We Can't Rely On the Fed to Rescue Us

Pity Fed Chairman Ben Bernanke. With U.S. and global growth slowing, all eyes are on next week's meeting of the Federal Reserve's policy committee. On Wednesday, the New York Times devoted its lead, page one story to nudging the Fed towards pumping more money into the banking system.

The Bernanke Fed, divided between hawks and doves, is in an unusually awkward situation. With a presidential election campaign under way, it does not want to appear to be tilting towards re-election of President Obama by pumping out liquidity. But, as the Times notes in a story that appears to be informed by Bernanke himself, sentiment is growing within the Fed for more stimulus.

The markets speculate: Will Bernanke lead the Federal Open Market Committee (probably on a divided vote) to a decision to buy more bonds, in the hope that a further diminution of already record-low interest rates will have a tonic effect on spending? Would such action have any palpable effect on the economy after QE1, QE2, and Operation Twist? Probably not.

Bernanke is like the mythical Atlas. With fiscal stimulus off the table in a divided Congress, the uncertainty of tax hikes next year, and burdensome regulations discouraging investment, the Fed chairman appears to be holding up the U.S. economy just as Atlas supported the world on his shoulders.

Meanwhile, Congress and the administration are doing nothing to help him. Worse, they are being counterproductive.

Those who lobby the Fed to pump more high-powered dollars into the banking system (money the central bank lawfully creates) fail to recognize that borrowing costs are already at record lows, and that more liquidity is unlikely to impart more impetus to the sluggish recovery.

The Fed is charged by law with maintaining price stability. Fed hawks, chiefly presidents of the regional Federal Reserve banks, worry that more liquidity will sow the seeds of faster, future, inflation. On the other hand, some liberals, such as New York Times columnist Paul Krugman, advocate higher inflation.

Congress and the president should not count on the Fed to bail them out of their mistakes. And, in truth, the White House has not been leaning, publicly, anyway, on the Fed, which is supposed to be politically independent.

Something similar has been going on in Europe, where Spain is in financial crisis, as are Greece and Italy. Even France is starting to catch the euro flu.

Policymakers are counting on the European Central Bank to keep the euro, the 17-country common currency, from fragmenting and imploding. The European Central Bank's refinancing rate is at 0.75 percent, the deposit rate is at zero.

The ECB has a Herculean task. In Spain, eagerly waiting for promised bailout loans to commercial banks staggering under losses from real-estate loans, yields on the government's 10-year bonds were just below 7.5 percent on Wednesday, down from their highs of 7.70 percent.

Spanish yields fell on the latest rumor that the European Stability Mechanism, a bailout fund, may be given a banking license to enable it to expand lending. But European countries continue to pursue policies that stunt growth, praying that Germany, the EU's biggest economy, will somehow come to their rescue.

What can individual countries do?

Let's start with America, which could fall off a fiscal cliff in 2013. If Congress does nothing, federal income taxes on wage and salary earnings will rise on January 1 in all income brackets, from 10 percent to 15 percent in the lowest tax bracket, and from 35 percent to about 42 percent at the top. Taxes will rise from 15 percent to 25 percent on long-term capital gains and from 15 percent to up to 44 percent on dividends.

The nonpartisan Congressional Budget Office has estimated that the effects of the tax increases and automatic spending cuts-10 percent from defense and discretionary spending-would induce a mild recession, reducing job creation by 1.25 million in 2013.

Congress has known since the Bush tax cuts were extended for two years in December 2010 that this day was coming. It could have considered the Simpson-Bowles recommendations, or some variation, and passed them. Or it could have considered the recommendations from other groups, such as the Debt Reduction Task Force of the Bipartisan Policy Center.

Nevertheless, the Democratic Senate failed to pass any tax reform or cuts in discretionary spending or long-term entitlements, even though bills were passed by the Republican House of Representatives. Nothing will be done before November 6.

Hence, the logical path for Congress to take would be to extend current tax rates for another year and allow the next Congress to undertake fundamental tax reform. That would stop the economy from going into a recession now.

That is the Republican proposal. Mr. Obama, with an eye on the masses, insists, as he did for a while in 2010, that Congress should let tax rates rise for those with incomes of $250,000 or more. Such a bill was voted out of the Democratic Senate on Wednesday. But the Republican House objects to raising taxes because of the negative effects on economic growth.

Bank of America's chief economist Mickey Levy told a conference at the American Enterprise Institute on July 19 that Europe could be doing more to help itself. Its austerity measures have primarily taken the form of tax increases, rather than cuts in government spending. This is slowing European growth.

Moreover, some European countries could begin to dismantle their convoluted labor regulations, which discourage anyone from being hired. Germany did this several years ago, and now has one of the lowest unemployment rates in Europe, 5.6 percent. In contrast, Italy, Spain, and France impose substantial costs on hiring. Italy and France have unemployment rates of 10 percent, and Spain's is at 25 percent.

Consider Italy's labor laws, described in detail by The Wall Street Journal on June 25. They discourage hiring. Once an employer has more than 10 employees, he must submit to the government a list of every health and safety hazard his employees might encounter, along with remedies.

After 15 employees, but not before, the company can be unionized, with union representatives entitled to a day's paid leave each month for union responsibilities. The 16th worker has to be handicapped, and, with 50 workers, 7 percent of the workforce has to be handicapped in some way.

Mr. Levy suggested that Europe could overcome its problems if it streamlined its regulations on labor and business. Now, entrepreneurship is discouraged, it's hard to start a business, it's hard to innovate. These European-style regulations have parallels in the United States, and Congress and the administration are oblivious to the harm they have on the economy.

It's clear that political difficulties in Europe and in America are stifling economic growth. So, people turn to central banks, hoping that by printing money they will paper over the problems long enough for another set of politicians to exert more responsible leadership.

But central banks are unable to help in the face of persistently flawed economic policies. Both in the United States and in Europe, we cannot rely on them for economic rescue.