Late in the fall of 2010—with the unemployment rate near 10 percent and the inflation rate at one percent—Kevin Warsh stood before the annual meeting of the Securities Industry and Financial Markets Association to critique the Federal Reserve’s bold and controversial steps for boosting the economy. The economy’s true ills were structural, Warsh argued. In his view, the Federal Reserve’s actions could paper over these deep problems, but do little to change the trajectory of the economy, aside from increasing the level of inflation. Contrary to Warsh’s warning, the Federal Reserve went ahead with its plan. Today the unemployment rate is at 4.3 percent, and inflation is still below the Federal Reserve’s target of 2 percent.
This misjudgement goes beyond a simple policy error. Even the best policy makers make mistakes. Warsh’s error, however, was indicative of a broader mindset, one that has had devastating macroeconomic implications. As it turns out, both the Eurozone and the United States had unemployment rates near 10 percent in November of 2010. Citing concerns very similar to Warsh’s, the European Central Bank decided not pursue quantitative easing type measures, and instead used its influence to push through fiscal austerity and structural reforms. The result was disastrous. By 2013, the Eurozone unemployment rate had climbed to 12 percent, while the U.S. was at 8 percent and slowly but steadily on the path to recovery.
When the Japanese stock market and real estate bubble crashed in 1991, the economy entered a long recession and weak recovery reminiscent to the U.S. and European experiences after 2008. The Bank of Japan likewise cited structural impediments to growth. Ben Bernanke, then a professor at Princeton, criticized the Bank of Japan for a “self-induced paralysis” and “the unwillingness of monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work.”
As fortune would have it, when the global financial crisis struck in 2008, Bernanke was Chairman of the U.S. Federal Reserve. Despite criticism both inside and outside of the Fed, most notably from Wall Street, Bernanke was not content to blame the crisis on structural factors. Instead, he adopted an extraordinary range of atypical monetary policy devices to battle the crisis.
Warsh was a critic of these measures, according to the Fed transcript:
The path that you’re leading us to, Mr. Chairman, is not my preferred path forward….I can think, Mr. Chairman, of a tough weekend that the Europeans had, particularly your counterpart at the ECB,…But [your counterpart] did not take action until very late that Sunday night, until the fiscal authorities did their part. ….He chose to wait. I think we would be far better off waiting.
Since he has left the Fed, Warsh has continued this line of criticism in the face of the overwhelming success of Bernanke and his successor Janet Yellen. Unemployment is near record lows, the economy completed a record string of job gains, and has avoided the lost decade that both the Eurozone and Japan experienced during the same and a previous crises, respectively.
The U.S. economy has steadily improved, but it is not out of the woods completely. While the economy has had an impressive run of jobs gains, the combination of low interest rates and low inflation leave it vulnerable to the same type of trap that it faced after the global financial crisis.
Should we face a major shock — a banking crash or sustained spike in oil prices — we may be forced to return to the type of creative measures that Bernanke used to guide the economy out of the last downturn. We will need a Federal Reserve Chair who has the judgment to know which levers to pull, and a commitment to aggressively pursue the Fed’s legal mandates. Given his record during the last crisis and his unwillingness to recognize his mistakes, Warsh’s nomination would leave us more exposed to a lost decade. That is a risk the U.S. economy cannot afford.