As the world faces what is clearly emerging as the greatest financial crisis since The Great Depression, attention is increasingly focused on the new master of the financial universe, Ben Shalom Bernanke, Chairman of the US Fed. How will he steer the closely inter-twined global financial Armada through what is often described as the perfect ?stagflationary? storm? Low profile, plain speaking and democratic in contrast to his preecessor, Bernanke was initially seen as the poor man?s Alan Greenspan, caught sleeping at the wheel as the sub prime crisis imploded, and too doctrinaire and scholarly to don the mantle of a real world central banker. In recent months, however, as the Greenspan legend unravels in wake of the expansive subprime financial crisis, ?Helicopter Ben? has been widely credited for being ahead of the curve in anticipating the worst through dramatic rate cuts, liquidity injections and bank bail-outs to shore up a tottering financial system.
A self-confessed ?Great Depression buff, the way some people are Civil War buffs?, he appears eminently equipped intellectually to lead the battle from the frontlines. He has indeed been doing so in heroic fashion in close consultation with Hank Paulson, Secretary of the Treasury. The lessons he drew from the Great Depression probably explain why the US Fed response to the sub prime crisis was so different from that of the European Central Bank that was focused on the inflationary threat, even as Bernanke saw potential deflation as the greater threat. In retrospect, the professor may well have made the right call, for the US real economy appears to have held up relatively well so far, even as Europe stutters into recession.
However, as the oft-repeated one-liner from Bollywood goes, the movie is by no means over, indeed, we might simply be at the end of the beginning. The jury is still out on whether the US economy can hold out against recession, and whether tools honed through deconstructing the Great Depression and the inflationary seventies are appropriate for taming a 21st century hybrid monster that appears to combine elements of both on account of the excessive liquidity deriving from global imbalances and financial innovation.
Just as Greenspan was prescient in sniffing out productivity gains underlying the ?great moderation? that permitted both sustained high growth and lower inflation, Bernanke was amongst the first to draw attention to the global savings glut arising from the ballooning current account surpluses of emerging economies that drove interest rates down and may have, along with financial innovation, inflated the sub prime bubble under the very nose of the master of the universe (retired). It is therefore surprising that Bernanke, apart from a predilection for ?leaning against the wind?, by and large goes along with Greenspan in not targeting asset prices while formulating monetary policy.
The Great Depression and the inflation crisis of the seventies spawned what are perhaps the two great economic orthodoxies of the 20th century, namely Keynesian economics to tame deflation, and monetarism, along with the augmented Philips Curve, to tame inflation. Even as fiscal policy is hostage to politics, the burden of stabilisation has increasingly fallen on independent Central Banks using monetary policy. Bernanke apparently considers deflation deadlier than inflation, and that is perhaps why he seems to favour explicit inflation targeting, unlike his illustrious predecessor who nevertheless appears to have had an ?informal target? not very different from Bernanke?s in the 1-2% range. He recognises the limits of monetary policy however, for interest rates cannot be pushed below zero. It is in such a scenario that Bernanke propounded perhaps his most controversial theory: a money-financed tax cut which is essentially equivalent to ?helicopter drop? of money.
Ethan Harris? exceptionally lucid and elegant exposition on a difficult subject is testament to his conceptual clarity and range of experience spanning both Wall Street and Mint Street. Some difficult questions however remain to be both asked and answered. How would such a helicopter drop fare in a turbulent open economy buffeted by robust cross border capital flows? Despite deleveraging, the problem is not one of liquidity ? ask sovereign wealth funds! ? but of pricing of risk, which is fast leading to a virtual nationalisation of the financial sector in the very heart of global capitalism. Nationalisation of risks means more regulation that could constrain the very financial innovation that lay at the heart of the great moderation. If the State resolutely refuses to bail out the financial sector, how can the central bank do so on its own? Ben Bernanke has his task cut out to fashion the monetary tools for the 21st century.
The writer is Secretary, Prime Minister?s Economic Advisory Council