Why Chairman Bernanke Is Wrong [Part One]
Posted January 13, 2011
There are many areas where my views differ from those of Ben Bernanke. Here is the first.
Fed Chairman Bernanke believes in the Monetary Theory of the Great Depression, which holds that the Federal Reserve could have prevented the Great Depression by stopping the US money supply from contracting during the early 1930s. This is important because the Fed’s policy response to the current economic crisis – printing money and using it to buy financial asset from banks – was adopted because of Bernanke’s faith in this idea. The Monetary Theory of the Great Depression is incorrect, however. Consequently, the Fed’s Quantitative Easing policy is more likely to exacerbate than resolve the global crisis.
The Great Depression was caused by the inability of the private sector to repay the debt it incurred during the Roaring Twenties, just as the economic crisis that began in 2008 was caused by the inability of the private sector to repay the debt it incurred between 1995 and 2008. Printing money and preventing a contraction of the money supply does not change the fact that the private sector cannot repay its debts.
All business cycles follow the same pattern. At the start of the cycle, bank lending begins to pick up, causing an improvement in economic activity. As credit expands, businesses invest more and hire more workers. Asset prices rise. As profits grow, bank deposits grow. This results in still more credit growth since deposits provide the funds that banks extend as credit. All of these positive factors reinforce one another for a number of years and the economy enjoys a boom. Eventually, however, excessive investment leads to gluts and falling product prices, while overly inflated asset prices become unaffordable and begin to fall. Falling product prices and falling asset prices lead to business distress and insolvencies; and business failures lead to bank failures and, hence, to the destruction of deposits. Credit contracts and the economy enters recession.
Money has traditionally been defined as coins and paper money in circulation plus demand deposits held at banks. When it is understood that bank loans and bank deposits are very nearly the same pool of funds, it becomes clear that in order for the Fed to prevent the money supply from contracting during an economic downturn (or depression), it must prevent credit (bank loans) form contracting. Otherwise, deposits and, therefore, the money supply would also contract. To prevent credit from contracting, the Fed must implement measures that turn bad loans into good loans. So, when Bernanke and other proponents of the Monetary Theory of the Great Depression claim that economic collapse could have been prevented if the Fed had stopped the money supply from contracting, what they really mean is that the Great Depression could have been prevented if the Fed had stopped the private sector from defaulting on its debt. And that is what the Fed hopes to achieve now through Quantitative Easing.
Quantitative Easing impacts the economy by artificially pushing up stock prices and by helping to fund the government’s trillion dollar budget deficits at low interest rates. Higher stock prices create a wealth effect that funds consumption and supports aggregate demand, just as government deficit spending supports aggregate demand.
These “stimulants” only have effect so long as the printing press continues to run, however. When the Fed stops creating money and buying assets, asset prices will fall, wealth will evaporate, spending will slow and the economy will slide back into recession. It is only necessary to consider the events of 2010 to see that this is true. On March 31st, the Fed ended its first round of Quantitative Easing during which it had created and spent more than $1.7 trillion buying financial assets from banks. Less than six weeks later, the stock market “flash crash” occurred. By July, the S&P 500 Index had lost nearly 15%, destroying at least $1.5 trillion in wealth in only three months. Economic indicators took a sharp turn for the worse during the summer and concerns grew that the economy was sliding back into recession. At that point, the Fed began dropping hints about its plans for a new round of money creation, “QE 2”. The market and the economy rebound.
The US economy has become dependent on the stimulus provided by paper money creation. Stock prices, bond yields, retail sales and employment now all move up and down in line with the Fed’s program of liquidity injections. When governments create money, there are undesirable side effects, however. First, in addition to causing asset price inflation, printing money causes food price inflation as well, putting at risk the very lives of many of the two billion people on this planet who live on less than $2 per day. Second, it contributes to the deindustrialization of the United States as it shifts economic activity from healthy manufacturing and production to services and consumption paid for with capital gains on unsustainably inflated asset prices. Third, it rewards the banking industry for activities that fundamentally damage the health of the economy. When the Fed promises to prevent the money supply from contracting by implementing measures that prevent the private sector from defaulting on its debt, it is certain that bankers will pump more and more credit into the economy and profit handsomely from doing so. Fourth, creating dollars causes the dollar to lose value relative to other currencies and hard assets like gold and land. Finally, driving economic growth by paper money creation is not sustainable and will end very badly sooner or later – unless there is a complete policy rethink about how government spending and money creation can be used to restructure the US economy and restore its viability.
On November 8, 2002, Fed Governor Bernanke gave an address on the occasion of Milton Friedman’s 90th birthday in which he described and lent his creditability to the Monetary Theory of the Great Depression (which Friedman and Anna J. Schwartz had developed in the early 1960s). Bernanke concluded that speech with the following words, “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we (meaning the Fed) did it. We’re very sorry. But thanks to you, we won’t do it again.”
About this, Bernanke was wrong. The Fed did not cause the Great Depression. However, by accepting an incorrect explanation of the causes of the Depression, the Fed, under the leadership of Greenspan and Bernanke, has pursued a series of disastrously inappropriate policies that have brought the world to the brink of a New Great Depression.
In all fairness, however, it should not be forgotten that the Federal Reserve was created by bankers for the benefit of bankers. Judged from the perspective of the banking industry, it must be said that the Fed has been incredibly adept at fulfilling its original mission.
Economics In The Age Of Paper Money
Thanks for starting your site and blog. Finally I have a link to give my friends and acquaintances instead of talking until I am blue.
The same bankers you indict here have also directed capital investment outside the US, and the self interested corporate leaders have followed their directions in order to maximize stock prices and thus compensation. With labor essentially free in most of the world, the US stands no chance of growing the middle class through manufacturing. That ship has sailed. There are occasional exceptions, but we cannot build an economy on an anecdotal basis.
The tide of dollars the Fed has created have done little because the velocity of those dollars is nearly zero. Out to the banks, back to the Fed, repeat ad nauseum. As most banks suspended dividend payments until this shell game could rebuild their capital, there has been no mechanism to distribute even a paltry amount beyond that merry-go-round. The real economy and finance are completely divorced from each other. It is no coincidence the next bubble is building in cyberspace, sorry, Net 2.0. Facebook is a $50B diversion. It will create a few more folks with real money to turn it back to the same banks to “invest,” but have negligible and arguably negative impact on real GDP. Can I buy food, shelter, or fuel with anything from the Internet, other than IPO funny money? No.
Unless the nation prioritizes mining and manufacturing, including a real strategy to reduce the imbalance of international accounts in petroleum related products and consumer goods, GDP ex all this non-value added stuff will actually decline. Tax cuts will not fix this problem, as the real money at the top has many disincentives to invest here. This requires a public/private partnership larger than we have contemplated. We have the technology to produce petroleum products from both natural gas and coal, but without public policy in place to direct the flow of funds and get off the whole wind/solar kick as insufficient to meet short- or medium-term needs we can’t get there. In the current political and regulatory environment, we are doomed to continue to transfer wealth to those who don’t need it and take jobs away from those who do. Then we will later face confiscatory taxation of the top of the wealth scale, which will unleash the tsunami of Fed money and drive inflation sufficient to wreak violent unrest. Our policy makers better get their heads out of their rear ends and make steps toward some kind of home-growth agenda. It’s almost too late.
The current market environment resembles that in early 2008. Rising commodity prices, food riots, oil edging higher, failing financial institutions, etc. However, at that time, the Fed let Lehman fail (although it did rescue Bear Stearns to some extent before that). On purpose or not, that’s a separate topic. Now, instead of failing financial institutions (the major ones would get bailed out anyway in a heartbeat), there are failing/bankrupt countries (Ireland, Portugal, Spain, Italy, Japan, US, to name but a few). If one of these countries failed, then it would spark a similar global collapse to what happened in the fall of 2008. They do not fail though because other countries/central banks would come to the rescue by printing ample money (e.g. China backing the euro, ECB loans to Irish financial institutions).
If we assume that every major bank, corporation and country gets bailed out and that the central banks will continue to support asset prices and monetize debt, then this goes against the deflationary argument that is so popular among certain people. Can the resulting inflation get out of control? Is money printing something that needs to be done in bigger and bigger quantities to get the same result once taken (e.g. similar to drugs, alcohol) and the more difficult the recovery will be?
On the other hand, the bursting of the China bubble or a sudden derivative collapse could indeed have a major deflationary effect, at least temporarily (even if the money quantity remains the same, money velocity could fall sharply). Is it worth waiting for such a temporary event and then invest heavily in gold and land (and maybe stocks in energy, utilities), hoping that history will repeat itself like in 2008? Dangerous strategy, but something to think about.
This economic crisis looks deeper than any of the previous crises since the Great Depression. However, the fact that this debt fueled global economy has still not collapsed and it has produced some impressive booms in certain areas could well indicate that even if it is flawed, this cat has nine lives and the doom scenario would only arrive in the distant future. And in the long run, we are all…
A great book on the Fed and the banking cartel is the “The Creature from Jekyll Island: A Second Look at the Federal Reserve” by Edward Griffin.
“Old Hickory” is relevant.
The United States seventh President Andrew Jackson continues to be under scrutiny for his American Indian removal policies and his personal slave holdings. We would all be well served to spend equal time examining Old Hickory’s revoking the Charter of the Second Bank of the United States which held great influence over the United State’s economy. Jackson was in fact the only US President to totally pay off the National Debt and his banking practices are well worth investing some time in understanding.
Jackson was successful in the redeployment of banking funds from the centralized Second Bank to local and state banks. However, the resulting localized banking practice of issuing paper banknotes without gold or silver reserves created rapid inflation and mounting State debts. As a result, in 1836 Jackson issued the “Specie Circular” which required purchasers of government lands to pay in “Specie” which were gold and silver coins. Consequently, there was great demand for the Specie and local banks did not have enough of them to exchange for banknotes thereby directly leading to the banking system collapse and the Panic of 1837 which included an economic depression and renewed National Debt.
In today’s nationalized economies how one would migrate to a reserve based system from fiat money is incomprehensible to me short of using petrolum or food grain as the reserve basis. In fact, the United States current balance of trade condition (and national debt) is just unfathomable unless you are under the overindulgent influence of some of Old Hickory’s best fermented grain products.
Richard Duncan, thank you for your always solid and reliable insight. Go Dores!
One thing I fail to understand is that why most analysts are recommending the purchase of Gold as a safe investment? The problem today is that the price of Gold is not derived by it’s physical demand or supply but more by the speculative positions standing long or short on the commodity exchange like any other traded commodity, stock or currency.
The basic mechanism of price discovery (based on demand and supply for actual use) of anything traded on an exchange has been terminally infected by speculators having access to unlimited funds and super fast computers for trading leading to volatile price swings. This has been made worse by the launch of ETFs for anything and everything under the sun by the financial community.
The price of everything including Gold is likely to suffer when the speculators unwind their positions due to some event that they have not anticipated or foreseen.
Just like gold’s value, paper money’s value is also determined by supply and demand. Price discovery is obtained by trading both on and off exchanges through derivatives and OTC spot forex. It, too, is just a commodity.
The difference is easily discernable, however, to any one by a simple test ~ simply strike a match and hold it under both a dollar and a piece of gold.
Even an economist should readily be able to see the difference in the result. One is paper with a printed promise from a corrupt and faulty banking system and can, on occasion, be used to the light cigars of the wealthy. If citizens lose faith in it’s value, fiat currency can, also, be used to start fires in the BBQ or to wall paper a bathroom.
The other has a durability that has allowed it to exist in nature in a pure state for millions, or even billions, of years. It can be fashioned into useful and decorative objects, and satisfies one of man’s primordial desires ~ the desire for shiny objects, the same desire that motivates people to obtain new cars, polished fixtures, fine china, silverware, fine crystal, and, of course, jewelry. Not a desire that’s likely to change any time soon.
The real problem is that, although most of us like to own gold, and think of it as a valuable item, we have been brainwashed into thinking that it’s somehow old-fashioned, out-of-date, and inferior to paper and plastic.
We’ve also accepted with too little thought that a 19-30% credit card rate is not really loan sharking simply because it’s necessary for the bank’s business model. Or that money printed by the FED and distributed to banks, money for which the taxpayers will ultimatedly be responsible, is not just another tax, when in fact, it is just another tax, a very, very large tax.
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Its funny how Bernanke quotes Anna Schwartz while she thinks he’s completely misguided in his policies.
From the Wikipedia entry for Ben Bernanke
Thank you for taking the time, and educating your readers on very important topics.
one flaw in your argument – desposits are not needed for a bank to make a loan. further, Bernanke and QE2 providing Reserves to banks have zero effect on loan demand. this is important because it means the Fed can only target rates – and rates are at records lows, and yet no one wants or needs a loan.
your analysis that the private sector deleveraging caused the great depression, and now the great recession is spot on. the diff btwn QE1 and 2 is that there was “stimulus” that made it into the real economy in QE1. QE2’s rise in the stock market was just speculative trading with a lot of traders not understanding that bank reserves would have no effect on the economy. they assumed it would, so that led to a rally which was doomed to come back down once the results weren’t actually there.
the only solution is for the Govt to replace the money destruction that is happening via private sector debt deleveraging – while also not allowing the private sector to re-lever. So massive tax cuts put into the hands of real consumers and/or jobs programs. This of course will vastly increase the US Gov debt and deficit – but in a land of fiat money, the US Gov can print to its hearts content and never have to worry about paying off it’s “debt”. The reason is that it isn’t really debt. The US is NOT like you and me or any other household – we can create money out of thin air. The US Gov can – but again, it only makes it into the real economy via tax cuts or jobs programs – not bank reserves.
Unfortunately our politicians, and most economists don’t understand this. This prescription sounds keynsian, but it isn’t. Keynsian’s don’t understand the role of private sector debt – as you clearly point out in this post. And they don’t fully understand Gov debt – they too seem to think it needs to be re-paid. It doesn’t. The US can runs debts and deficitis forever because it isn’t actually “debt” it is simply spending – spending more fiat into the system. You may not like the sound of that because it sounds inflationary – but not when FAR FAR FAR more money is being destroyed via private sector deleveraging.