October 28, 2010
William McChesney Martin, a former Federal Reserve Board chairman, once famously described the Fed’s role as taking away the punch bowl just when the party gets going. In his new book explaining how the economy really works, journalist Greg Ip seizes on Martin’s imagery to describe in layman’s terms the essential strategy of the Federal Open Market Committee, the Fed’s August policy-making body: “FOMC deliberations are consumed by figuring out just how much punch to supply. If everyone is having a good time spending money, the Fed cools things down by taking the punch bowl away, that is, by raising interest rates. The opposite is also true: If spending is moribund, it is the Fed’s job to supply as much punch as necessary to get the people to come to party in the first place.”
Or, in the case of the current, pathetically lethargic economy which seems to have defied practically every monetary trick in Fed Chairman Ben Bernanke’s bag, the FOMC next week will likely resort again to quantitative easing, the arcane technique which shifts the central bank’s focus to expanding its balance sheet through bond purchases rather than targeting short-term rates.
“In theory, quantitative easing endows the Fed with awesome power,” writes Ip, the U.S. economics editor for The Economist magazine and one of the most talented economics writers in Washington. “It could buy up every U.S. bond in existence. Yet in practice, this is the Star Trek of central banking, taking the Fed into strange new worlds with unknown consequences.
Ip’s book, The Little Book of Economics (John Wiley & Sons, Inc.), is a clever, easily accessible guidebook and reference that explains the building blocks and drivers of economic growth, and the endless tug of war between inflation and deflation. Ip offers a nuanced examination of the forces affecting unemployment, as well as an insider’s look at how government actions impact the economy through more typical channels of public finances and interest rates, or the more complex web of regulations and prudential supervision.
“Business cycles and market cycles have a lot in common,” Ip writes. “Both are driven in great part by a tug-of-war between expectations and reality. Just as stock prices are a bet on the future of companies that may prove wrong, business and households are constantly making plans based on how much they expect their sales or wages to grow tomorrow. The future is inherently uncertain, so these decisions often depend as much on gut feelings and cold calculations.”
On Tuesday The Fiscal Times spoke with Ip from New York:
TFT: To begin with, what precisely do you expect to come out of next week’s two-day meeting of the Fed?
GI: I strongly expect that they’re going to announce the second program of quantitative easing – that is to say, purchasing bonds with newly printed money, hoping to pull down long-term interest rates. In the first program, so called QE1, they purchased something like $1.7 trillion of bonds and mortgage-backed securities over a period of about a year. This time I don’t think they will actually give us a full amount or a full time frame. I think they’re more likely to announce that they will do a certain amount of money every few months until their forecast for inflation and unemployment is more satisfactory.”
TFT: What do you see as the potential benefits and risks of QE2?
GI: I think the biggest risk associated with this is that it won’t work. The first program succeeded in bringing mortgage rates down and treasury yields down. Mortgage rates are now the lowest in a generation, I think ever, and yet the real reason people aren’t buying more homes or borrowing money is not because mortgage rates are high, but because they can’t qualify for a mortgage.
I don’t think [the other risks] are very large. I think one is that this results in a dramatic decline in the dollar as our foreign trade partners think this is a deliberate attempt to drive its value down by printing more of them . . . And associated with that is the risk of a run up in commodity prices as we saw in 2008. I can't dismiss those possibilities because the way the dollar and commodity prices behave is in great part psychological, whereas I think the fundamental reasons for either of those things to happen are quite small.
TFT: Your main chapter on the Fed invokes the image of the Vatican. I suppose that would make Ben Bernanke the Pope. What is your assessment of Bernanke, and do you think he has succeeded in rehabilitating his public image after a very rocky period of public and congressional skepticism about his performance during the financial crisis?
GI: It’s too soon to tell. The main thing people criticized him for [in 2006] was this was a guy who was mainly from the academic world but had little practical experience with markets and banking and so on. And it turned out that the subject he had devoted his academic career to – things like the Great Depression, things like how a broken financial system can turn a recession into a depression were exactly the kinds of things we needed the Fed chairman to know about for the crisis that we encountered. This was the greatest irony. That period when Congress was venting its fury at the Fed for bailing out AIG, for not being tougher on the banks and so forth, it was in some sense lucky that the person running the Fed wasn’t a banker. He was an academic.
But the longer-term judgment on his success is really going to be an open question for quite a few years. Yes, we did avoid the panic turning the recession into another Great Depression, but we don’t know if we’re going to turn into Japan [and its stagnate economy], we don’t know if five years from now unemployment will still be eight or nine percent. And if it is, people will be I think very uncharitable about Bernanke’s tenure, both by the steps he has taken since the crisis and the role he had in allowing the crisis to develop or the condition for the crisis to develop in the first place. That’s just reality which history doesn’t just judge you on the quality of the decision you made at the time, but on the results.
TFT: Everyone wants to know when the economy and the unemployment rate will improve. What’s your prognosis?
GI: I think it will improve next year. I think that there’s too much gloom right now. When I look at the forecast for next year, you have people thinking we’ll only grow around two and a half percent, which is roughly around the economy’s long-term potential rate, which means it’s only fast enough to create jobs that keep up with population growth. It doesn’t do anything to reemploy the 8 million people who lost their jobs over the course of the recession. I honestly think that’s too pessimistic. It’s very unusual for an economy to get stuck in a rut like that. It happened to Japan but I don’t think we’ll be like Japan.
As I look at the things holding the economy back, things like the negative equity situation, things like banks’ lack of capital, all of those things are getting better; they’re not getting worse . . . As long as this process of the dollar declining doesn’t become either a panic or trigger a long global trade war or currency war, I’m optimistic that these things will do what in theory they’re supposed to do, which is revive exports, revive consumers, revive investment. I think the economy will do better than 3 percent next year. I think the unemployment rate will come down, it won’t come down a lot, but it will come down to maybe 9 percent, perhaps lower by next year.
TFT: You note in your book that unemployment is the single best sign post of the economy’s health. Looking forward, do you see any silver lining in the current numbers and projections?
GI. [Laughter] No. I don’t know. I think my optimistic forecast is as much an act of faith as it is based on a rigorous dissection of the current figures. . . Unfortunately I can’t point to any really convincing signs right now that things are about to turn around. I would note that the stock market is up about 10 percent since the Fed began loudly signaling it would likely do another program of quantitative easing. .. I would point to that as one thing to be hopeful about.
TFT: Well, I still like your optimism, Greg. One last question: Why did you decide to write this book?
GI: I studied economics in college, but when I started writing about economics as a journalist – first in Canada and then here in the United States – I discovered that I needed to learn a whole lot more to understand how the data worked and how business cycles worked. And also, basically, to realize that the world of practice doesn’t always work the way it does in theory . . . So I wrote the book to try and give the average person out there who doesn’t want to go to college, who doesn’t want to be an economist, who doesn’t want to plow through Greek letters, and stacks of numbers and charts, the framework they need to think about the economy. How is it that inflation comes about? What are the real contributors to long term and short term economic growth? And do it in a relatively painless and at times entertaining fashion. So that’s why I did that. I really wanted to write the kind of book that I wish I had at my finger tips when I started covering economics decades ago.