Ben Bernanke on the Transmission Mechanism

     Marcus Nunes had this link at his site of a paper Bernanke wrote way back in 1989. He discusses the transmission mechanism. Recently Sumner revealed that-we shouldn't waste our time on the transmission mechanism as it is too hard to figure it out and doesn't matter anyway. Bernanke here feels differently and at least has a theory. Scott certainly doesn't win points for curiosity in any event.

       For Marcus' post please see

     http://thefaintofheart.wordpress.com/author/jmarcusnunes/

      For Bernanke

      http://www.philadelphiafed.org/research-and-data/publications/business-review/1988/brnd88bb.pdf


     It is an old paper and the text is pretty sketchy, so I am stuck having to copy it here by hand. However listen to how Bernanke begins the paper:

     "Federal Reserve actions seem to have important effects on the macroeconomy, but precisely why is one of the most poorly understood and contentious issues in economics."

      Right there I have to give him some credit. I mean here he is a monetary academic his whole life but he at least admits this. Sumner in a way admits it too by throwing up his hands and saying, "I don;t know but it's too hard and doesn't mattter anyway."

      It's hard to understand that amount of lack in intellectual curiosity. Bernanke takes issue with the conventional "money view" of monetary transmission to the "credit view." At least it's a different approach. No it doesn't make it right necessarily. The "money view" that Bernanke describes here is very recognizable:

     "The prevailing economic wisdom traces out the following  "monetary transmission mechanism": 1) the Fed adds reserves to the banking system; 2) banks create more money; 3) the added liquidity reduces market interest rates; and 4) the lower market rates and greater liquidity encourage new spending. This chain of reasoning has led to the popular focus on the money supply and market interest rates as indicators of Fed policy. But this standard "money view" has proven misleading on occasion, and recently some economists have begun to take a different perspective on how policy works."

     Basically he is not denying the money view wholly but suggesting that maybe it can't take all the credit. I find this of interest largely as there have been so much debate about the efficacy and appropriateness of fiscal vs. monetary policy as a tool to fight recessions. The money view clearly has some holes. Whether or not the credit view solves it is another thing-certainly far from entirely.

     For more on Beranke's views of the transmission mechanism, and more broadly, the evolution of the transmission mechanism in US monetary history see

     http://research.economics.unsw.edu.au/jmorley/emt.pdf

    Indeed it could be argued that Bernanke's own credit view hasn't served us so well during this recession. Arguably he was too quick to want to return to the credit bull market whereas certain changes needed to be made and the financial system needed to be modified and strengthened.

   So the search for the elusive transmission mechanism lives on. I have recently offered my view about what monetary policy is largely. It seems to me from reading Minsky's 1986 book on instability that it's accurate to say that fiscal policy and monetary policy should be seen as two different types of medicine-monetary policy is largely about the financial economy whereas fiscal policy is about the real economy. This doesn't mean that monetary policy doesn't matter-without a healthy financial sector the economy's ability to grow and create wealth would be greatly retarded.

   However, it does mean that there are some jobs more appropriate to one, other jobs for the other. If you want to create jobs monetary policy is a fairly awkward and groping tool. On the other hand to provide the banks with stability and protect against the kind of bank panics that were epidemic prior to the Federal Reserve Act monetary policy is very effective. In that sense Bernanke was correct to use a lot of firepower to avoid the destruction of the financial sector, however it's arguable that some of the tools he chose were mistaken.

   The best that can be said is that we did better than Europe which practiced fiscal austerity and tremendous cautiousness in monetary policy even going as far as raising rates last year.