08/05/2012 07:14 pm ET Updated Oct 05, 2012

Don't Blame Bernanke

Let's not expect central bankers to bail out the continuing economic mess. That's not who they are, and cheap money can only do so much to levitate a deflated economy.

This past week, Mario Draghi, president of the European Central Bank, said that he would not in fact do "whatever it takes," as he had pledged a week ago Thursday, to save the euro and the European economy. After Draghi floated a commitment buying more government bonds without demanding rigid austerity policies in return, his trial balloon was shot down by Jens Weidmann, president of the German Bundesbank. Draghi will remain captive to the budget hawks led by the Germans who are keeping Europe depressed.

Here in the U.S., the policy-setting Open Market Committee of the Federal Reserve met on Wednesday and decided against taking any further action for now. Financial commentators clucked that the Fed perhaps should have done more.

But, face it, there is not much more that that the Fed can do, and we should not expect it to perform miracles. Interest rates are already at record lows, and that is not enough to revive an economy suffering from the aftermath of a financial collapse. After the crash of 1929, critics called the fantasy that cheap money alone could rescue a deflated economy "pushing on a string."

Today, consumer demand is deflated by high unemployment, low wages, and diminished capacity to borrow. Growth slowed to an annual rate of just 1.5 percent in the first half of 2012.

Banks are willing to lend only to their best customers. Corporate America is sitting on nearly two trillion dollars that corporations won't invest because they don't see demand for their products.

Homeowners are out several trillion dollars in net worth because of the housing bust. Wage earners, who supported economic growth in the 1990s and early 2000s by borrowing against their homes, have less to borrow against, and have been paying down debt.

In these circumstances, interest rates could be zero, and it wouldn't provide enough stimulus.

Government needs to do two things that neither Democrats nor Republicans have been willing to do.

First, we need a massive program of mortgage refinance, not just for borrowers with plenty of equity (who have been refinancing) but for underwater homeowners with negative equity.

The administration has been unwilling to embrace such a strategy for fear of the impact on bank balance sheets. However the Treasury has supported the idea of Fannie Mae and Freddie Mac supporting more refinancings. But Ed DeMarco, head of the agency that regulates Fannie and Freddie has opposed the idea. DeMarco's own agency thinks the approach would be helpful.

DeMarco's stance makes no sense. He is acting head of the Federal Housing Finance Agency, and he is not a policymaker. Obama should begin the shift to a far more aggressive program of mortgage refinance by firing DeMarco.

But even with more robust efforts to deal with the overhang of excessive mortgage debt and depressed housing prices, the economy will still be stuck in a hole.

We need massive public investment on a scale that is far outside mainstream debate. How massive?

It took World War II to cure the Great Depression, and during the war the government ran deficits averaging 25 percent of GDP for four straight years.

Government also had high surtaxes on the wealthy, with top rates of 91 percent. It turned around and spent and invested that money. The war restored the productive capacity of America, put fifteen million people to work, and restored household purchasing power -- even though most of that production was blown up.

If you watched any of the PBS encore broadcast of the Ken Burns documentary, The War, this past week, you have some sense of what kind of a production machine can be energized by government contracts in the face of a depressed economy.

There is so much that we could spend that money on -- energy self sufficiency, infrastructure, a smart electrical grid, public transportation, better education at all levels -- all of which would not only create economic activity and jobs, but would make for a more productive economy.

But nothing like this is part of the mainstream conversation. If you propose this sort of thing, you are packed off to the Museum of Un-reconstructed Keynesians. White House economists quietly admit that you are right, but you are politically radioactive (even with a Nobel Prize.)

Though President Obama strikes the right rhetorical notes, the actual budget debate is the Republicans demanding that we cut more while the Democrats respond that we should cut a little less. Nobody is declaring that only massive public investment will cure the shortfall in private purchasing power.

And so we will continue with growth depressed, and unemployment stuck above 8 percent, with some slightly better months of job growth like July, and some worse ones like April, May, and June.

Despite this feeble performance, President Obama may get re-elected, thanks to the reliable ineptitude of Mitt Romney. Unless Obama's feistier campaign performance translates to a Democratic Congress and a much bolder recovery program, Obama's second term will be a time of continuing economic frustrations.

By opening the monetary floodgates, Fed Chairman Ben Bernanke helped save the economy from a second Great Depression; and for this he deserves our thanks. But what we have now is a prolonged Lesser Depression that the Federal Reserve can't cure.

Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos. His latest book is A Presidency in Peril.