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Economists enter the Twilight Zone

Alice had her looking glass. Rod Serling had his Twilight Zone. And now Federal Reserve Chairman Ben Bernanke is ushering Americans into the strange economic world of the "zero bound." This is a technical term for the current state of U.S. monetary policy: By cutting nominal interest rates to zero — or near zero — last week, Bernanke used up the last of the central bank's conventional antirecession weaponry. For now, the Fed will forget interest rates and begin intervening directly in credit markets using "all available tools." Expect the central bank to follow through on, and perhaps expand, its previously announced plans to buy up hundreds of billions of dollars' worth of securities backed by mortgages, car loans and credit-card debt. It may also promise low interest rates on medium-term government debt. With a balance sheet already in excess of $2.2-trillion, the Fed is morphing from a lender of last resort to the last lender, period.

Inflationary, you say? Certainly the foreign currency markets see it that way, which is why the dollar plunged the day after Bernanke's announcement. But that's just the point. Bernanke is determined to prevent a deflationary spiral and a second Great Depression. Consumer prices fell at an annual rate of 1 percent in October and 1.7 percent in November. These unheard-of numbers are easily explained: Debt-strapped firms and households are slashing spending and hoarding cash. Everyone is selling — at deeper and deeper discounts — but no one is buying. So far, this counts as disinflation. But if it isn't checked, it will mutate into true deflation, that horrible condition in which every debt must be repaid in dollars that have more buying power than the ones you borrowed — and credit totally collapses.

The way to prevent this is for the government to pump out more and more money, until, at some point, dollars become so cheap that people are willing to part with them in return for assets such as cars or houses — or securities backed by car loans and mortgages. Then, at last, prices will begin to rise, and the deflationary spiral will be aborted. Or so Bernanke himself explained in a now-famous 2002 speech in which he alluded, jokingly, to the possibility of dropping dollars from a helicopter.

Will it work? Fortunately, the Fed chairman has spent much of the past decade studying these issues; no one can say that Bernanke enters this battle intellectually unprepared. The bad news, however, is that the "zero bound," like the Twilight Zone itself, is so strange and so little explored that even the most brilliant economists don't exactly know what to do once they get there. Japan is the only advanced economy to have experienced prolonged deflation in recent years. In the first half of this decade, the Bank of Japan fought the phenomenon with many of the same instruments that Bernanke is using now — yet achieved only mixed results, as Bernanke himself reported in a 2004 research paper. Japan's sluggish recovery, of course, reflected certain structural inefficiencies, such as a highly protected food market, which do not plague the United States. But the United States does have bad habits of its own — the burden of costly health care comes to mind — which may limit its ability to rebound.

The success of the Fed's strategy will depend not only on its own efforts but also on the size and shape of the fiscal stimulus package that President-elect Obama and a Democratic Congress appear set to enact early next year. If and when sustained growth kicks in, the Fed will have to shut down the monetary printing press as swiftly as it turned it on — because if there's anything worse than deflation, it's hyperinflation.

Economists enter the Twilight Zone 12/21/08 [Last modified: Thursday, November 4, 2010 1:11pm]
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