The Policy Response To The New Depression – Highly Recommended

Below, please find the last chapter of the paperback version of my first book, The Dollar Crisis.  It was written in December 2004, four years before the beginning of the global economic crisis and the launch of Quantitative Easing.

THE DOLLAR CRISIS:  Chapter 20

BERNANKEISM

ANTICIPATING THE POLICY RESPONSE TO DEFLATION

The Fed would already be faced with its worst nightmare, deflation in the United States, had the price of oil not risen above $50 a barrel following the US invasion of Iraq. Globalization is exerting tremendous downward pressure on the US cost structure that can only intensify in the years ahead as service sector jobs follow manufacturing jobs offshore. A correction in the US current account deficit will cause the floor to drop out from under global prices and threaten the world with a 1930s style deflationary depression. The following paragraphs will consider how policy makers in the United States are likely to respond to that event.

America’s free trade policy, which it has pursued for decades, is obviously flawed. Free trade between countries with enormous wage rate differentials and within an international monetary system entirely lacking in any mechanism to prevent large-scale, persistent trade imbalances is untenable. However, US policy makers are afflicted by the collective hypnosis of conventional wisdom which has taught them that free trade is good and must always be good under any and all circumstances. It is anyone’s guess as to how much longer those in charge of economic policy in the US will cling on to this strange idea.

Meanwhile, it is almost certain that they will respond to the approaching crisis by applying the two great economic policy tools of the last century: Keynesianism and Monetarism. The abuse of those tools will prolong and exacerbate the death throes of the Dollar Standard.

The first recourse will be to employ more fiscal stimulus. With prices falling and in light of the extraordinary amount of paper money that has been created in recent years, interest rates will be very low and there will be little difficulty in paying interest on a much larger amount of government debt. It would not be surprising to see the US budget deficit surpass one trillion dollars by 2007 or 2008 if the US current account has come down significantly by that time.

If, at that point, the US current account deficit has been reduced, foreign central banks would not have a sufficient inflow of dollars to finance such a large deterioration in the US budget deficit, even assuming that Fannie and Freddie have ceased issuing any new, competing, debt of their own.

The Fed, however, as Governor Bernanke explained, has already put considerable thought into how to deal with such a contingency and stands ready, in Bernanke’s opinion, to support “a broad-based tax cut” through “a program of open-market purchases to alleviate any tendency for interest rates to rise”.

How long could such “cooperation between the monetary and fiscal authorities” underpin the global economy?   For quite a number of years most probably. Economic trends play themselves out over very long periods of time. Moreover, US policy makers will use every last tool at their disposal to prevent, or, at least, delay a global depression. An economic system underpinned by large scale fiscal stimulus financed by central bank monetization of government debt could hardly be described as capitalism (perhaps the term Bernankeism would be appropriate) but, with any luck, it could stave off disaster for a considerable length of time.

Nevertheless, despite the best efforts of policy makers to keep the Dollar Standard alive and to stave off the depression that would most probably follow its collapse, ultimately, one of the following scenarios is likely to overwhelm even Bernankeism.

  1. A protectionist backlash against free trade, resulting in a trade war similar to that which occurred during the Great Depression.
  2. A US asset price bubble (as interest rates fall toward zero), that drives property prices so high that they can’t be financed even at very low interest rates. This is similar to what occurred in Japan at the end of the 1980s.
  3. A meltdown of the under-regulated $200 trillion derivatives market. $200 trillion is roughly six times global GDP.
  4. The loss of nerve on the part of policy makers that deters them from undertaking ever more unorthodox economic policies, resulting in a “deer in the headlights” kind of policy freeze.
  5. A decline in interest rates to zero percent or very near zero percent as in Japan at present.

Any one of the first four scenarios could undermine the Dollar Standard, but the final scenario, where interest rates fall very near zero percent, would certainly deal it a fatal blow. From that point, the only option left to stimulate aggregate demand would be to drop paper money from helicopters. That too would fail, however, for who would accept paper dropped from helicopters in exchange for real goods and services? Hyperinflations would quickly set in. Economic transactions would then be conducted through barter rather than via the medium of a debased script. Eventually, a gold standard would reemerge.

Exactly how these events will unfold is impossible to forecast, nevertheless, the eventual outcome is within sight. The Dollar Standard is inherently flawed and increasingly unstable. Its demise is imminent. The only question is will it be death by fire—hyperinflation—or death by ice—deflation? Fortunes will be made and lost depending on the answer to that question.

 

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11 comments

  1. Richhard,

    Twelve years ago you wrote:

    “From that point, the only option left to stimulate aggregate demand would be to drop paper money from helicopters. That too would fail, however, for who would accept paper dropped from helicopters in exchange for real goods and services? Hyperinflation would quickly set in. Economic transactions would then be conducted through barter rather than via the medium of a debased script. Eventually, a gold standard would reemerge.”

    Your accurate predictions are very, very impressive, Richard. From watching Macrowatch and your interviews I assume that you now see helicopter money aimed at technological development such as health, nanotechnology and energy and/or debt forgiveness and cash grants to those without debt to be valid solutions for the advanced economies.

    Am I corrrect?

    1. Thanks Peter!

      When the global economic bubble started to implode in 2008, an extraordinary experiment began (out of necessity to prevent or, at least, delay a new Great Depression. The Fed has printed US$3.6 trillion. Add in the BOJ, the ECB and the BOE, and those four central banks have printed more than US$8.1 trillion. All this money creation certainly created a lot of asset price inflation. That was the goal – to reflate the bubble. QE 2 seemed to cause food prices to spike, but that spike did not last.

      I believe the lesson the central banks have learned from this experiment is that they can finance trillions of dollars of government deficit spending without causing consumer price inflation (since Globalization is so deflationary). That has certainly been true for the last eight years. Therefore, they would like for the governments to borrow and spend more to generate higher rates of economic growth. That is what they are encouraging the governments to do.

      The central banks don’t want to drop money from helicopters directly down to the people on the ground because most of those people would just blow the money buying consumer goods made in China. Instead, the central banks would like to print money and give it to the governments to invest in infrastructure and research. I agree that that is the right approach.

      So, yes, your statement above is correct except for the part about “debt forgiveness and cash grants to those without debt”. I am not in favor of debt forgiveness or cash grants to individuals.

      Thanks for the question.

      Richard

  2. Richard,

    Very prescient…

    One question:

    In chapter 20 you state “Free trade between countries with enormous wage rate differentials and within an international monetary system entirely lacking in any mechanism to prevent large-scale, persistent trade imbalances is untenable.”

    I also note your thoughts on ‘The Donald’ introducing import tariffs, and the severely negative and immediate impact of same.

    Are the points related? Or do you think that both having (1) no adjustment mechanism and (2) interference of import tariffs, would have negative consequences.

    Keep up the great work,

    All the best
    Roland

    1. Roland, Thanks for the question.

      While the global economic bubble was still forming, it was appropriate to warn that a bubble was taking shape, to describe its causes and to make recommendations about how to prevent it from growing larger. That was pre-crisis. We are now in a different phase.

      In 2008, the bubble nearly imploded, but it was reflated by policymakers. In this post-crisis phase, the correct policy is to keep the bubble reflated until we can figure out a way to grow our way out of the crisis. Trade tariffs now would pop the bubble and send us spiraling into a New Great Depression so severe that our civilization just might not survive it. In this phase, we have to do whatever it takes to keep the global economic bubble inflated.

  3. I am in agreement with the commentator above:
    “From watching Macrowatch and your interviews I assume that you now see helicopter money aimed at technological development such as health, nanotechnology and energy and/or debt forgiveness and cash grants to those without debt to be valid solutions for the advanced…”

    I get the feeling something is happening. Is it helicopter money?

    We’re kinda trying to feel what’s up.

  4. Hi Chris,

    Yes, in effect, helicopter money is already happening. In Japan, Europe and the UK, the governments are borrowing money and spending it; and the central banks are financing the government deficit spending. (The same thing was going on earlier in the US.)

    The public just doesn’t really understand what is happening. And the governments don’t yet fully understand what an opportunity this represents in terms of creating the ability to invest in new infrastructure, invest in new technologies, re-train the work force and restructure the economy – and, to prevent the global economic bubble from imploding into a New Great Depression.

    But, gradually, it seems they are beginning to understand. That’s why more “Helicopter Money” is likely.

  5. Given that 2/3 of the US economy is supposedly consumer driven, and given a great unmet demand for goods and services at the consumer level under the present economic conditions, and overhang of student loan debt due to malinvestment in education by those overly-optimistic about the payback of such spending, can you more fully explain why you would be against debt write-downs or cash assistance to individuals? We have cash assistance to arms manufacturers and their cronies, to whit, the 6+ Trillion missing at the Pentagon, why is corporate welfare okay, but people’s welfare is not? Wouldn’t giving money to people instantly increase the overall velocity, and wouldn’t this be good? Would direct employment for infrastructure improvement be acceptable?

    1. I think investment in new industries and technologies by the government is a better idea than the government handing out cash to people or forgiving student loans. In the latter case, it would just give a one time boost to consumption. After a one year boost to consumption, consumption would drop again and the economy would probably go into recession. Once the money is spent, it’s gone.

      But, if the government invests, it could restructure the economy and generate profits that would repay the initial investment many times over. For example, I’d like to see a cancer “moonshot”. Then, when the government (or the joint venture company it funds and sets up with the private sector) finds the cure for cancer, that company could be listed on the stock market for $10 trillion dollars. That money could be used to pay down the national debt. And, we would have a cure for cancer.

      Thanks for the question.

  6. I noticed today during the Clinton/Trump debate today that no one was talking about reshoring– this was the idea a few years back that companies were returning production from China back to the US and Canada. (Many commentators in Canada picked up this thread) The idea was popular at the time and a lot of the big accountancy and consulting companies published reports describing this as a major trend shift. I think the authors of that flawed research must be embarrassed. I remember Richard saying on talk radio that he didn’t see much merit in the argument. Another good call. Chris

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