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This talk was delivered at the Burton S.
Blumert Conference on Gold, Freedom, and Peace.
In 2002, then-Fed Governor Benjamin Bernanke burst into our monetary
consciousness with his printing
press speech. His fine work earned him the honorary title
"helicopter commander." While largely a background figure since
then, his recent appointment to succeed Alan Greenspan as Fed chair makes
this an ideal time to review Dr. Bernanke’s views on monetary policy, and to
speculate about what his chairmanship will bring.
Since the Fed emerged from its near-death experience in the 70s, it has
largely been identified with the label "inflation fighting."
Notably, Dr. Bernanke’s research and speaking have dealt almost entirely with
the subject of deflation. While his infamous address before the National
Economists Club, titled Deflation:
Making Sure "It" Doesn’t Happen Here (2002) has been endlessly
reported and debated, more revealing and less well known are Dr. Bernanke’s
many speeches on deflation between 1999 and 2004, and a series of research
papers on the same subject produced by the then-Fed governor and his
colleagues.
I have identified fourteen papers and speeches dealing with deflation,
seven by Dr. Bernanke and seven by other Fed governors and staff economists.
These materials are all available for public download on the Fed’s web site.
To steal a line from columnist Dave Barry, I’m not making this up. This
article will cover the most important points from these articles. Since I had
to read all of these, I consider myself quite fortunate that none of the
speeches was by Alan Greenspan.
These writings deal with three themes: the menace of deflation, the Fed’s
strategy for preventing it, and their contingency plans to fight it (should
their prevention efforts fail).
While Governor Bernanke is not the only member of the anti-deflation wing
at the Fed, the Chair apparent has emerged as the most prominent advocate of
this new agenda. His leadership merits the name "Bernankeism" for
this policy program.
Upon reading the source materials, three main tenets of Bernankeism
emerged. I will describe them and illustrate with examples in the Fed’s own
words. The three are: prevention is better than cure, learn the lessons of
history, and the possibility of "unconventional measures."
The first principle of Bernankeism is that it is better to prevent
deflation than to attempt a cure after the disease has set in.
The basis of the Bernanke school’s thinking on deflation is the standard
(mainstream) macro-economic view that consumer spending (not saving) drives
economic activity, and that insufficient consumer spending is the cause of
recessions. According to this view, when recession strikes, inflation is
called for.
Inflation works in three ways. One, by lowering real prices when nominal
prices are for some reason "stuck" at above-market-clearing levels;
and two, and by threatening a continued erosion in the purchasing power of
cash, inflation motivates anti-social cash hoarders to spend, thus providing
the missing stimulant to economic activity. A third is through so-called
"wealth effects": when asset prices inflate, people misperceive the
inflation as true wealth and then increase their spending.
Deflation is so dangerous, according to Dr. Bernanke because it is a
self-reinforcing process that is very difficult to reverse once it has begun.
They start from the true observation that when people spend less, prices
fall. They then reason that when prices fall, people become increasingly
reluctant to spend because they anticipate that prices will continue to fall.
People start to hoard cash, planning to buy tomorrow when things are cheaper.
The less people spend, the more prices fall, and the more that people hoard.
In the grip of cash hoarding, according to Bernankeism, the entire economy
would spiral down as all spending ground to a halt. This is why they think
that deflation is like a chronic illness.
For an example of this view, I will cite the research paper titled Monetary
Policy and Price Stability (1999) (by Fed research staffers):
If economic activity is weak or contracting and interest rates hit the
zero bound, a dangerous dynamic can be set in motion. Falling inflation, or
even escalating deflation, would increase real rates of interest. As this
depresses aggregate demand further, downward pressures on prices would raise
real interest rates further: The economy would potentially face a downward
deflationary spiral.
Governor Bernanke and his accomplices are obsessed with something known as
"the zero bound problem." Eight of the fourteen papers and speeches
that I examined deal with this problem either as their main point or in
passing.
The zero bound comes about as follows. The Fed commissars concern
themselves largely with controlling a single rate of interest, the Fed Funds
rate. This rate can be lowered only to near zero, but not to zero or below,
because no one would buy a bond that had a zero or negative yield; they would
hold cash instead. This poses a problem for the central banker bent on
inflation: if the Fed Funds rate hit zero (or near-zero as it did with
Japan), inflation cannot be accelerated by cutting the Fed Funds rate. In
these circumstances, the Fed’s inflation program would be frustrated.
For this reason, Bernankeism advises the central bank to avoid the zero
bound problem by creating a constant state of pleasant and benign inflation
of around 2—3%. This will keep the economy a safe distance away from the
dangerous precipice beyond which lies deflation, and gives the Fed room to
cut rates.
For an example of their thinking, I cite a speech titled An
Unwelcome Fall in Inflation (2003). Dr. Bernanke states:
I hope we can agree that a substantial fall in inflation at this stage has
the potential to interfere with the ongoing U.S. recovery, and that in
conceivable — though remote — circumstances, a serious deflation could do
significant economic harm. Thus, avoiding a further substantial fall in
inflation should be a priority of monetary policy. To my mind, the central
import of the May 6 statement is that the Fed stands ready and able to resist
further declines in inflation; and — if inflation does fall further — to
ensure that the decline does not impede the recovery in output and
employment.
The second principle of Bernankeism is that central bankers must heed the
lessons of history. According to the papers and speeches, the Fed’s fear of
deflation is based the two great 20th-century failures of central banks to
inflate: America’s Great
Depression and the Case of Japan
in the 90s.
Dr. Bernanke accepts Milton Friedman’s theory of the Great Depression. In
the Friedman view, a contraction of the money supply brought about by loan
defaults and then bank failures turned what would have been an ordinary
recession into the Great Depression. This catastrophe could have been avoided
had Fed inflated sufficiently. The Friedmanites depict a Federal Reserve
System ideologically paralyzed by the so-called liquidationists.
Our next Fed chair, in a
speech given in the honor of Milton Friedman (2002), expressed contrition
on behalf of central bankers everywhere in saying, "I would like to say
to Milton and Rose: Regarding the Great Depression. You’re right, we [the
Fed] did it [caused the Depression]. We’re very sorry. But thanks to you
[Friedman], we won’t do it again." The Fed has learned its lesson.
The failure of Japan’s central bank to inflate its economy out of the mess
following the bursting of the 1980s stock and real estate bubbles comes in a
close second to the Depression in the Bernanke manual for deflation fighters.
Four of the 14 Fed speeches deal mostly or entirely with Japan’s attempt to
inflate its way out of a series of recessions that followed their bust.
Despite successive Keynesian-stimulus public-works programs (that have nearly
paved the entire island of Japan into a parking lot), and several years of a
near-zero short-term interest rate, and a massive program of foreign exchange
intervention that has left the BOJ holding hundreds of billions of dollars
worth of US Treasuries, the BOJ has been unable to generate much inflation at
all.
To cite one of many examples, in a speech titled Preventing
Deflation: Lessons from Japan’s Experience in the 1990s (2002) (a paper
by four Fed staff economists) we read:
We conclude that Japan’s sustained deflationary slump was very much
unanticipated by Japanese policymakers and observers alike, and that this was
a key factor in the authorities’ failure to provide sufficient stimulus to
maintain growth and positive inflation. Once inflation turned negative and
short-term interest rates approached the zero-lower-bound, it became much
more difficult for monetary policy to reactivate the economy.
The term "conventional measures" figures prominently in much of
the Fed’s discussion. "Conventional measures" is a term from the
central banker’s dictionary. These measures consist of essentially two
things: controlling the short-term Fed Funds rate and purchase and sale by
the Fed of government securities by its so-called Open Market Committee.
The lesson of Japan, according to Bernankeism is that when the powers of a
central bank are limited to "conventional measures," the central
bank may not be able to prevent deflation, nor to fight it once it has taken
hold. In the Fed’s view, Japan tried conventional inflation measures to their
utmost. However, because the deflation caught them by surprise or perhaps due
to the inherent limitations of conventional measures, the BOJ’s efforts were
too little, too late.
The third principle of Bernankeism is the necessity of
"unconventional measures."
Inflation is always the answer (according to these thinkers), but, they
are afraid that it may nearly be impossible to bring it about when they most
need it. Suppose that the Fed found itself fighting a stubborn deflation. If
conventional measures had been tried and failed, and with the US on the brink
of following Japan down the road to a long and painful deflationary morass,
what would be the alternative?
I quote Dr. Bernanke himself from a paper titled Monetary
Policy Alternatives at the Zero Bound: An Empirical Assessment (2004).
When the economy is at the zero bound, "a central bank can no longer
stimulate aggregate demand by further interest-rate reductions and must rely
on u2018non-standard’ policy alternatives." What does he mean by
"non-standard"? This is what passes for "thinking outside of
the box" among central bankers.
The reader of the Fed’s papers and speeches will find a series of
increasingly exotic plans for the dollar. From beginning to end, these
methods range from the merely unsound to the bizarre and terrifying.
The paper titled Monetary
Policy and Price Stability (1999) introduces some of the more mild of the
so-called alternatives. The first of these tools is to expand the menu of
assets that the Fed could purchase through its open market operations. The
Fed’s current structure limits its activities to the purchase of short-term
US Treasury bonds. When the Fed can no longer lower short-term interest
rates, long-term rates are the next obvious target. Among their options for
lowering long bond yields are: the purchase of long-term US Treasury Bonds,
writing interest rate option contracts, purchasing foreign exchange reserves
(in an attempt to lower the exchange rate of the dollar), and purchasing
private sector securities like stocks and bonds. The measures described in
this paper would involve massive Fed intervention in US financial markets.
If the above methods were not sufficient to "simulate aggregate
demand," the Fed could loan money into existence, accepting as
collateral almost any private sector asset whatever. In the paper titled Monetary
Policy and Price Stability, we find:
A central bank can also attempt to spur private aggregate demand by
extending loans to depositories, other financial intermediaries, or firms and
households. By making the loan, the central bank turns an asset that may be
illiquid for the lender into a liquid asset. This may be particularly helpful
in spurring aggregate demand should the financial sector be under stress and
in need of liquefying its assets.
In the United States, the Federal Reserve currently lends only to
depository institutions. But in contrast to the limited type of securities
the Federal Reserve can purchase, it can accept as the security for a loan
virtually any security that the Federal Reserve Banks themselves deem
acceptable. And in fact, the Federal Reserve accepts mortgages covering one-
to four-family residences; state and local government securities; and
business, consumer, and other notes. These notes can be open market
securities such as corporate bonds and commercial paper or can be commercial
and industrial loans extended by banks, for example.
The measures described so far rely on loaning money into existence in
order to generate inflation. This channel depends on the willingness of
borrowers to borrow the cheap money that the Fed prints. But what if
borrowers won’t borrow? Don’t worry, say the Bernankeists, we will print the
money and distribute it.
From the paper titled Monetary
Policy When the Nominal Short-Term Interest Rate is Zero (2005), in a
section with the ludicrous title Wealth Creation, we find:
In ordinary circumstances, monetary policy exerts its stimulative impact
in part through increasing the financial wealth of the public — such as
producing capital gains in bond and equity markets. If, at the zero bound,
the Federal Reserve had already taken what actions it could to raise bond and
equity prices, it might look to other tools it has to increase the public’s
wealth. One tool commonly attributed to the Federal Reserve, at least in
theory if not by the Federal Reserve Act, is that of conducting “money
rains.”
Money rains are a clean way to study theoretically the effects of
increases in the supply of money. In practice, it seems a bit difficult to
envision how the Federal Reserve could literally implement a money rain —
that is give money away either through directly disbursing currency to the
public or by disbursing it through the banking system. The political
difficulties that are likely to arise from the Federal Reserve determining
the distribution of this new wealth would be daunting.
The above plan aims to decrease the value of each dollar by increasing the
quantity in circulation. But what if the Fed prints but people are unwilling
to spend? The next weapon in their arsenal is to make money pay a negative
rate of interest. While that sounds difficult, in the paper titled Monetary
Policy in a Zero-Interest-Rate Economy (2003), two Fed economists explain
how:
No one would be willing to hold any asset that pays a negative nominal
rate, as long as zero-interest money is available as a store of value. The
strategy for eliminating the zero bound, therefore, is to make money pay a
negative nominal interest rate, by imposing some type of “carry tax” on
currency and deposits.
It’s easy to envision such a system with regard to deposits at the Federal
Reserve or transactions deposits at banks; for the most part, the technology
to implement such a system is already in place. A tax or fee on Reserve
deposits of 1 percent per month, for example, would mean that those deposits,
in effect, pay a nominal interest rate of roughly minus 12 percent.
The technological difficulty lies mainly in imposing such a tax on
currency. In the 1930s, Irving Fisher of Yale University, one of the greatest
[sic] American economists, proposed such a system, in which currency had to
be periodically u2018stamped’, for a fee, in order to retain its status as
legal tender. The stamp fee could be calibrated to generate any negative
nominal interest rate that the central bank desired.
If "aggregate demand" has not been sufficiently stimulated by
the above measures, the Bernanke Fed stands ready to play its final card: the
direct monetization of goods and services. From the same paper,
under the heading The Goods and Services Solution, we read:
Why not have the Fed just conduct an open market purchase of real goods
and services? Even more so than exchange rate intervention, this strategy
would represent a direct stimulus to aggregate demand.
As posed, though, the strategy has a major drawback: it violates the
Federal Reserve Act. The Fed isn’t authorized to purchase goods and services,
apart from those needed for the operation of the Federal Reserve System.
The strategy can be implemented, however, by coordination with fiscal
policy-makers. The Federal government, for example, could purchase goods and
services and finance the purchase with new debt, which the Fed in turn would
buy — in technical terminology, the Fed would ‘monetize’ the resulting debt.
By coordinating with fiscal policy, the Fed could even implement what is
essentially the classic textbook policy of dropping freshly printed money
from a helicopter.
My final example is from a story that ran in The
Financial Times (March 25, 2002). The paper reported:
The US Federal Reserve in January considered a variety of “unconventional”
emergency measures to be taken if cutting short-term interest rates failed to
arrest a US recession and prevent Japanese-style deflation. One of those
steps may have been a plan to buy US stocks.
According to the reporter, an unnamed source was quoted as follows:
the Fed “could theoretically buy anything to pump money into the system”
including “state and local debt, real estate and gold mines — any
asset."
These "unconventional measures" all have two things in common:
one, that they are more inflationary than the conventional central bank
policies; two, that they are among the most absurd, bizarre, and preposterous
monetary crank schemes ever proposed by anyone calling themselves an
economist. Not to mention that some of these plans are illegal (according to
existing Fed regulations), though who doubts that in a crisis, this would be
ignored?
Setting that aside, the question remains: Do they really mean it? Or is
this just a lot of musings by academic economists with time on their hands?
Too many boys with toys? Is Bernankeism a serious plan? Or is it an
orchestrated propaganda campaign?
In attempting to answer that question, we must not forget that everything
the Fed says must be looked at as propaganda. In the realm of media relations
there is surely no body on the planet whose utterances are more scrutinized
than the Fed. The mere possibility of the removal of the word
"measured" from the statements accompanying recent rate increases
has spawned an entire body of analysis and commentary. A Google search on
"removal of the word measured" yields over 500 hits.
The Fed is well aware of this and it can only be assumed that calculation
plays a large part in their artifice. Every statement by a Fed governor is
without doubt carefully crafted and vetted as a part of its overall message.
The Fed’s management of the media, dubbed by some the "Open-Mouth
Committee," is a key part of the manipulation of public opinion that
preserves the Fed mystique.
Even the Fed itself is not secretive about their use of opinion
management. One of Bernanke’s papers, Monetary
Policy Alternatives at the Zero Bound: An Empirical Assessment enumerates
"using communications policies to shape public expectations about the
future course of interest rates" as one of the three main types of
non-standard policies. And in Central
Bank Talk and Monetary Policy, we read:
Although effective communication by the central bank is always important,
it becomes especially important when the rates are near zero. Indeed, when
the proximity of the zero bound prevents further rate cuts to stimulate the
economy, talking about future policy actions may be one of the few tools at
the central bank’s disposal by which to influence conditions in financial markets.
However, because something is propaganda does not mean that it is a
deliberate untruth. As Rothbard wrote:
To achieve a regime of big government and government control, power elites
cannot achieve their goal of privilege through statism without the vital
legitimizing support of the supposedly disinterested experts and the
professoriat. To achieve the Leviathan State, interests seeking special
privilege, and intellectuals offering scholarship and ideology, must work
hand in hand.
Austrian economist Joseph Salerno has written that
modern macro-economics is a "fiat profession," a manufactured
discipline whose purpose is to legitimize inflation, and whose development
has been funded by the same state that benefits from inflation.
Seventy years after Keynes, macro-economic inflationism has become so
entrenched in the economics profession that all university-trained economists
were taught this. When false ideologies have been sufficiently entrenched,
propaganda no longer depends on deliberate lies. Sincerely held beliefs by
properly trained experts are sufficient. Dr. Bernanke is most probably a true
believer. Unlike Alan Greenspan, who got his start as a forecaster and
consultant before becoming a government employee, Dr. Bernanke is a leading
figure in the fiat macro profession, and his eminence in this academic field
pre-dates his appointment to the Fed.
I have no doubt that the authors of these papers would like to implement
their plans, if the conditions played out the way that their theories
describe. But how likely is this to happen? Not very. When the Fed first
started talking about deflation, interest rates were at generational lows and
the economy was in the midst of a post-bubble recession.
While the media and much of the financial markets fell for what can now be
seen clearly in retrospect as a deflation scare, there was no deflation. A
few Austrians and assorted contrary thinkers have pointed out that the
Greenspan era been one of rampant inflation. The inflation of our time has
produced asset bubbles, rather than rising consumer prices. Even at the time
of the 2002 deflation scare, the housing bubble was well underway. A recent
Wall Street Journal series Awash
in Cash: Cheap Money, Growing Risks, documents the inflation of nearly
all asset classes around the world. The second
article in the series explains how timberland, formerly an obscure and
uncorrelated asset class, has doubled or in some cases quadrupled over the
last few years.
The economic problem that has resulted from serial asset bubbles is that
the relative prices of financial assets, compared to final goods, are
unsustainably high. This is Greenspan’s "conundrum" of low
long-term interest rates. One way or another, there must be a normalization
of relative prices between credit-sensitive assets and final goods. I will
call this normalization a "financial asset deflation."
There are two ways that a financial asset deflation could occur: one, a
deflationary crash in financial assets that would take down stocks, housing,
and blow the whole fiat money fractional reserve banking system to
smithereens; the other: an accelerating consumer price inflation (or even
hyperinflation), in which everything we buy gets more expensive, allowing the
prices of end goods to catch up with the elevated prices of financial assets.
Some within the Fed know that they must continue to inflate or face a
collapse. And when conventional measures no longer work, they must be ready
to print money and buy the assets. No one knows the score better than Alan
himself, who has staved off the collapse several times during his tenure by
flooding the markets with liquidity when the system threatened to unravel.
Greenspan’s admission of the possibility of a financial collapse was first
revealed by Lawrence Parks in his book What Does Alan Greenspan
Really Think? Greenspan’s knowledge is also proved by the release, after
the five-year sliding wall, of late 90s Fed meeting minutes. FOMC
transcripts from the 1996 meetings show that, contrary to Greenspan’s
statements at the time to the effect that a bubble cannot be identified
until it has burst, the Greenspan Fed was aware that the stock market was in
a bubble.
Greenspan for years publicly
denied that there could even be such a thing as a housing bubble, relying
on the reasoning that housing is illiquid and all housing markets are local
in nature. A recent New York Times story titled Fed Debates
Pricking Housing Bubble, reports that some Fed governors have publicly
dropped oblique hints that they know that the recent speculative blow-off in
housing is driven by the Fed’s own low interest rates.
I believe that the anti-deflation wing headed by Bernanke is telling part
of the truth, but with an element of misdirection. Yes, they are worried
about deflation, but relevant comparison is to Argentina, not Japan. Yes,
they must stand ready to monetize anything and everything, but they are far
more worried about collapsing asset bubbles than slowly falling goods and
services prices. There
has already been speculation that anomalously large bond purchases from
Caribbean sources that have shown up in this year’s flow of funds data from
the Fed are a cover for Fed purchases of treasury debt.
Yet they cannot openly state that they are
playing this game without risking a run on the dollar and a collapsing bond
market. The fear of deflation enables them to keep the game going, at least
for a while. And who better to do this than Chairman Bernanke.
Robert Blumen [send him mail] is
an independent software developer based in San Francisco.