Sunday, November 7, 2010

Banana Ben Bernanke

The headlines should read, "United States Defaults on Sovereign Debt." That's what has happened under the euphemism of "quantitative easing," a.k.a. printing money. The money being used to buy back government debt has been created out of thin air. It has absolutely no value. Government bonds are being purchased with pieces of paper worth about what Bernie Madoff's IOU's were worth.

Ben Bernanke (Federal Reserve head) says that "quantitative easing" has been done by past Federal Reserve heads, and it is true. The Fed should print money as the economy expands, but only in proportion to that expansion, not at this insane rate he is doing. Proper increases in the money supply create price stability, confidence and therefore a stage for continued growth. The hope is that enough currency will be added to the economy so as to allow it to operate without radical price changes.

Imagine an economy the size of the United States with a money supply the size of France. Nominal prices would be a fraction of what they are because the currency would be worth so much more. In theory exchange rates for other currencies would be much higher than today, and that would be fine. If things were stagnant we could operate our economy this way without any serious consequences. The problem is that the economy expands and shrinks, and it does so in fits and starts. Without changes in the money supply, prices would jump up and down according to how much currency was needed to conduct business. This would reduce confidence of everyone holding that currency and would reduce their willingness to invest for the long term, thereby reducing growth.

The Fed should raise and lower money supply according to our economic growth. However, it must be done carefully. Everything I am saying is theoretical, and economics has a way of fooling us consistently. So no matter what theory one subscribes to, any action should be moderate so that we will adhere to the physician's admonition, "First do no harm." What the Fed has chosen to do today is anything but moderate. It is radical by any standard.

The inherent assumption in the "Bernanke Theory" is that we are at risk of deflation, and deflation would worsen unemployment. The theory says deflation would cause an increase in the value of our currency, making imports cheaper and exports more expensive, resulting in fewer jobs to create exports. Also, it would put foreign competition at an advantage exporting products which we also make, again resulting in fewer jobs.

Of course the opposite of deflation, inflation, which will be the result of this policy, does its own damage. Fewer people will invest in the country due to a declining value of the currency, and only interest rate increases would attract some level of investment. The problem there is that with higher rates the business cycle slows, thus fewer jobs are created. Also, whatever assets one holds are reduced in value. At the end of the day inflation is a tax, imposed on all savers, earners, and anyone holding assets of any type. Of course that tax accrues to the government in the form of reduced debt or more accurately, reduced purchasing power owed.

I would argue that deflation is not likely to occur, but even if it does, it is probably a symptom of a rapid contraction of prices in one sector or another, not the cause of an economic slowdown. Japan has had deflation for over 20 years because of a stagnant economy and the crash of their stock market in 1987. The US may experience it now because of the housing crash, but it doesn't follow that fewer jobs will be created because of it. We have had periods of mild deflation in the 1920s and they were boom times. In theory shouldn't declining prices induce economic activity, not curtail it? I certainly don't know exactly what all the causes are, but neither does Bernanke. His "cure," for his new demon deflation is inflation. His prescription is like infecting a patient with cancer in an attempt to treat his diabetes.

This type of effort to reduce government liabilities with a printing press has been tried by every banana republic on the planet, and the only question unanswered by looking at their history is how severely the investment community will punish us because we have become a deadbeat nation. Make no mistake. We will be punished. In nominal terms there has been no reduction in the value of the debt, but in purchasing power terms, which is the only real measure of worth, we have already experienced severe reductions, and that applies to every dollar based asset we own.

Just look at the value of our currency. Every western nation can now buy US assets for an amount of purchasing power far below what they had to pay before this scheme was hatched. The only thing that has kept the dollar decline from becoming far more severe is that the markets anticipate that other countries might crank up the presses as well. So the result is, we know we will be hurt, but we are not sure yet how much.

It can be argued that in aggregate the United States citizens owe the government debt, so the dilution of their worth is constructively a repayment of their own indebtedness. The questions that arise are, what about foreigners who hold US debt and were promised repayment with equal purchasing power? They don't owe our nations debt. Answer: they are screwed. Also, who gave the Federal Reserve the authority to do this? They are charged with maintaining price stability and maintaining employment. This latest fiasco does the opposite of their charge to maintain price stability, and it is highly questionable if it will help employment.

This policy is the idiot dream of an academic, but worse, it is a dream when all available evidence (and common sense) shows that even in the unlikely event it helps in the short term, it is certain to be destructive in the long term. It is even worse. We know so little about the unintended consequences of this action, we risk unimaginable damages to ourselves and to the world financial system. King Canute had a better chance of commanding the sea than Banana Ben has of making this work.