By Gal Noir*

In his Congressional testimony on October 4th, Federal Reserve Chairman Bernanke uncharacteristically praised the benefits of fiscal policy, calling it “of critical importance” and conveying concerns with the looming deficit reductions. He cautioned: “an important objective is to avoid fiscal actions that could impede the ongoing economic recovery.”

Many economists expressed worry that such advocacy of fiscal policy will erode America’s (already) wavering confidence in the Fed and will further weaken their support for austerity measures. More troubling still, the economists said, was the possibility that the public may follow suit and start demanding from Congress bolder government action on the jobs front.

A few dissenting scholars thought that it was high time for Bernanke to put his money where his mouth was, so to speak. Among them was Dr. Tcherneva, who had studied Bernanke’s academic proposals for government action during crises and his actual policy moves as Fed Chairman during the Great Recession (2011).**   “I am not at all surprised that Chairman Bernanke is making the case for fiscal policy” Tcherneva said. “I am only astonished that it took him so long. After studying his policy prescriptions for the case of Japan, I am left with the nagging conclusion that Bernanke actually favors fiscal policy over monetary policy. And while the reasons for this position are tucked away in his 2000 paper,***  they were nowhere to be found in his testimony before Congress. This too was very surprising. Considering his scholarship, I was expecting a very different speech today” Tcherneva said.

And indeed Tcherneva may have been right. In a breaking development, housekeeping personnel at the Federal Reserve Board building in D.C. have found a crumpled draft of what appears to be the original speech Chairman Bernanke had intended to deliver. In an exclusive, we reprint the original draft below. Paragraphs in bold are the only ones that made it into the final version.

Chairman Ben S. Bernanke
Economic Outlook and Recent Monetary Policy Actions
Before the Joint Economic Committee, U.S. Congress, Washington, D.C.
October 4, 2011

DRAFT VERSION

“Chairman Casey, Vice Chairman Brady, and other members of the Committee, I appreciate this opportunity to discuss the economic outlook and recent monetary policy actions.

Twelve years ago, I published a detailed recipe for stabilization policy during severe recessions. I watched the economic difficulties Japan faced all through the 90s and concluded that it suffered from a case of self-induced paralysis due to policy inaction (Bernanke 2000). Ladies and gentlemen, I fear that the United States may be facing a similar problem today. I for one have tried aggressively to employ various traditional and non-traditional levers of monetary policy, but as I have explained in my 2000 paper, central banks cannot bring recoveries alone. They need their fiscal arm.

Based on the case of Japan, I had concluded that the central bank should take the following steps:

1. Commit to an inflation target and a long-term low interest rate environment;
2. Depreciate the currency through open market purchases of foreign currency;
3. Engage in non-traditional OMOs – including purchases of long term government securities and other private sector liabilities such as non-performing loans, commercial paper, corporate bonds, asset-backed securities and other;
4. Last but not least, finance various fiscal transfers (e.g., tax cuts) to boost consumption demand

I admit that I did not entirely follow my own recipe. I did commit to a low-interest rate environment for the foreseeable future, but have opted not to state a specific inflation target. Experience has taught me that it is notoriously difficult to hit an inflation target (especially in a deflationary environment) and I cannot risk the Fed’s credibility further by promising something I cannot deliver. The Fed also did not engage in open market purchases of foreign currency. Although this is a function normally performed by central banks, it is technically a fiscal function because the legal authority over the exchange rate rests with the Treasury (see Bernanke, 2000, p. 161 and Tcherneva 2011, p. 416). I am confident that had the Fed recommended to the Treasury this course of action, the Treasury would have agreed. However, we did not wish to set off a currency war and engage in competitive devaluations. It is bad business and it infuriates our trading partners.

I have, however, employed all sorts of non-traditional Open Market Operations. Yes, I realize that many of them have been controversial, and that their legality has been questioned. But my objective has been to bring short, medium, and long terms rates down by purchasing government securities of various maturities. This is how we accomplished policy prescription #1 above. Through TARP and various other programs, we also purchased $trillions of ‘toxic’ private sector financial assets. I must admit that these (latter) non-traditional OMOs are not technically monetary policy either, even though everyone calls them that. I personally call them ‘monetary policy actions with fiscal components’ (Bernanke 2000), but they are essentially fiscal policies.

For the Fed to execute such purchases, it needs an act of Congress (e.g., TARP I and TARP II) or some other authorization, such as Section 14(b) of the Federal Reserve Act, which many believe I had abused, but that’s a topic for another day. In essence, Congress has to charge the Fed with buying the non-performing private assets. Normally, the public associates fiscal policy with various purchases by Congress (bombs, roads, healthcare), but we at the Fed clear all government payments, whatever they may be. When the Fed purchases some private sector asset (MBS, CDOs, CDSs) on behalf of the government, it is the same thing—it’s is still fiscal policy.

The reason why I favor fiscal policy is that it enables monetary policy through its ‘fiscal components’. The Fed can ‘stimulate’ the economy primarily because of its fiscal arm.

The objective is to generate growth through a wealth effect, which occurs when we increase the holdings of net financial assets (nfa) in the hands of the private sector and, unfortunately, the Fed cannot do this alone. As I have clearly stated before, central banks cannot rain money unilaterally on the population (Bernanke 2000, p. 163). This can be accomplished only in coordination with a country’s fiscal authority. (No wonder everyone is calling for a Fiscal Union for the Euro Zone—after all, that is a perfect example how central banks cannot do much stabilization without fiscal policy).

Creating a wealth effect and boosting private sector holdings of nfa happens only when monetary policy finances its various fiscal components. Buying foreign currency, as I have explained above, has fiscal components but I will skip this discussion since we didn’t use this course of action (you can find a detailed discussion in Tcherneva 2011).

Buying Treasury securities of any maturity does not increase private sector nfa, because these types of OMOs only swap one government liability for another (reserves for Treasuries and vice versa). Buying toxic private financial assets however does, and is best thought of as fiscal policy.

As I wrote in my paper:

“By a fiscal component I mean some implicit subsidy, such as would arise, for example if the BOJ [or any Central Bank] purchased non-performing bank loans at face value (this is of course equivalent to a fiscal bailout of the banks, financed by the Central Bank). This sort of money-financed “gift” to the private sector would expand aggregate demand for the same reason any money-financed transfer does …” (Bernanke 2000, p. 164)

Yes ‘subsidies’, ‘gifts’, whatever you wish to call them, they are net new additions to private sector financial wealth. I will leave aside the question of whether money drops (or ‘gifts’) to the banking sector boost aggregate demand. After years of stuffing bank balance sheets with reserves through QE1, QE2, and purchases of non-performing private financial assets, without seeing any meaningful growth, I have serious doubts about the transmission mechanism from bank reserves to investment. More importantly, in my 2000 paper I clearly stated that policy action #3 (non-traditional OMOs) is not even necessary, when we have policy action #4 at our disposal (money financed fiscal transfers) (p. 164). But for that we also need Congressional action.

Indeed, I wasn’t very fond of nontraditional OMOs in the first place, but since fiscal policy no longer adds any stimulus to the economy, I am doing the best I can with the limited tools I have.

Here is why I wish I didn’t have to engage in such aggressive nontraditional OMOs. As I said in my 2000 paper:

“Nonstandard open market operations with a fiscal component, even if legal, would be correctly viewed as an end run around the authority of the legislature, and so are better left in the realm of theoretical curiosities” (Bernanke 2000, p. 164)

I wish I could still call them a ‘theoretical curiosity’! But I stress again, Congress left me no choice but to exercise them, given its own refusal to put in place bold stimulus policies.

Indeed, I find fiscal policy to be more expedient, because such ‘gifts’ to the private sector are better provided through swift votes in Congress on subsidies, tax cuts, and other programs (I made the case for Congressional action in Japan in Bernanke 2000 on p. 164). Again I will leave aside the debate about how effective investment subsidies and tax cuts are, but the point I am making is that fiscal policy is crucial and preferable for several reasons.

1. First, the impact of non-traditional OMOs may take a long time to kick in. I had argued earlier that as long as the Fed buys real or financial assets, at some point the imperfect substitutability of assets will ensure that the prices of assets purchased would rise (Bernanke, 2000, p 164). We have only bought financial assets so far, but at least we managed to stabilize their prices, which makes me think that maybe we should start buying real assets like labor, for example, to support wages and incomes. That would mean that we will start hiring the unemployed, but that too would require a fiscal component—an act of Congress. Plus it is better for Congress to do this, given its experience with such programs.
2. Second, I prefer fiscal policy because there is a real problem with the legitimacy of non-traditional monetary policy actions that seem to circumvent the authority of the legislative body (ibid.).
3. Finally, monetary policy can finance all types of fiscal transfers without any concern for solvency or sustainability because government-issued money “is special; it is not only a zero-interest liability, but also a perpetual liability” (Bernanke, 2000, p. 163). In fact, the Fed cannot even refuse to finance fiscal policy. As I have stated before:

“Under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero. . . . The U.S. government has a technology, called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” (Bernanke 2002)

Because of this speech and because of QE1 and QE2, I have been labeled “Helicopter Ben”, but note that I cannot rain money on the population alone. This can be done only when the central bank finances government spending. And if you’d like to call that ‘a helicopter drop of money’, so be it. The point is that the Fed never bounces a government check unless Congress orders us to do so (an absurd scenario which almost became reality in August 2011 during the debt ceiling debates). We are the government’s bank. This is not a proposal, it’s what we do. We help ensure that the U.S. government is solvent, so long as we have Congressional approval.

Some economists have argued that my proposal for government action should not be limited to subsidies and tax cuts, but should include direct job creation for the unemployed, infrastructure investment, universal child allowance, homeowner assistance, stronger social security, universal health and other (e.g., Tcherneva 2011). These are all policies that deal with labor markets, poverty, housing, retirement, and the many other long-term challenges we face.

These are precisely the sorts of policies I am asking you to consider today.

Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies–pertaining to labor markets, housing, trade, taxation, and regulation, for example–also have important roles to play.

For the case of Japan, I called for a Rooseveltian Resolve. I wrote that “FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done” (ibid. p. 165).

Today I ask of you, esteemed Congressmen and Congresswomen, to do the same. Abandon dated ideas about what constitutes sound finance and spring into action. The Fed is here to help.

For me to be able to do my job, I need you to do yours. Remember, fiscal policy enables monetary policy. The Fed stands ready to fund any and every government program that would bring full employment, sustainable growth, and long term prosperity — be it a ‘New New Deal’, a ‘Green New Deal’, or the ‘Job Guarantee’. Such policies will be sustainable because the Fed stands behind the full faith and credit of the Federal Government.

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies–pertaining to labor markets, housing, trade, taxation, and regulation, for example–also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans. Thank you.”

We are pleased to bring you this exclusive report. The reasons why the Chairman scrapped this draft of the speech in favor of the lukewarm version he delivered still remain a mystery.

*Gal Noir is an undercover investigator of hijacked economic truths and an occasional blogger
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**  Tcherneva, P.R. “Bernanke’s paradox: can he reconcile his position on the federal budget with his recent charge to prevent deflation?” Journal of Post Keynesian Economics, Spring 2011, Vol. 33, No. 3, pp. 411-433. (You can read a version of this paper here)

*** Bernanke, B.S. “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” In R. Mikitani and A. Posen (eds.), Japan’s Financial Crisis and Its Parallels to U.S. Experience. Washington, DC: Institute for International Economics, 2000, pp. 149–166.

www.pavlina-tcherneva.net

(cross posted at NEP)