…our current fiscal policy has the potential to make it much more difficult for the Fed to carry out its job. Senator Chuck Schumer (D-NY) recently expressed his enthusiastic support for Bernanke on the expectation that Bernanke would speak out about the need to reduce deficits. Indeed I think Bernanke will do so. But one can speak about the need to reduce deficits (something on which I would like to see both parties come to an agreement) without taking a stand on exactly how that should be done (something on which feathers in the political fight will continue to fly). If Bernanke does speak up on deficits in this limited, bipartisan way, the influence of the Fed Chair’s tongue could grow even greater and the deficit problem might be raised front and center.
I think Bernanke should tread very carefully. The danger comes if Bernanke signals a problem and nothing good happens in response. That would make it clear that matters will get worse.
True, you cannot fool markets forever. But if we cannot get out of our current fiscal mess, I don’t want markets to learn that all at once. I don’t want markets to learn — again all at once — that our very bright Fed chair is ineffective and that no one in the administration is listening.
Bernanke needs to signal concern about the deficit in exactly the right way. Ex post, he needs plausible deniability about having complained too loudly. Ex ante, he needs to signal he is complaining. (That’s a tough combination, eh?) Too much squawking, too soon, would be a mistake. Instead he should play the chess strategy — "The threat is stronger than the execution" — and over time subtly shift the rhetorical bargaining power in Washington toward fiscal sanity. A "do or die" stance won’t turn out well when the Administration cannot coordinate with an increasingly rebellious Congress, and that is assuming the Administration wants to do something good in response. Finally people who play "showdown" or "chicken" with the Bush Administration don’t, er, always come out so well…