The irony is rich, if unintended. For months, the Obama administration and many others have been urging banks to increase lending, especially to businesses. On Wednesday, Federal Reserve Chairman Ben Bernanke outlined for Congress new methods to discourage lending by banks.
This does not reflect disloyalty on Bernanke’s part, nor any fundamental disagreement between the Obama administration and the central bank on the basic economic policy strategy to follow going forward. Rather, it illustrates just how difficult implementing that strategy will be since it requires the Fed to walk a knife’s edge between two dangers.
Here is the basic quandary: On the one hand, the more the Fed increases the money supply, the more willing banks are to lend, all other things being equal. On the other hand, if the Fed increases the money supply too much for too long, inflation will occur either at the consumer level or in stock market or real estate prices.
Over the past 30 months, the Fed has done its part — creating new bank reserves that are the base of the money supply — with a vengeance. It did this to prevent the collapse of financial markets and stave off an even deeper recession.
That has not led to large increases in the money supply nor touched off inflation because banks have not lent out much of the new reserves the Fed created. Instead, they have left these reserves on deposit with the Fed, and since 2008, the central bank has been able to pay the banks interest on such deposits.
This does not mean the Fed’s efforts were futile. The additional reserves bolster the financial statements of fragile banks and other financial firms, including AIG. Many more would have failed without the massive Fed intervention, and the recession could have been much worse.
Banks could respond to administration pleas, pull some of this money back from the Fed and lend it to businesses or households. That could improve output and boost employment, but it also would raise the money supply and increase the likelihood of inflation.
But if the Fed raises the interest it pays banks on their risk-free reserve accounts, bankers will be at least marginally less willing to make business or consumer loans at a time of great uncertainty. The risk of inflation decreases but so may economic growth.
Optimists can look at this and say, “Gee, the Fed is really smart to think ahead and develop new procedures so they can meet their statutory mandate to foster the highest possible economic growth consistent with low inflation.”
Realists may say, “The Fed faces a pretty difficult task in walking this knife’s edge between recession and inflation. Let’s hope these proposed policies help them balance successfully.”
Pessimists will react, “This is happy talk. The situation is such that the chance the Fed can stay on this tightrope is near zero. The question is whether it is going to be inflation or unemployment or even both, as we had in the 1970s.”
In fairy tales, characters like Goldilocks can find porridge that is neither too hot nor too cold and beds that are neither too hard nor too soft. But this is the real world. Call me a pessimist.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.