"The most significant threat to our national security is our debt," Admiral Michael Mullen, Chairman, Joint Chiefs of Staff, August 27,2010


Monday, June 11, 2012

Ben's Odyssey -- Chapter II


Od-ys-sey (noun):  a long wandering or voyage usually marked by many changes of fortune; an intellectual or spiritual wandering or quest.

After defining deflation, Ben, in his 2002 speech to other economists, asks and answers the question of the threat of deflation to the US.  Ben’s comments follow and are preceded by bullet points –

·         I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself.

·         The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself.

·         I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.

Next Ben discusses using lower interest rates to fight deflation:

·         Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero.

·         When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.

·         Hence I agree that the situation is one to be avoided if possible.

And further expands on avoiding deflation before it happens:

·         … central banks with explicit inflation targets almost invariably set their target for inflation above zero, generally between 1 and 3 percent per year.

·         The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly.

·         Third, as suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates

Then Ben says, “Suppose that, despite all precautions, deflation were to take hold in the U. S. economy and, moreover, that the Fed’s policy instrument – the federal funds rate – were to fall to zero.  What then?"  When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.  Well, Ben has some more ideas; a lot more ideas –

·         …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. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

·         One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.

·         If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

·         …. the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).

·         If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities.

·         For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral.

·         For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.

Wow, Ben sure has a lot of things in his carry bag for this odyssey of his.  But, remember this was ten years ago and Ben may have been thinking – I’d better not scare these guys too much, at least not yet, so Ben moonwalks backward, just a bit:

·         I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange.

·         I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar.

·         Each of the policy options I have discussed so far involves the Fed's acting on its own.  In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example…

Then Ben departs from his script – remember he is on the board of the fed; not in the congress but he plants the seed for the congress to do their part when he embarques on his odyssey –

·         Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.

So Ben was ready to fight deflation in 2002 – why would that be?  And why is Ben already so far down the road on deflation fighting?  In our next chapter, we will look at just what he has done on this odyssey of his and we will start to ask some questions using facts and Ben’s own words.

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