Fed critic deserves a decent debate

In: Uncategorized

1 Sep 2008

The following comment by me appeared in this week’s Fund Strategy.

Central bankers are not generally known for having blazing public rows. But the recent annual shindig organised by the Federal Reserve at the mountain resort of Jackson Hole, Wyoming, was an exception. Once the debate is translated into straightforward English it can be seen to have important implications for economic policy.

The row was precipitated by Willem Buiter, a professor at the London School of Economics and former Bank of England monetary policy committee member, in a paper to the conference.*

Shorn of the usual caveats, maths and technical language it seemed to be arguing that the Fed has been too timid in dealing with the credit crunch. It should have been prepared to tolerate greater economic pain in the short term to pave the way for a stronger recovery. This weakness was presented as a result of being too sensitive to political pressure and the needs of Wall Street.

Alan Blinder, a professor at Princeton and former vice-chairman of the Fed, led a vigorous response. In a reference to the fact that Buiter was born in the Netherlands he said that: “One day a little Dutch boy was walking home when he noticed a small leak in a dike that protected the people in the surrounding town. He started to stick his finger in the hole, but then he remembered his moral hazard lesson. ‘The companies that built this dike did a terrible job,’ the boy said. ‘They don’t deserve a bailout. And doing that would just encourage more shoddy construction. Besides, the dumb people who live here should never have built their homes on a floodplain.’ The boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned, including the little Dutch boy.”

But Blinder’s response, while amusing, was based on a caricature of Buiter’s argument. Buiter specifically said in his paper that the Fed was not facing the possibility of a catastrophe. In Buiter’s view it had a choice between a short, painful but not fatal shock and a prolonged period of slow growth.

Buiter over-estimates the stomach of the Fed, or any of the other main central banks for decisive action. But the debate is certainly worth having rather than dismissing with a caricature.

* Papers available at: www.kc.frb.org

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