Why Chairman Bernanke Is Wrong (Part One)
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.
P.S. For more perspective from Richard Duncan you can visit his blog on economics in the age of paper money at www.richardduncaneconomics.com.