In a recent talk he gave at the London School of Economics Bernanke basically laid out the thinking behind his monetary strategy with the statement: "Put out the fire first and then think about the fire code." This is code for flood the US economy with dollars and then worry about the inflationary consequences for the country. No wonder he saw nothing wrong with letting the monetary base explode by 107 per cent (from just under one trillion dollars to nearly three trillion dollars) from 8 August last year to 9 January.
It appears that Obama1 thinks that Bernanke is a genius who will save his economic bacon by underwriting his irresponsible spending schemes. According to this story line the banks will start running down their excess reserves, the economy will begin to recover and unemployment will fall: revenues will rise and Obama's reckless spending binge -- funded in part by severe cuts to the nation's defence's -- will be kept afloat.
But what about inflationary pressure from Bernanke's reckless monetary policy? No problem. As inflation begins to accelerate he will slow it down by gradually withdrawing money from the economy by selling Treasury bonds. Moreover, this monetary tactic will have little or no effect -- so they think -- on the dollar. In their eyes the US will remain a save haven for foreign investors. Hence this 'defensive' demand for dollars will act as a barrier to a significant devaluation. In addition, countries with large dollar balances -- think China with its trillions in greenbacks -- will not be eager to drive down the value of their 'fixed' dollar assets by dumping greenbacks. How wonderfully ingenious! Obama gets the best of both worlds and a second term. Best of all, the Democrats get a permanent majority.
There is just one problem. There is no way this scheme can possibly work. What it does stand a good chance of doing, however, is wreaking absolute havoc with the economy and exchange rates. The fundamental problem is that as a true believer in the Keynesian cult Bernanke has no real understanding of money, and certainly no grasp of capital theory.
Let us assume that all goes -- at least initially -- as hoped and that the banks start lending and business starts borrowing. The banking system operates on a 10 per cent required reserve ratio. What this means is that even if only half of the newly expanded monetary base was fully loaned out this would increase the money supply by about four trillion dollars. In other words, the monetary base is so huge -- thanks to Bernanke -- that running down excess reserves by a comparatively small amount could lead to a massive credit expansion.
(It needs to be stressed at this point that neither Obama nor Bernanke are relying on the so-called stimulus to rescue the economy. Obama's big spending program2 is intended to entrench big government behind the smoke screen he calls a stimulus while Bernanke's monetary shenanigans are meant to be the real driving force behind economic recovery).
The fatal flaw in this monetary scheme is Bernanke's failure to understand that money is not neutral. He, along with virtually all other economists, assume, tacitly or otherwise, that the money supply affects only the level of prices while individual prices are determined by the forces of supply and demand. As such, it is not possible for monetary expansion to create malinvestments that will have to be liquidated at a later date.
The concept of neutral money is another dangerous fallacy and one for which America is currently paying a high price. Money enters the economy at various points where it then raises the demand for goods. The result of this demand ripples out to the rest of the economy. By this means those who receive the new money first are the winners. The last ones to get the money are the losers. This is called the "Cantillon effect"3. If the new money enters the economy through the capital market due to interest rates being forced below their market clear rates then the demand for capital goods will be disproportionally increased. We call this the "Wicksell effect".
The result is that a boom is triggered, the higher stages of production are over-extended, malinvestments are created, the boom comes to an end, unemployment rises and malinvestments emerge in the form of idle capacity. This is a brief sketch of the classic boom-bust cycle.
Should all of the new money enter the economy at the lower stages of production consumption will be greatly increased at the expense of the higher stages of production where the marginal productivity of labour is invariably higher because of the ratio of capital to labour. The result is that investment moves into the lower stages of production where investments tend to be less time consuming and hence labour productivity is lower, meaning real wages would have to fall.
Therefore it does not matter at which points Bernanke injects new money into the economy because his injections will immediately act to distort the nation's production structure. The larger the injections and the longer they continue the larger will be the distortions. Now these injections are like a monetary magnet in that they continue to attract resources. Because of the nature of inflation these expanded economic activities will require more and more money to maintain themselves. In addition, the monetary expansion will eventually fuel further rises in domestic prices as aggregate monetary demand rises.
Should some clever little central banker get it into his head that he can control the situation by simply slowing down the rate at which the new money is injected into these economic activities he will find himself sorely frustrated. As soon as he tries it economic activity will begin to slow, output will fall and unemployment will rise. This will happen as surely as night follows day. But this is the good news. The monetary injections will have raised nominal incomes which in turn will raise the demand for imports and exert a downward pressure on the dollars
With surging prices at home and a depreciating exchange rate foreign holders of greenbacks might just decide that they have had enough and start a run on the currency by dumping their dollar balances forcing the fed to raise interest rates and trigger a recession. If you think this is pretty ugly, then it is my melancholy duty to inform you that there is even worse to come.
Fed figures reveal that in the first quarter of 1980 "household debt service payments and financial obligations as a percentage of disposable personal income" was 15.9 per cent. This figure had risen to 19.05 in the third quarter of 2008. There is no doubt that the US has been on a massive borrowing binge, one that was fuelled by the fed's irresponsible monetary policy. (It only has two monetary stances: tight and loose with loose being the norm. From October 1997 to January 2009 it expanded the money supply by about 120 per cent4). This suggests that the rise in interest rates would also set off a financial bloodbath among debtors.
And why would America be in this mess? Because Bernanke designed a Machiavellian monetary policy intended to support Obama's fanatical worship of Big Government.
1. Obama is so ignorant of the economic history of the 1930s that he really believes that Roosevelt's "initial steps did actually work". The problem, according this great economic historian, is that Roosevelt went for "a balanced budget, and then what you had was a recession within a depression." Pure unadulterated drivel by a complete economic ignoramus. (see here and here) This is so bad he must be getting it from Krugman -- or should that be Bernanke?
2. A great many Americans are beginning to wake up to the fact that Obama conned them. This spending package is the bigest barrel of pork in American history and is part of a strategy to make the Democrats a permanent majority in government. By the time this lot got throught with economy Argentina would look like an economic miracle in comparison.
3. This problem was heavily discussed during the Bullion Controversy that Walter Boyd's open letter to Prime Minister Pitt started in 1801. It's a great pity that the world's central bankers are completely ignorant of this extremely important episode in the history of economic thought.
4. Austrian definition of the money supply: Cash, demand deposits with commercial banks, and thrift institutions, government deposits with banks and the central bank.
