CITI: In A Parallel Universe Where Paul Krugman Is Fed Chairman...

Paul Krugman

Photo: Dave Shankbone via Flickr

What would Krugman do?Federal Reserve Chairman Ben Bernanke’s most convincing critics are not arguing with the Fed’s ultra-low interest rates, which have kept interest rates and bond yields at record lows.

Instead, they are uniting behind the banner of economist Paul Krugman, berating Bernanke and friends for not taking more activist policy action to address sluggish economic and employment growth.

In an article for the Times Magazine, Krugman takes aim at Bernanke for not supporting the same policies he had endorsed while studying the Great Depression and the Japanese Lost Decade during his academic career: in particular, setting higher than desired inflation targets to ramp up employment.

Bernanke refuted these allegations in a press conference Tuesday, arguing that such policies right now would be “reckless” and “unwise.”

But consider that Krugman got his way. In a new investor note, Citi’s Steve Englander considers a parallel universe in which Krugman ran the Fed and imposed higher inflation targets until unemployment reached more acceptable levels.

Englander notes:

The difference between Krugman Fed inflation and 1970s stagflation is that the Krugman inflation would have a real effect by reducing the real debt burdens, whereas the 1970s inflation in retrospect was doomed to fail because policymakers were trying to hit an employment target that was unachievable without constantly accelerating inflation.

But he falls short of endorsing Krugman’s position, that “higher expected inflation would aid an economy up against the zero lower bound, because it would help persuade investors and businesses alike that sitting on cash is a bad idea” [Krugman’s words].

Englander sees two potential downside risks here: first, that the policy doesn’t work, and second that the Fed loses credibility. Thus, he sees three possible outcomes:

  1. “Full court press fiscal and monetary policies succeed, we get back to full employment and the Fed regains its virtue and shifts back to low inflation.” (immediate USD weakness) If it works, then policy rates could probably be raised pretty quickly, but the initial dollar devaluation could generate “a round of global capital controls that disrupt both economies and financial markets.”
  2. “Same as 1) but we high inflation is stickier and becomes a permanent or semi-permanent factor.” (even higher and more prolonged USD weakness)
  3. “The policies fail. Weimar Republic.”

Contrast that to Bernanke’s policies, which have these two possible outcomes:

  1. “Low inflation, stagnant growth and constant debate on whether additional the banking system will be force-fed additional reserves.” The dollar goes back and forth between strength and weakness, amid continuing concerns about the viability of the euro.
  2. “A Bernanke Fed that succeeds in gradually returning to full employment.” The dollar strengthens once the Fed signals that it is exiting its easing strategy.

Englander concludes, “We leave it to you to weight the probabilities of these outcomes.”

However, Krugman shoots himself in the foot here. In his lengthy article on Bernanke, he endorses an old criticism of Bernanke’s—that the Bank of Japan was wrong in not “try[ing] anything that isn’t absolutely guaranteed to work.”

But if Englander’s assessment of the U.S. outcomes is correct, then the possible bad results associated with Krugman’s policies are far worse for the viability of the dollar than Bernanke’s.

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