Paul Krugman:
Inaction is the Greatest Risk: Inaction is the Greatest Risk (Wonkish) Brad DeLong is exasperated with people who insist that the Fed's modest moves toward more support for the economy are "risky", but cannot explain why in any intelligible fashion…. It is just bizarre to angst about how the Fed might "distort" markets that are already hugely distorted.
But my first take on the nature of that distortion is a lot simpler than Brad's.
The key point is that we are in a liquidity trap…. [The Wicksellian] "natural" [nominal] interest rate, the rate that would match savings and investment at full employment, is negative. And we can't get there, because of the zero lower bound…. Now, you can talk about what has caused this situation; debt overhang and forced deleveraging is a prominent candidate. In any case, however, it exists. And the Fed's duty is to try to correct the distortions this situation creates, above all the distortion of mass unemployment. It can do this by trying to raise expected inflation, so that the real interest rate falls even though the nominal rate can't; it can try to correct it by buying risky assets, and thereby raising the natural rate. Whatever it does, however, should be seen as an attempt to rectify a huge existing market failure, not as somehow distorting a well-functioning market…
The problem is that neither Ben Bernanke nor Muhammed El-Erian is stupid, and yet both of them think that further extending the Federal Reserve's balance sheet--taking what seems to me to be a very limited amount of duration risk off of the private sector's books and onto the government's books (or, rather, erasing it: an investment bank may fear that a run may force it to sell long-run Treasuries at a moment when they are depressed, but a government does not assume but rather extinguishes risk when it buys back its own long-term bonds--even if those bonds are still accounted for as a credit to one part and a debit to a second part of the government)--has "costs" and is in some sense "risky". Why? What are they thinking of? It remains a mystery to me…
