Sunday, October 18, 2009

Ben Bernanke vs. Edwin Truman on U.S. Domestic Demand

Ben Bernanke is back at it. In a speech before the Federal Reserve Bank of San Francisco, he noted that Asia continues to save too much and the United States too little. As a result, global economic imbalances may once again grow. Here is what he had to say about Asia:
For their part, to achieve balanced and sustainable growth, the authorities in surplus countries, including most Asian economies, must act to narrow the gap between saving and investment and to raise domestic demand. In large part, such actions should focus on boosting consumption.
Bernanke is saying Asian economies must increase their domestic demand going forward to help reign in global economic imbalances. He also acknowledges that U.S. domestic demand will have to come down via less fiscal stimulus for this endeavor to work. So, in short, the key to a rebalanced world economy is better management of domestic demand. Fine, but where was the Federal Reserve with managing U.S. domestic demand back in 2003-2005? If better management of domestic demand is key to removing global imbalances now, surely it would have helped in the early-to-mid 2000s. The Federal Reserve could have done a lot on this front. Had it reigned in U.S. domestic demand back then it seems likely Asia would have been more likely to switch to its own domestic demand sooner. As Mark Thoma notes, though, Bernanke fails to mention this point in his talk.

The Federal Reserve cannot claim ignorance on this point. Edwin Truman, one of its long-time former employees, argued forcefully for the Federal Reserve to take seriously the growth in U.S. domestic demand and its implications for the build up of global economic imbalances back in 2005:
What the Federal Reserve has not acknowledged is that monetary policy has a role to play in slowing the growth of total domestic demand relative to the growth of total domestic supply or domestic output. The issue of concern is not just the effects of external adjustment on financial markets, but also on the real economy. It is one thing for politicians to be reluctant to acknowledge the real economic costs of external adjustment. The Federal Reserve does not have that excuse.

The majority of the members of the FOMC apparently do not embrace the view that they should pay more attention to total domestic demand. They are mistaken. Monetary policy is not just about managing domestic output and employment; it is also about managing total domestic demand, and most importantly managing the balance between demand and output. The view that net exports are a “drag” on GDP rests on knee-jerk arithmetic analysis. Exports and imports of goods and services are jointly determined with consumption, investment, and many other macroeconomic variables. Moreover, policy should focus significant attention on total domestic demand. In particular, the Federal Reserve should ponder whether it is not unnatural to continue to stoke the furnace of domestic demand three years after the dollar has begun to weaken, the US economy has moved into an expansion phase, and the US external deficit has widened. It was wrong for Mexico to ignore the message for monetary policy from the foreign exchange markets in 1994 and for Thailand to do so in 1996. Is it wise for the Federal Reserve to do so in 2005?
Too bad his views were not embraced by the FOMC. Let's hope he gets more of hearing going forward.

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