Since folks have asked my thoughts (you had to ask?) on the Krugman-Bernanke debate, I will throw in my two cents. The question at hand is whether the Fed can plausible generate more inflation, and thereby lower real interest rates and reduce the unemployment rate by announcing a commitment to higher inflation rate over the near future. This could mean, for example, committing itself to 4 percent inflation over the next 5 years.
If this policy was successful, it would lead to lower real interest rates, which would in turn lead to more consumption and investment. Ideally we would also see a decline in th real value of the dollar, leading to more net exports, the essential long-term path to full employment.
My view is that this path would likely be successful, if the Fed were really committed to it. That means continually buying up vast amounts of assets if the inflation rate did not appear to be rising. This should ultimately freak enough investor types into thinking that Bernanke was sufficiently nuts that he could cause inflation. They would then hedge themselves against this risk by buying up all sorts of commodities to protect against inflation, which would then lead to inflation.
That looks like a pretty compelling story to me, but perhaps at least as important, I don't see the downside. Bernanke's obsession with the Fed's inflation fighting credibility (like the ECB's) is really pathetic. How much is this worth when you just wrecked an economy with your incompetence in protecting against asset bubbles?
Other things equal, it is better to have central banks that have some credibility in fighting inflation, but how does this compare against tens of millions of people in the U.S. and euro zone being unemployed? If the latter is such a small matter, would the inflation fighters volunteer to surrender their jobs so that some of the unemployed can work?
Finally, if buying up tons of assets will not cause inflation, then there is definitely no excuse not to do it. The Fed can hold $10 trillion in assets and pay the interest to the Treasury each year. Currently it is refunding about $80 billion a year to the Treasury from its interest in assets.
Suppose this was instead $400 billion a year or $4 trillion over a decade? That should make even the most ardent deficit hawk happy. There would be no deficit problem in that story, which would mean that we can freely spend on all sorts of things that can boost growth and help people. Tell me again that story about Fed credibility?
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