Wed, Sep 22, 2010 - Page 9 News List

Lack of optimism stalling US’ economic recovery

Part of the problem is the public and Congress no longer trust the ability of the US Federal Reserve to stimulate the economy



Remember the song Put On a Happy Face? Just smile, it says, and you’ll “spread sunshine all over the place,” even if you don’t start out feeling very happy yourself.

In many ways, this is fine advice. But if you’ve ever tried to act on it, you know that it’s not always easy to wish optimism into existence.

Optimism, or lack thereof, may seem the province of psychology, not macroeconomics. But the issue is very relevant to the difficulties that policymakers face: A deficit of optimism has much to do with why the US economy remains stalled today.

The US Federal Reserve, pondering what to do to stimulate the economy, has a number of tools at its disposal. However, if it could just convince the public that it was committed to monetary expansion and economic growth, it would help the economy pick up speed.

Yet that is easier said than done. Here’s the problem: The economy needs help, but monetary policy, which is the Fed’s responsibility, has not been very expansionary. This is true even though the Fed has increased the monetary base enormously since the onset of the financial crisis.

How can this be? Supplying more money did not actually result in enough additional spending. The debilitating financial shock of the past few years convinced many consumers and businesses that they needed to save more. So they are holding on to much of the new money.

Given this problem, there is a logical and seemingly simple move available to the Fed: Just make people believe that it is seriously committed to increasing the rate of inflation. Traditionally, the Fed has focused on restraining inflation, not stoking it. But these are unusual times.

If the Fed promises to keep increasing the money supply until prices rise by, say, 3 percent a year, people should eventually start spending. Otherwise, if they just held the money, it would be worth 3 percent less each year.

In a self-fulfilling prophecy, the Fed could stimulate spending and the economy, and at no cost to the Treasury. Of course, if no one believes the Fed’s commitment to price inflation, spending and employment will not go up. The plan will fail, and people will view their skepticism as vindicated.

In other words, one of our economic problems can be solved, but only if we are willing to believe it can. Federal Reserve Chairman Ben Bernanke wrote about this conundrum before he accepted his current job. In 1999, when discussing what the Japanese central bank could do about the country’s deep recession, Bernanke suggested “a target in the 3 to 4 percent range for inflation, to be maintained for a number of years,” saying that it would show the bank’s credible commitment to reflate the economy.

Sadly, although Bernanke clearly understands the problem, the Fed hasn’t been acting with much conviction. This is understandable, because if the Fed announces a commitment to a higher inflation target but fails to establish its credibility, it will have shown impotence. It would be a long time before the Fed was trusted again, and the Fed might even lose its (partial) political independence. All of a sudden, the Fed would end up “owning” the recession.

Part of the credibility problem stems from the political environment, especially in Congress. Imagine the day after the announcement of a plan for 3 percent inflation. Older people, creditors and workers on fixed incomes — all connected to powerful lobbies — would start to complain. Republicans would wonder whether they had found a new issue on which to campaign, namely, opposition to inflation. And Democrats would worry about what position to take. Presidents of some regional Fed banks would probably oppose the policy publicly.

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