Peering into the soul of Ben Bernanke

January 24th, 2008

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One unfortunate aspect of life is that sometimes, we do not have the luxury to choose between a good choice and a bad choice. Often, we are faced with a bad choice and a bad choice. In such crossroad situation, the choice we make is determined by who we are.

Ben Bernanke is facing such a crossroad. He holds a position of such great influence that his decisions will determine the future and path of the US economy, which in turn will affect the rest of the world. Very unfortunately for him, he is in an awful position. Currently, the US economy is facing the threat of severe deflation, in which the only cure is severe inflation (or even hyper-inflation)- there is no middle ground. Therefore, Ben Bernanke is faced with a bad choice of deflation or the other bad choice of inflation. What a fix! Which one will he choose?

To answer this question, let us look at a speech he made before the National Economists Club in November 21, 2002:

The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

Each of the policy options I have discussed so far involves the Fed’s acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers.

Dear readers, as you read the words in bold in the last paragraph, do you notice something familiar? Hint: refer to our earlier article, Watch the US government. As we peer deep into the soul of Ben Bernanke, we see a money printer in his heart. The next question is, how deep is his money printing heart? We cannot really quantify the answer to this question, but seeing that a couple of days ago, he surprised the market by giving it a gift of ’emergency’ interest rate cut of 0.75 percent, we guess his money printing heart is pretty deep.

In a way, Paul Volcker, the chairman of the Fed in the 1980s, is the anti-thesis of Ben Bernanke. He was credited with ending the US’s stagflation crisis in the 1970s by crushing the economy into the worst recession since the Great Depression. To do this, he had to raise interest rates to unbelievably high levels, to the point that in 1981, interest rates charged by banks exceeded 20 percent (Note to Australian readers: the Labor was often blamed for the super high interest rates of the 1980s. Now you know where such high interest rates come from- such high interest rates was a global phenomenon). Paul Volcker crushed severe inflation by crushing the growth of money supply (see Cause of inflation: Shanghai bubble case study).

Remember what we said before in Recipe for hyperinflation,

If they press on relentlessly [to fight deflation] till the final end, there can only be one outcome: the US dollar will be joining the long list of failed fiat paper money in the annals of human civilization.

Today, Ben Bernanke the money printer may be appointed to be the deflation-fighting hero. But how will future generations see him? For his sake, we hope he will change his money printing heart. Or better still, if we are he, we would have resigned- it is better to be a nobody academic than to be looked unfavourably by history.

Meanwhile, accumulate gold (see Why should you invest in gold?).