Yellen looks toward a Keynesian approach

This has been a banner week for the world economy, inspired largely by events in the United States.

Anatole Kaletsky

In Washington, the first congressional testimony from Janet Yellen in her position as new Federal Reserve Board chairwoman reassured and impressed two notoriously petulant audiences: Tea Party congressmen, who had assembled a posse of hostile witnesses to attack the Fed’s “easy money” policies; and panicky Wall Street investors, who had spent the previous month swooning on fears that monetary policies might not be easy enough.

The significance of Yellen’s testimony lay not in the fact that she was a bit more “dovish” than former Chairman Ben Bernanke, or seemed more committed to the new central bankers’ fad for “forward guidance,” as opposed to “quantitative easing.” More striking, if subtle, was the change in economic philosophy that Yellen represented.

Bernanke, despite his radicalism during the financial crisis, was philosophically an orthodox monetarist, who followed his mentor Milton Friedman in believing that the main job of a central bank is to stabilize inflation. For monetarists, consistently hitting an inflation target is, in normal circumstances, a sufficient criterion of monetary policy success. They believe that using monetary policy for other economic objectives, such as stimulating growth or creating jobs, is doomed to failure and ultimately leads to galloping inflation.

Once inflation is stabilized, monetarists explain, the “real” economy should be left to market forces. These determine the optimal levels of unemployment and growth that a low-inflation economy can achieve.

Yellen’s testimony, in contrast, revealed Keynesian thinking, which views monetary policy as just one instrument, if perhaps the most important, in a complex macro-economic toolbox that has to be used proactively to achieve a broad range of both monetary and real objectives. Not just moderate inflation, but also full employment, strong growth, financial stability and perhaps even better income distribution. Keynesians disagree with the monetarists’ view that inflation control should always be a higher priority for the central bank than full employment.

More fundamentally, Yellen seems to believe along with many modern Keynesians, that because monetary policy must deal with many conflicting objectives, central banks must adopt a “control engineering” approach. Instead of trying to hit a single inflation target precisely, they should try to keep numerous economic variables -- unemployment, growth, capacity utilisation, financial leverage -- within tolerable limits, focusing most attention on whichever variable is veering furthest away from the acceptable range.

Before the 2008 fiscal crisis, many investors and business leaders would have been horrified by this pragmatic philosophy. They believed the monetarist doctrine that any deviation from single-minded inflation targeting would produce soaring prices. Today, however, most of the “bond-market vigilantes” who have sharply criticized Fed policies since 2008, point to the threat of deflation, not inflation, as evidence of this failure.

So Yellen can now adopt a philosophy that would have been considered inflationary in the past -- without raising a revolt in financial markets. On the contrary, Wall Street seems to prefer the pragmatic, control-engineering approach to single-minded monetarist inflation targeting. As demonstrated by the enthusiastic reaction to Yellen’s testimony this week.

Slideshow ( 3 images )

The positive response to the new Fed leadership was clearly helped by other encouraging events this week. U.S. politics produced a breakthrough that would have been almost unthinkable even a few months ago: Both houses of Congress passed a “clean” bill to extend the Treasury’s borrowing powers until March 2015.

This vote confirmed that the period of nihilistic partisan extremism in U.S. politics has ended, that Washington’s self-destructive budget battles are over and that U.S. fiscal policy is now set on a steady course until after the 2016 presidential election.

Many fiscal conservatives still argue that the newfound predictability of U.S. fiscal policy is anything but good news. An armistice in the budget wars, they insist, will merely allow government debt and borrowing to spiral out of control.

But just as this week’s debt ceiling votes exposed as myth the cliché that America had become ungovernable, new fiscal figures released Wednesday revealed that the U.S. budget crisis was also a mirage. It now turns out that tax revenues are surging, spending is under firm control and deficits are narrowing much faster than almost anyone expected, to just 3 percent of gross domestic product this fiscal year. So strong were this week’s Treasury figures, in fact, that one of Wall Street’s most respected economists, Ed Hyman of International Strategy and Investment, said, “At the pace the federal deficit has narrowed … Obama might leave office with a small surplus. Of course this is wildly out of line with [official projections still showing] a $539 billion deficit in 2016.”

U.S. experience seems to be vindicating a Keynesian approach to fiscal policy -- as well as to central banking. When an economy is emerging from deep recession, the best way for the government to deal with deficits is to ignore them. Instead of trying to cut spending or raising taxes, it is better to maximize fiscal and monetary stimulus and then wait for economic growth to bring deficits down.

The run of good news from Washington has transformed the grim mood that suddenly descended on financial markets in January. U.S. investors are now reinterpreting the recent disappointing employment figures and focusing instead on the many other statistics pointing to strong and accelerating economic growth.

This data reassessment has had an immediate and powerful global effect, as I wrote last week. Exaggerated fears of a global economic slump caused by financial and political turmoil in emerging markets now appear to be dissipating. The evidence that U.S. economic growth and employment are gaining traction is having a profound effect on the confidence of central bankers, politicians, investors, consumers and business leaders around the world.

As the U.S. recovery accelerates, broadens and becomes more sustainable, the world can finally see evidence that the extraordinary monetary and fiscal policies of the post-crisis period are starting to work as intended. The better that monetary and fiscal stimulus are seen to be working in the United States, the more these policies will be emulated in other countries -- and the greater will be the probability of a genuine economic recovery around the globe.

PHOTO (TOP): Federal Reserve Chairwoman Janet Yellen testifies before a House Financial Services Committee hearing at the Rayburn House Office Building in Washington, February 11, 2014. REUTERS/Mary F. Calvert

PHOTO (INSERT 1): Federal Reserve Chairman Ben Bernanke testifies before the Senate Banking, Housing and Urban Affairs Committee on Capitol Hill in Washington, July 22, 2009. REUTERS/Kevin Lamarque

PHOTO (INSERT 2): Traders are pictured at their desks in front of the DAX board at the Frankfurt stock exchange, February 13, 2014. REUTERS/Remote/Stringer