman: Two things. We don’t know that. Asset bubbles have happened even without not-so-easy money. And, in a depressed economy, where alternative uses of money are not great, people are going to bid up the prices of profitable corporations and stuff like that. So it’s not clear.
And second, what is the alternative? Are you really saying you’re willing to pay a price in terms of high unemployment in order to prevent irrational exuberance in the stock market? Is that a sensible thing? It’s a funny thing, by the way, how people who love free markets are also quite sure that they know that investors are being irrational, right?
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We actually have an experiment in Sweden. They bought fully into the notion that easy money is making people careless, so let’s raise interest rates. But actually, those asset bubbles have not gone away, and Sweden is now experiencing actual deflation. So they managed to get the worst of both worlds. It’s a cautionary tale for the people who are saying, “Raise rates now, even though the economy is still depressed.”
Paul Solman: But in Sweden itself, the economy is not depressed?
Paul Krugman: It’s getting there. They had several really good years. They weathered the economic crisis really well. Then they said we’re worried about asset bubbles, and they raised interest rates, even though they were not fully recovered. And now, they’re starting to turn into the sick man of the north, which is quite an amazing achievement.
Couldn’t Inflation Get Worse Quickly In the Future?
Paul Solman: Sure there isn’t inflation now of any note, and hasn’t been for quite a few years. But the argument has always been once inflation takes off, then it’s impossible to rein it back in, and one of your professors, Franco Modigliani, once told me told me, that’s something you absolutely have to worry about.
Paul Krugman: Yeah, except he said that quite a long time ago. In recent history, meaning the past 25 years or more, there’s one thing that the Fed has been really good at cracking down on, and that’s inflation. When the Fed decides that inflation is too high, they have the tools, and they’ve shown historically that they have the will, to bring it down. And, it might be painful. But, so is what we’re going through now.
So the argument that says that once inflation starts, the Fed will be incapable, either technically or maybe politically, to bring it back under control, flies in the face both of what we know about how money works, and in the face of history.
Inflation has been amazingly under control, not just here, but through almost all of the world. You really have to go searching desperately to find any contemporary examples of good, old-fashioned runaway inflation.
Paul Solman: Zimbabwe?
Paul Krugman: Well, Zimbabwe’s already starting to recede into the past. You know, I’ve been in monetary debates, and one of my principles is that the first person to bring up Zimbabwe has lost the argument. Is that where you have to go? Come on.
Quantitative Easing Should Have Continued
Paul Solman: So what should the Fed be doing? Interest rates are at zero because the Fed has been buying up bonds and driving down the yield, the amount of interest that the government has to pay to borrow money.
Krugman: First, only short-term U.S. government bonds are at a zero interest rate. Long-term U.S. government bonds, private debt or quasi-private debt, Fannie – mortgage-backed stuff, is not at a zero interest rate. So what the Fed can do is buy those [bonds] and attempt to drive down other interest rates. That’s what quantitative easing is all about.
I understand why they wanted to stop [quantitative easing]. There are questions about how effective it is. How big do you want the Fed’s balance sheet to get? How much stuff do you want the Fed to own? But I think stopping it is a mistake. The fact of the matter is, the economy still looks problematic. Inflation is falling, not rising. It’s not a good time to lay off.
The Fed can also try to work, as we say, “open mouth operations.” Open mouth is when they promise to do stuff. They say, “We will keep this going, we will not raise interest rates until the inflation read is above our previous target.” They can try to move people’s expectation about what will happen. The expectation of the markets still is that sometime next year, the Fed will be starting to operate as it does normally. I don’t think so, and actually, I hope not.
Paul Solman: And “operating normally,” in this case, would be actually allowing rates to rise, and that would be by not buying government securities; they would actually be selling them.
Paul Krugman: That’s right. Eventually they need to sell off those government securities. There’s no hurry because they have other ways they can pull back. They would start doing things like raising the interest rates they pay on reserves right now. They can sell off those government securities, not too fast, but run it down.
There will come a time when the Fed is no longer owning all of this stuff. But, in all of these things, I end up quoting Saint Augustine, you know, “Oh Lord, make me chaste and continent, but not yet.” And I still think we’re very much in the “not yet” phase.
Paul Solman: So there’s nothing to worry about in the fact that the Fed had less than a trillion dollars worth of money it had created before quantitative easing and now it’s over $4 trillion?
Paul Krugman: Well, you know, against stupidity the Gods themselves contend in vain. If we had a complete crazy person in charge of the Fed, things could go bad whatever the circumstances. The question is, do they actually have the tools to avoid a takeoff of inflation, despite those $4 trillion in assets? The answer is yes, they do.
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Paul Solman: And by raising the interest on excess reserves they’re actually paying banks to redeposit the money at the Fed as opposed to lending it out into the world and starting inflation.
Paul Krugman: That’s right. The Fed basically now, on the one hand, they have assets; in the other hand, they have liabilities, which are these reserves that banks hold with them. They can pay more on the liabilities, which has the same effect as selling off some of the assets.
They have, if they want to turn the screws on the economy, multiple ways to do that. I’m sure that if and when we actually have an inflationary threat, they’ll do whatever it takes.