In Hindsight Bernanke Was Prophetic in 2002

Thursday, December 18, 2008

Federal Reserve chairman Ben "Printing Press" Bernanke and his fellows around the FOMC oak table may appear being behind the curve since the onset of the debt crisis in August 2007. Its erratic rate policy rather followed loud calls from Wall Street pundits, establishing such nicknames like Nanny Benny or even Ben Dover.
But one has to wonder whether the Fed has really been all that clueless about the disastrous implications of a property market gone white hot, fuelled by cheap credit and next to no loan requirements.
Re-reading Bernanke's most infamous speech titled "Deflation: Making Sure 'It' Doesn't Happen Here" from November 2002 I am surprised that Bernanke had been actually quite prophetic about the future policy of the Fed.
Bernanke tabled already then the idea that the Fed could become a participant in the commercial paper market, buy long term US Treasuries and distribute government money willy-nilly (stimulus checks.)
At the same time he also touched the issue of zero interest rate policy (ZIRP), saying that the Fed could manipulate the long end of the market in order to keep financing costs low.
Bernanke has certainly made good on its promise to prevent deflation, continuing the easy money policy his predecessor Alan Greenspan had conducted in order to prevent all possible market meltdowns that came along. From the Black Monday '87, the mini crash '89, the Asian currency crisis in the mid 1990s, Long Term Capital Management in 1999, to the bubble in 2000 and the property bubble in this millennium the Fed has always thrown fresh credit at every problem that came along.
Read the following excerpts from Bernanke's speech that established his image of an inflationista and earned him the nicknames "Helicopter Bernanke" and "Ben electronic printing press Bernanke."
On deflation and zero interest rate policy:
...a deflationary recession may differ in one respect from "normal" recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero. Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the "zero bound."
...Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern--the limitation that it places on conventional monetary policy. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate--the overnight federal funds rate in the United States--and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.
Running Out Of Ammunition
Bernanke then also admitted that a ZIRP diminishes the arsenal of weapons the Fed has. Now they boast of unspecified tools ready to direct interest rates.
Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory.
...However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.
Preventing deflation:
Suffering from deflation phobia Bernanke then relied on the Fed's supervisionary powers in order to stabilize financial markets.
The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. And at times of extreme threat to financial stability, the Federal Reserve stands ready to use the discount window and other tools to protect the financial system, as it did during the 1987 stock market crash and the September 11, 2001, terrorist attacks.
Well, this obviously did not work in the current crisis where supervisors and authorities sat on their ears, eyes wide shut.
Curing Deflation:
Being by now the absolute high priest of ever expanding credit Bernanke sees his main task in growing debts to combat the ghosts of deflation.
...under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.
In order to keep the party fuelled by spending going Bernanke mainly wants to push aggregate demand.
To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities.
On fiat money and gold:
Ironically Ben's most immortal quotes about helicopters and the electronic printing press are linked in context with the virtue of gold, which is in contrast to Federal Reserve Notes (FRN).
Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
This may be the shortfall in Bernanke's thinking which is fixated on creating new credit. But growing government expenditures are certainly not the way to erode America's mountain of debt.
Oh, and for the record, here again Ben's helicopter quote, where he referred to Milton Friedman's helicopter drop in order to keep the economy going.
A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.
Still any doubts that Bernanke will ultimately be the death knell of the Fed, having created hyper inflation instead?


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