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The Radicalization of Ben Bernanke

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In the past few months, Bernanke has expanded the central bank's role in two major ways. The Fed has committed over a trillion dollars for buying securities issued by federal housing agencies, and another trillion for other products such as student loans, credit card loans and auto loans. Not only is the Fed devoting enormous funds to restart the flow of credit, but it is deciding where and how to allocate the credit. This is a remarkable shift from the traditional, hands-off approach to central banking. Bernanke is now making the Fed a major banking player in its own right.

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Then in March, the Fed said that it will begin buying long-term Treasury bonds on the open market, hoping to push down long-term interest rates (by increasing the amount of money available for long-term lending) and thereby stimulate borrowing. The implication is that the Fed will finance these purchases by creating money. Not only that, but Bernanke wants us to know exactly what the Fed is doing; he hopes to push up our expectations of future inflation, so that wages and prices will nudge upwards, not downwards.

In short, Bernanke is making the biggest bet placed by a U.S. central banker in decades, wagering that he can pull the economy out of a deep crisis by creating money without unleashing high and long-lasting inflation. In a speech Friday, Bernanke admitted that his efforts are "rather unconventional programs for a central bank to undertake," but added that they are "justified by the extraordinary circumstances in which we find ourselves."

Will it work? In a normal advanced economy, creating hundreds of billions of dollars in new money would not foster runaway inflation. As long as the economy is underperforming -- for example, with high unemployment -- stimulating the economy will only cause that "slack" to be taken up, the theory goes. Only when unemployment is low again can workers demand higher wages, forcing companies to raise prices.

But is the United States really a normal advanced economy anymore? We seem to have taken on some features of so-called emerging markets, including a bloated (and contracting) financial sector, overly indebted consumers, and firms that are trying hard to save cash by investing less. In emerging markets there is no meaningful idea of "slack;" there can be high inflation even when the economy is contracting or when growth is considerably lower than in the recent past.

If the United States is indeed behaving more like an emerging market, inflation is far easier to manufacture. People quickly become dubious of the value of money and shift into goods and foreign currencies more readily. Large budget deficits also directly raise inflation expectations. This would help Bernanke avoid deflation, but there is a great danger that unstable inflation expectations will become self-fulfilling. We do not want to become more like Argentina in 2001-2002 or Russia in 1998, when currencies collapsed and inflation soared.

In his prime, former Fed chief Greenspan was considered one of the most powerful men in the world, simply by changing short-term interest rates in response to inflation. But the Great Moderation that he oversaw, it turns out, was an illusion, and Greenspan has admitted that his beliefs in a self-correcting free market were wrong.

Now Bernanke, the soft-spoken but authoritative academic, has redefined the Federal Reserve on the fly and exercised powers that Greenspan never dared touch. Bernanke's strategy is risky, and only time will determine whether he is being brave in averting a larger crisis, or reckless in unleashing inflation that could increase quickly and uncontrollably. Today, Bernanke's gamble looks like the worst possible alternative, apart from all the others.

Simon Johnson, a professor at MIT's Sloan School of Management and the former chief economist of the International Monetary Fund, and James Kwak, a student at Yale Law School, are co-founders of BaselineScenario.com, which tracks the global financial crisis.


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