Deflation: The Blood on Bernanke's Hands

We left off yesterday’s issue “When Good Falling Prices Go Bad” wondering what stock market investors were thinking. They bought stocks heavily on Monday. Then, yesterday, they sold them a bit – the Dow fell 38 points.

Yesterday was largely uneventful. Gold rose a dollar. Oil climbed to $82.

Maybe stock market investors are not really expecting to get rich. Maybe they’re trying to avoid getting poor. They may figure that the real risk is being in cash…not in stocks.

If so…they may have a point.

Here’s the low-down…

As near as we can tell, the Japanese-style correction is still underway. Consumers are careful about spending because they fear they might not have jobs. Employers are careful about hiring because they fear they might not have revenue. And banks are careful about lending because 1) few people want to borrow, and 2) the banks figure they may need the money themselves.

Meanwhile, Ben Bernanke has staked his entire reputation on being able to avoid a Japanese-style slump. He gave a famous speech about it back on the 21st of November 2002. He called it “Deflation: Making Sure it Doesn’t Happen Here.”

Well, that was when the inflation rate was not far from the Fed’s 2% target. What’s happened since? The consumer price inflation level – as measured by the government – has now dropped down to 0.5%. And many economists think it will go negative soon.

Hmmm… This leaves Mr. Bernanke in a tight spot. It looks like deflation is happening here. And it is happening after Ben Bernanke has already used most of his tricks to stop it. The Fed is lending money at 0.25% interest – effectively zero. What’s it going to do next? Pay you to take the money?

If Bernanke allows deflation to happen…and persist…he will have Congress on his back. The Fed is supposed to be independent. But every Fed member knows which side his bread is buttered on. And no one doubts where the butter comes from – the US Congress and the administration. And everyone also knows that there will be mid-term elections this year.

As it stands, the voters are not too happy. They’ve seen the banks get bailed out. They’ve watched Goldman’s boys make their millions. And they’ve begun to wonder whose interests their elected representatives are really serving – the voters who sent them to Washington? Or the special interests who write big campaign checks? (Goldman gave millions to the Obama campaign…one of the best investments it ever made…)

Unfortunately for democracy, the poor voter has no idea of what is going on or why. If he has a job and his house is rising in price, he’ll likely vote for the clowns already in Washington. If not, he’ll want new clowns.

And right now, his house is likely to be underwater…and probably sinking. As for his job, he’s lucky to have one.

Ben Bernanke must surely feel the pressure to “do something,” right?

Not only that, his reputation is at stake too. What did he say in that remarkable 2002 speech? Oh yes, that “under a paper money system, a determined government can always generate higher spending and hence positive inflation.”

Well, maybe. But so far, it is looking as though it may not be as easy as the younger Mr. Bernanke thought. We have a paper money system, no doubt about that. We also have a Fed that is determined to keep inflation positive. But we also have inflation that is becoming less positive every day…and may turn negative soon.

Bill Bonner
for The Daily Reckoning

The Daily Reckoning