Financial markets were anxious to hear what Ben Bernanke, the Governor of the US Federal Reserve, had to say about the immediate future in his speech on Friday to the Federal Reserve Bank of Kansas City's Jackson Hole symposium. After the Fed's recent announcement that short-term interest rates in the US are likely to remain at near-zero levels until at least the middle of 2013, they hoped for a signal that Bernanke would also authorise another round of quantitative easing (QE) to boost the ailing US economy. In the event he simply reminded his audience that the Fed had a "range of tools that could be used to provide additional monetary stimulus".
It is unfortunate that this short-term focus has distracted attention from what the Governor had to say about the longer-term outlook for the US economy. Bernanke is an optimist, dismissing the prospect of a prolonged period of economic stagnation in the US and other western economies and expecting a return to the growth rates and levels of employment seen before the financial collapse and recession. And he thinks this will happen if policymakers stick to the same formulae they have been applying for many years. Thus, the job of the Federal Reserve is to ensure inflation remains low and stable over time and that of the Administration and Congress is to put in place a credible plan to stabilise and then reduce government debt. It is almost as if the financial crisis and recession never happened.
Bernanke must be aware of the studies, such as those by the IMF and Reinhart and Rogoff, which show recessions that follow periods of massive debt accumulation, asset bubbles and financial crises tend to be followed by long periods of economic pain and turmoil. In such circumstances, monetary policy, including quantitative easing, does not work because there are too few borrowers and lenders are reluctant to lend. Household and business confidence is low, making them reluctant to take on more debt, while banks are focused on repairing their balance sheets, rather than expanding them. Fiscal policy can be effective in supporting growth for a period, but eventually reaches a point at which further stimulus is impossible and pressures grow for a reversal of policy. This is a pretty good description of the state of affairs in the US right now. Spending cuts will detract from growth but monetary policy is largely impotent to offset their effect. Japan in the 1990s is the template for what happens next: disappointing growth for many years.
Bernanke should also be asking himself what the events of the last four years tell us about the underlying strength of the US economy. GDP growth rates during the period from 2000 to 2007 were not at all exceptional and yet it turns out that a significant proportion of this growth was generated by financial engineering, debt acquisition and asset bubbles, particularly in housing. Growth would have been very disappointing if all the unsustainable bits had not occurred. Did some combination of the emergence of China, the financialisation of the US economy, reduced investment in productive capacity and the stagnation in median wages hold back growth, or was it due other factors? Until this question is asked and answered, it is difficult to be confident that the US economy will grow at a healthy pace in the long-term. That's bad news for the global economy too.
Perhaps it is in the job description of the Governor of the Federal Reserve to be optimistic about the US economy. One can imagine politicians would be quick to accuse Bernanke of "running down our economy" if he was not. But from this side of the Atlantic, his speech sounds dangerously complacent.
Tony Dolphin is senior economist at the Institute for Public Policy Research (ippr)