Naked Economics: Undressing the Dismal Science pdfdrive com

party headed out of control—is that it can be fun for a while. In the short run,
easy money makes everyone feel richer. When consumers flock to the Chrysler
dealership in Des Moines, the owner’s first reaction is that he is doing a really
good job of selling cars. Or perhaps he thinks that Chrysler’s new models are
more attractive than the Fords and Toyotas. In either case, he raises prices, earns
more income, and generally believes that his life is getting better. Only gradually
does he realize that most other businesses are experiencing the same
phenomenon. Since they are raising prices, too, his higher income will be lost to
inflation.
By then, the politicians may have gotten what they wanted: reelection. A
central bank that is not sufficiently insulated from politics can throw a wild party
before the votes are cast. There will be lots of dancing on the tables; by the time
voters become sick with an inflation-induced hangover, the election is over.
Macroeconomic lore has it that Fed chairman Arthur Burns did such a favor for
Richard Nixon in 1972 and that the Bush family is still angry with Alan
Greenspan for not adding a little more alcohol to the punch before the 1992
election, when George H. W. Bush was turned out of office following a mild
recession.
Political independence is crucial if monetary authorities are to do their jobs
responsibly. Evidence shows that countries with independent central banks—
those that can operate relatively free of political meddling—have lower average

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those that can operate relatively free of political meddling—have lower average
inflation rates over time. America’s Federal Reserve is among those considered
to be relatively independent. Members of its board of governors are appointed to
fourteen-year terms by the president. That does not give them the same lifetime
tenure as Supreme Court justices, but it does make it unlikely that any new
president could pack the Federal Reserve with cronies. It is notable—and even a
source of criticism—that the most important economic post in a democratic
government is appointed, not elected. We designed it that way; we have made a
democratic decision to create a relatively undemocratic institution. A central
bank’s effectiveness depends on its independence and credibility, almost to the
point that a reputation can become self-fulfilling. If firms believe that a central
bank will not tolerate inflation, then they will not feel compelled to raise prices.
And if firms do not raise prices, then there will not be an inflation problem.
Fed officials are prickly about political meddling. In the spring of 1993, I
had dinner with Paul Volcker, former chairman of the Federal Reserve. Mr.
Volcker was teaching at Princeton, and he was kind enough to take his students
to dinner. President Clinton had just given a major address to a joint session of
Congress and Fed chairman Alan Greenspan, Volcker’s successor, had been
seated next to Hillary Clinton. What I remember most about the dinner was Mr.
Volcker grumbling that it was inappropriate for Alan Greenspan to have been
seated next to the president’s wife. He felt that it sent the wrong message about
the Federal Reserve’s independence from the executive branch. That is how
seriously central bankers take their political independence.
Inflation is bad; deflation, or steadily falling prices, is much worse. Even modest
deflation can be economically devastating, as Japan has learned over the past
two decades. It may seem counterintuitive that falling prices could make
consumers worse off (especially if rising prices make them worse off, too), but
deflation begets a dangerous economic cycle. To begin with, falling prices cause
consumers to postpone purchases. Why buy a refrigerator today when it will cost
less next week? Meanwhile, asset prices also are falling, so consumers feel
poorer and less inclined to spend. This is why the bursting of a real estate bubble
causes so much economic damage. Consumers watch the value of their homes
drop sharply while their mortgage payments stay the same. They feel poorer
(because they are). As we know from the last chapter, when consumers spend
less, the economy grows less. Firms respond to this slowdown by cutting prices
further still. The result is an economic death spiral, as Paul Krugman has noted:

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Prices are falling because the economy is depressed; now we’ve just
learned that the economy is depressed because prices are falling. That
sets the stage for the return of another monster we haven’t seen since the
1930s, a “deflationary spiral,” in which falling prices and a slumping
economy feed on each other, plunging the economy into the abyss.
4
This spiral can poison the financial system, even when bankers are not doing
irresponsible things. Banks and other financial institutions get weaker as loans
go bad and the value of the real estate and other assets used as collateral for
those loans falls. Some banks begin to have solvency problems; others just have
less capital for making new loans, which deprives otherwise healthy firms of
credit and spreads the economic distress. The purpose of the Troubled Asset
Relief Program (TARP) intervention at the end of the George W. Bush
administration—the so-called Wall Street bailout—was to “recapitalize”
America’s banks and put them back in a position to provide capital to the
economy. The design of the program had its flaws. Communication about what
the administration was doing and why they were doing it was abysmal. But the
underlying concept made a lot of sense in the face of the financial crisis.
Monetary policy alone may not be able to break a deflationary spiral. In
Japan, the central bank cut nominal interest rates to near zero a long time ago,
which means that they can’t go any lower. (Nominal interest rates can’t be
negative. Any bank that loaned out $100 and asked for only $98 back would be
better off just keeping the $100 in the first place.)
†
Yet even with nominal rates
near zero, the rental rate on capital—the real interest rate—might actually be
quite high. Here is why. If prices are falling, then borrowing $100 today and
paying back $100 next year is not costless. The $100 you pay back has more
purchasing power than the $100 you borrowed, perhaps much more. The faster
prices are falling, the higher your real cost of borrowing. If the nominal interest
rate is zero, but prices are falling 5 percent a year, then the real interest rate is 5
percent—a cost of borrowing that is too steep when the economy is stagnant.
Economists have long been convinced that what Japan needs is a stiff dose of
inflation to fix all this. One very prominent economist went so far as to
encourage the Bank of Japan to do “anything short of dropping bank notes out of
helicopters.”
5
To hark back to the politics of organized interests covered in
Chapter 8
, one theory for why Japanese officials have not done more to fight
falling prices is that Japan’s aging population, many of whom live on fixed
incomes or savings, see deflation as a good thing despite its dire consequences
for the economy as a whole.

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The United States has had its own encounters with deflation. There is a
consensus among economists that botched monetary policy was at the heart of
the Great Depression. From 1929 to 1933, America’s money supply fell by 28
percent.
6
The Fed did not deliberately turn off the credit tap; rather, it stood idly
by as the money supply fell of its own volition. The process by which money is
circulated throughout the economy had become unhitched. Because of
widespread bank failures in 1930, both banks and individuals began to hoard
cash. Money that was stuffed under a mattress or locked in a bank vault could
not be loaned back into the economy. The Fed did nothing while America’s
credit dried up (and actually raised interest rates sharply in 1931 to defend the
gold standard). Fed officials should have been doing just the opposite: pumping
money into the system.
In September 2009, the one-year anniversary of the collapse of Lehman
Brothers, the chair of the Council of Economic Advisers, Christina Romer, gave
a talk ominously entitled “Back from the Brink,” which laid much of the credit
for our escape from economic disaster at the door of the Federal Reserve. She
explained, “The policy response in the current episode, in contrast [to the
1930s], has been swift and bold. The Federal Reserve’s creative and aggressive
actions last fall to maintain lending will go down as a high point in central bank
history. As credit market after credit market froze or evaporated, the Federal
Reserve created many new programs to fill the gap and maintain the flow of
credit.”
Did we drop cash out of helicopters? Almost. It turns out that the Princeton
professor who advocated this strategy (not literally) a decade ago for Japan was
none other than Ben Bernanke (earning him the nickname “Helicopter Ben” in
some quarters).
Beginning with the first glimmers of trouble in 2007, the Fed used all its
conventional tools aggressively, cutting the target federal funds rate seven times
between September 2007 and April 2008. When that began to feel like pushing
on a wet noodle, the Fed started to do things that one recent economic paper
described as “not in the current textbook descriptions of monetary policy.” The
Fed is America’s “lender of last resort,” making it responsible for the smooth
functioning of the financial system, particularly when that system is at risk of
seizing up for lack of credit and liquidity. In that capacity, the Fed is vested with
awesome powers. Article 13(3) of the Federal Reserve Act gives the Fed
authority to make loans “to any individual, partnership, or corporation provided
that the borrower is unable to obtain credit from a banking institution.” The
Federal Reserve can create $500 and loan it to your grandmother to fix the roof
if the local bank has said no and the Fed Board of Governors decides that it

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if the local bank has said no and the Fed Board of Governors decides that it
might do some good for the rest of us.
During the financial crisis, Bernanke and crew pulled out the monetary
policy equivalent of duct tape. The Federal Reserve urged commercial banks to
borrow directly from the Fed via the discount window, gave banks the ability to
borrow anonymously (so that it would not send signals of weakness to the
market), and offered longer term loans. The Fed also loaned funds directly to an
investment bank (Bear Stearns) for the first time ever; when Bear Stearns
ultimately faced insolvency, the Fed loaned JPMorgan Chase $30 billion to take
over Bear Stearns, sparing the market from the chaos that later followed the
Lehman bankruptcy. In cases where institutions already had access to Fed
capital, the rules for collateral were changed so that the borrowers could pledge
illiquid assets like mortgage-backed securities—meaning that when grandma
asked for her $500 loan, she could pledge all that stuff in the attic as collateral,
even if it was not obvious who would want to buy it or at what price. That gets
money to your grandma to fix the roof, which was the point of all this.
7
Monetary policy is tricky business. Done right, it facilitates economic growth
and cushions the economy from shocks that might otherwise wreak havoc. Done
wrong, it can cause pain and misery. Is it possible that all the recent
unconventional actions at the Federal Reserve have merely set the stage for
another set of problems? Absolutely. It’s more likely, at least based on evidence
so far, that the Fed averted a more serious crisis and spared a great deal of
human suffering as a result. President Barack Obama appointed Federal Reserve
chairman Ben Bernanke to a second four-year term beginning in 2010. At the
ceremony, the president said, “As an expert on the causes of the Great
Depression, I’m sure Ben never imagined that he would be part of a team
responsible for preventing another. But because of his background, his
temperament, his courage, and his creativity, that’s exactly what he has helped to
achieve.”
8
That’s high praise, and well deserved. Bernanke finished his second
term as Fed chair in 2014, at which point the global financial crisis was receding
in the rearview mirror.
*
I can’t remember the exact numbers, but they were something along these lines.
†
Okay, that’s not exactly true. At the height of the financial crisis, right around the time that Lehman
Brothers declared bankruptcy, the yield on three-month U.S. Treasury notes fell below zero, which means
that the nominal interest rate had turned negative. Remarkably, investors were paying more for something
than it promised to pay them back in three months. For policymakers, this was a sign of panic. Keith

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Hennessey, director of the National Economic Council in the White House, told James Stewart of The New
Yorker, “Treasury rates went negative! People were locking in a loss just to protect their money.” It’s also
true that storing huge amounts of cash is costly and difficult; under some circumstances individuals and
institutions may accept slightly negative nominal rates as a fee for keeping their money safe.

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CHAPTER 11
International Economics: