What are Ben Bernanke and Mario Draghi up to? Both Central Bankers are pursuing extreme monetary experiments. Will they succeed and what will happen if they fail?
Let’s consider Ben first. My read of his Jackson Hole speech is that he is on the defensive. Unemployment is his primary focus and he tried to prove that his monetary initiatives (QE1 and Operation Twist) have improved labour market conditions. Like every New-Keynesian, Bernanke believes that an active monetary policy can systematically influence the level of employment. Has he succeeded? Actually NO – the US unemployment rate is doggedly above 8% despite having engineered interest rates to historic lows. By any objective measure, Bernanke’s great experiment has failed. His speech therefore carried the following plea: the evidence is weak but don’t abandon the experiment as the economic costs of unemployment are too much of a risk. This is a bit like Saddam Hussein’s Information Minister declaring imminent victory while the US Marines stormed the Presidential Palace!
Now to Mario. His extreme experiment is to save the Euro by buying member country bonds. While the markets have applauded the initiative, the logic is does not address the basic issue. Europe’s problems are fiscal problems – put simply they continue to build up debt by spending more than they receive in taxes. It doesn’t matter whether the ECB buys the debt – or anyone else for that matter – the debt problem can only be solved through some combination of higher taxes and lower spending. The most dangerous aspect of Draghi’s initiative is that a repeat of the Greek ‘bond swap’ is inevitable in the event of a restructuring of any of the bonds that the ECB purchases (the ECB swapped their Greek debt for ‘new bonds’ that did not participate in the PSI.) In effect, the ECB becomes senior to private bondholders which should reduce the value of privately held bonds. Draghi’s extreme experiment is doomed to fail for these two reasons; (i) buying debt simply accommodates irresponsible fiscal policy and (ii) it downgrades the seniority of private investors.
Central bankers are supposed to be prudent and independent, as opposed to extreme experimentalists. Bernanke and Draghi were chosen because their political masters knew they would accommodate their own questionable fiscal activities. It therefore doesn’t matter whether QE3 works or the ECB’s shopping spree brings down interest rates – the people who elected their Central Bankers have no reason to change.