Bernanke's Bum Rap: Why a Little Inflation Is Good

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Jim Young / Reuters

Federal Reserve Chairman Ben Bernanke

The knives are out for Federal Reserve Chairman Ben Bernanke and QE2, his new effort to pump $600 billion into the stagnant economy through an obscure procedure called quantitative easing. After an unprecedented barrage of activity that helped prevent a depression and made him TIME's Person of the Year for 2009, followed by an unusual stretch of inactivity while the recovery stalled in 2010, he's printing money again. And outraged critics in the U.S. and abroad are predicting that his aggressive plan will boost inflation, weaken the dollar and "monetize the debt."

Well, yeah, but only if it works.

Bernanke doesn't quite put it that way, because of the strange conventions requiring American policymakers to pretend that inflation is always evil, a strong dollar is always desirable, and using monetary policy to reduce the impact of our national debt is always unthinkable. Yet these conventions, presumably designed to reassure markets, end up making the Fed even more incomprehensible to nonexperts and even more exploitable by demagogues. The next thing you know, Sarah Palin — who was clueless about the functions of the Fed when she was nominated for the vice presidency, according to the book Game Change — is publicly demanding that Bernanke "cease and desist" with QE2.

"We shouldn't be playing around with inflation," Palin said in a speech last week in Phoenix. "It's not for nothing Reagan called it 'as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.'"

That's because inflation was a crippling 12.5% when Reagan took office. It was a manageable 4.4% when he left. Today it's a negligible 1.2%, as violent as a violin, as frightening as a feather, as deadly as a dachshund. The Fed has a dual mandate to fight inflation and maximize employment, and right now, it's winning the fight against inflation while getting creamed by unemployment. This is why dovish critics — led by New York Times columnist and Nobel-laureate economist Paul Krugman, who is considerably better informed than Palin, although equally shrill — are taking the opposite stance, blasting Bernanke's QE2 as unconscionably late and overly timid.

Inflation has become a dirty word, and the term inflation fighter has taken on superhero connotations, so it's easy to forget that inflation has its pros and cons. When prices are rising, money is worth less today than it was yesterday; that's bad for lenders, who get repaid with less valuable currency; for savers, whose money loses buying power; and often for ordinary workers, when their wages rise more slowly than the prices do for the stuff they need to buy. But it's good for borrowers, including mortgage holders, credit-card holders and, yes, the Treasury — a multitrillion-dollar debt is less damaging when a trillion dollars is worth less than it used to be. Inflation can also juice the economy by encouraging spending, hiring and investing since families and businesses have less incentive to hoard cash. And while it's true that inflation by definition weakens the dollar, which sounds awful (and actually is awful for importers who want to buy foreign goods), a weak dollar is good news for U.S. exporters whose products become more attractive to foreign buyers. If you want awful, try an extended period of deflation; our last one was called the Great Depression, and Bernanke has dedicated his career to preventing a recurrence.

Right now, unemployment is a staggering 9.6%, while inflation and inflation expectations remain unusually low. Ordinarily, the obvious Fed policy response would be to step on the monetary gas by lowering interest rates, but the Fed already lowered interest rates as low as they could go in December 2008. And in order to fend off a full-fledged Depression, Bernanke continued to jam on the accelerator with an initial round of quantitative easing, buying $1.7 trillion worth of mortgage-backed securities and Treasury bonds. The action bloated the Fed's balance sheet to unheard-of proportions, and Bernanke then made it abundantly clear that he was extremely reluctant to give any additional gas and looked forward to the day the economy had recovered enough to apply the brakes.

That's because another downside to modest inflation is the possibility that it could spiral out of control. To some inflation hawks, America is always on the brink of becoming Zimbabwe or Weimar Germany, the dollar is perpetually on the edge of collapse, and Chinese investors are forever poised to abandon U.S. treasuries. So far, they've been wrong, and inflation doves like Krugman who have clamored for additional action have battered them with I-told-you-so comments. But markets are a confidence game, so there are genuine risks to inflationary policies. And it's not clear that blasting more money into the banking system will have the desired effect of stimulating loans and economic activity. The system is already quite liquid, and Bernanke has suggested that pouring in more cash could be like pushing on a string.

Nevertheless, as the recovery has sputtered and Americans have suffered, the case for action to prevent a Japan-style lost decade has become more compelling to Bernanke. On cue, the hawks are raging at Helicopter Ben. So are German and Chinese officials who like it when their exports are cheap and American exports are expensive. And so are political opportunists with an interest in economic stagnation continuing through 2012. "We don't want temporary, artificial economic growth bought at the expense of permanently higher inflation," Palin said in her speech.

Actually, a little economic growth that puts people to work would be helpful, and there's no reason it would have to be temporary. A little inflation to lure money out of bank vaults would be helpful, too, and there's no reason it would have to be permanent. Bernanke has proven that the Fed can adapt when circumstances change. Today, the problem is unemployment, and QE2 is a way to fight that. If tomorrow the problem is inflation, there are ways to fight that too.