BERNANKE CONFUSES DEPRESSION CURE WITH DISEASE (For all you funny money lovers out there)

An article in yesterday’s Wall Street Journal discussed how self-proclaimed “Depression buff” Ben Bernanke claims understanding of how the Fed caused the Great Depression and precisely what he would do to prevent such a calamity from reoccurring under his tenure. Not only are his assertions naïve and egotistical, but flat-out absurd.

Though he claims to have studied The Great Depression in depth, Bernanke is completely clueless as to its actual cause. However, he is partially right about one thing: the Fed did help create the Depression, but for the opposite reasons Bernanke believes. The Fed-induced credit boom of the roaring 1920s laid the foundation for the inevitable bust that ushered in the Great Depression. Bernanke has mistaken the disease for the cure, and his antidote, were it ever administered, would prove to be economically fatal to the U.S. economy.

The mistake made by the Fed during the 1920s was expanding the supply of money and credit too rapidly. However, as increasing productivity prevented consumer prices from rising, the Fed was unconcerned about the inflation it was creating. Instead, the excess money and credit that spilled into financial and real estate markets caused asset prices to rise, which resulted in claims of a “new era” (sound familiar?). The bust of 1929 led to the Great Depression of the 1930s not as a result of Fed tightening, as Bernanke claims, but due to the misguided economic policies of the Hoover and Roosevelt administrations. By preventing market forces from efficiently correcting the imbalances created during the inflationary boom of the 1920s, the Federal Government turned what otherwise would have been a normal, though severe, cyclical recessionary bust, into what became known as The Great Depression.

During the 1920s the British pound, then the dominant world currency, was under pressure. In an effort to prevent British inflation from causing the pound to weaken against the dollar, Federal Reserve Chairman Benjamin Strong decided to increase inflation in the United States as well. By debasing the dollar along with the pound, their relative values could be maintained, thus preserving the illusion of pound stability. Through competitive devaluation, Great Britain exported its inflation to the United States, much the way the U.S. now exports its inflation to China and Japan.

However, the money and credit supplied by the Fed unexpectedly produced the speculative stock market bubble of the roaring 1920s. When Benjamin Strong died in office in 1928, his successor George Harrison (not of Beatle’s fame) understood the problems and addressed them by correctly tightening monetary policy, reversing the inflationary expansion that occurred under Strong.

It is to this action which Bernanke objects and for which he blames the ensuing Great Depression. However, the problem was not that stock and real estate prices collapsed, but that they rose so much in the first place. It was not the mistakes of Harrison that caused the bust, but those of Strong that produced the false boom, making the subsequent bust necessary.

Had Harrison allowed the monetary expansion to continue, as Bernanke suggests he should have, the result would have been hyper-inflation, which would have produced even more dire economic consequences than did the bursting of the bubble. The problem is that Bernanke, like Harrison, will soon replace Greenspan, the modern version of Benjamin Strong (though a more accurate comparison may be to Montague Norman, the governor of the Bank of England during the 1920s.). However, unlike Harrison, Bernanke will likely make the wrong policy choice.

Ben Bernanke believes that credit expansions need never end - that a boom can be prolonged indefinitely simply by printing enough money. The fact that the incoming Fed chairman believes such nonsense is similar to a cold-war president having believed he could win a nuclear war. However, Bernanke’s finger will not be on the button, but on the printing press: and he seems itching to crank it up as he is convinced he will win the deflation war.

When asset prices are too high, credit out of line with savings, and consumption out of line with production, serious economic imbalances result. Curing those imbalances is a painful but essential process. In attempting to prevent the adjustments from taking place, Bernanke will do far more harm then good.

As a result of his confusion, Ben Bernanke wants to cure the disease by killing the patient. The best analogy is to a heroin addict continuously shooting-up to avoid the unpleasant reality of withdrawal. He may “succeed” but only by dying. In economic parlance, hyper-inflation is the monetary equivalent of a drug overdose, and Dr. Ben (Kevorkian) Bernanke seems dead set on administering it.

"One of the problems has been a failure of integration of these theories...."

Could a distinction be made between a tipping point and a cause? Today just as during the '20s & '30s certain areas have gotten extended which make them vulnerable to dramatic corrections. It then only takes a small pebble which could be almost completely random to start an avalanche.

If there were a dramatic correction today, for instance, could we really say what was the real cause versus a tipping point since a large multitiude of vulnerable, highly interdependent areas that are mutually reinforcing are involved? If it wasn't one tipping point item, would not another have eventually taken its place as things get extended? A great heart surgeon might be able to perform miracles for a while, but eventually we have to lose weight, stop smoking and exercise if we hope to not have a recurrence of a heart attack.

We need to lower the risks factors so we turn the Fed Chairman meetings into a boring position like having a regular physical. Increasingly becoming dependent on a heart surgeon or Fed Chairman's world class expertise almost becomes a moral hazard in itself. Better, it would seem, to not be as interventionist, allow more market discipline to take place at earlier stages before the whole system is put at risk. Eventually there will be a Fed Chairman no matter how smart who will not make the right call.

A person by way of analogy who does not take care of their health will eventually reach a stage where any procedure will have such side effects as to be counterproductive, thus tying the surgeon's hands. Today, if the Fed raises rates to have enough ammunition for the inevitable next crisis they endanger bringing down the asset markets and consumer demand at the same time. No matter what they do, whether they act or not, there is increasing danger.

The moral hazard of trying to protect people who need to be protecting themselves is just setting up a bigger fall. Corporations I think are anticipating this fall and are now holding almost unprecedented amounts of cash. The Fed Chairman's role is viewed with an increasing mystic almost like that of the ancient oracles at Delphi, the reading of entrails by a priesthood in ancient Egypt and old Soviet Kremlin watchers to predict the future with similar ambiguity.

Working to devolve these decisions and risks back into the hands of the citizens lessens the systemic risks. Bernanke needs to say he can buy us at best some time, but we have to do the heavy lifting ourselves, and that over time he is going to lessen the moral hazard that guaranteeing our protection brings being cognizant that the law of unintended consequences has not been repealed.

Trying to do away with forest fires only increased their destructiveness. Controlled burns allow a necessary natural regeneration as we've now learned. Not providing federal flood insurance would cause some to be damaged, but providing it has encouraged far more than would do otherwise to build in areas prone to destruction. The Fed faces the temptation of becoming an insurance agent rather than focusing on ensuring the value of the currency. In the former role it would seem only a matter of time before they fail imho although there might be an attempt to control more and more of the economy to forestall this outcome for awhile.

As citizens working with each other in association on issues we have in common we have to be able to assess dangers of hurricanes, fires in our neighborhoods, perils of overeating, buying overvalued stocks, the economic impact of wars, speculating in land and housing, etc. as we've always known if we are to retain our liberty and prosperity. Giving this job to big government only results in our eventual enfeeblement. People use to save money to provide a margin of safety. Today we now have an almost zero savings rate nationally. If people only drive more recklessly upon being given a seatbelt, they just endanger themselves and others more. Return market discipline, keep the currency sound and leave the rest to us and our elected representatives to make the adjustments.

(That is my hypothesis, being a non-economist.)

I believe that you and the "Austrians" are correct. It was not the "pricking" of the Roaring '20s bubble that caused the Depression. Once the credit bubble was created, the aftermath was inevitable. Sure, the Fed and FDR did plenty after the crash to hinder recovery, but the actual cause of the crash was the inflation of the bubble to begin with.

I still believe that we have repeated the same mistakes in the '90s and Bernanke can drop money from helicopters all he wishes, the debts we have built will be repudiated one way (inflation) or another (deflation). All we have done since the 2000-01 crash has been to shift from one bubble to another (stocks to housing) and put off the same inevitability as then.

Except that the dollar was tied to something with tangible value then and today it is nothing more than a confidence game.

"We need to lower the risks factors so we turn the Fed Chairman meetings into a boring position like having a regular physical. Increasingly becoming dependent on a heart surgeon or Fed Chairman's world class expertise almost becomes a moral hazard in itself. Better, it would seem, to not be as interventionist, allow more market discipline to take place at earlier stages before the whole system is put at risk. Eventually there will be a Fed Chairman no matter how smart who will not make the right call."

This is Friedman's argument and it's essentially right. Where the disagreement comes in is which measurement tool you use to effect an automatic rate hike or rate cut. Is it CPI? GNP growth? It is not as simple as it sounds, which is one reason the Fed looks (supposedly) at a myriad of factors to determine if the economy is heating up or cooling down.

"Where the disagreement comes in is which measurement tool you use to effect an automatic rate hike or rate cut. Is it CPI? GNP growth? It is not as simple as it sounds, which is one reason the Fed looks (supposedly) at a myriad of factors to determine if the economy is heating up or cooling down."

Why wouldn't it be the CPI if the Fed's role were limited to maintaining the soundness of the currency? What did Volker use?

People have come to rely on a Greenspan "put" which is inducing moral hazard behavior that eventually will inject greater instability into the system. I realize now that "full employment" is a legislated target, but trying to accomplish that through Fed policy (if that is happening) seems to put us back on the slippery slope. Better to accomplish these other goals through non-Fed policy?

I am all in agreement that the Fed has been damaging, at best, in the 1990s and early 2000s. But many economists hate the CPI as completely inaccurate.

I'm NOT a monetary economist. I'm a historian. But I attended a Liberty Fund seminar with five or six quite brilliant free-market economists discussing this very issue, and none of them could agree on what should be used, if anything, as a "target."

If I were king of the world, I'd have George Gilder be the Fed chairman. He's not an economist, but more of a "futurist," and he thinks that a little (repeat, LITTLE) inflation is actually no inflation because the monetary market is a little slow in adjusting for new inventions, productivity, etc. I tend to agree. People seem to adjust faster to inflation, if it is there, than to deflation. There are psychological elements of economics that are not measured in supply-demand curves---Keynes called them "Animal instincts," and Friedman agreed that they exist. For ex., in the late 1800s, there was humungous deflation, but farm prices appeared to deflate less slowly than all other prices. Well, that didn't sink in to the farmers, who raised "less corn and more hell." The Populist movement was born specifically out of this phenomena, which largely was psychological. And no one denies that psychology can outrace the market at times (See Kindleberger's work in "Manias, Panics," etc.)

My own study of the Panic of 1857, with Charles Calomiris (Journal of Economic History) found that markets reaction to news is based on their ability to transmit and process news---this is more than just "the nightly business news" or the WSJ. For ex., in 1857, the South was not affected at all by the Panic . . . because its banks were largely branch banking systems wherein, even in the 1800s, news about stability, resources, etc., traveled pretty fast between member banks. The NORTH, largely made up of unit banks, did not have that transmission mechanism, and as a result, news about financial flows moved more slowly, allowing panics to set in where they did not in Southern banks. (There were other factors, but this one was important).

Calomiris has MANY articles studying this, with the same conclusion: imperfections in the market vary in their impact, and the more institutional imperfections you eliminate, the more rapidly consumers/depositors react to news. So in that regard, I think Gilder is right in saying that the lubrication of a very small level of inflation overcomes that "lag time" between news of invention/productivity and money growth. I know the Rothbardian goldbugs here will completely disagree.

This was posted by hubbubhubbub to Santiago de la Vega

But it won't allow us to watch it anymore (M3 going stealth next year). Why? What does the Fed know about '06 that it's not telling us?

Notice how Gold has gone up almost everyday since the M3 announcement and Bernanke was confirmed. Something smells here.

My response is:

I agree with your comments above. The Fed has clearly put too much money in the system. That's what the price of gold is telling us and why the economy is booming. Money growth recently has slowed dramatically. Here's a chart of money growth I just generated from economagic.com: Click on the chart of money growth

Notice the huge bulge in money growth in 2002. That's what got Bush re-elected. It's also what's causing the spike in gold prices.

BTW, the rally in gold is real. Click on the chart of gold prices:

Notice the spike in prices and the lack of volume. No one was selling into this rally as it pushed through $500. When it comes back down and makes a nice bottom, buy it and don't sell it till you see record volume.

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