Thursday, September 25, 2008

Ben Bernanke: True to his Word

The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

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

Ben Bernanke Nov. 21, 2002

Almost 6 years ago, before he became Fed Chairman (and, it seems to me, his promotion was by virtue thereof) Ben Bernanke promised, in the event of a deflation scare, to "produce as many dollars as it [The Fed] wishes." Lately, it seems to me, Ben has proven to be true to his word.

Admittedly, it seemed for a time that Ben wasn't going to "blink" at the first sign of the deflation monster. Lehman was allowed to fail. But, as it became clear that Lehman was but the first of many dominoes already lined up, Ben "blinked," remembered his promise to turn on the "printing press" and hunkered down with Hank Paulson to plan the "helicopter drop of money."

As he wrote in 2002: 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. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.

Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.

The plan which emerged from the Paulson-Bernanke meeting (which, by rights should be called "Operation Helicopter Drop") involves, as per the CBO: CBO expects that the Treasury would probably fully use its $700 billion authority in fiscal year 2009 to purchase various troubled assets. To finance those purchases, the Treasury would have to sell debt to the public. Federal debt held by the public would therefore initially rise by about $700 billion.

"A ha," you might be thinking (if you've actually read this far down on the page) the Fed hasn't promised to buy these bonds from Treasury. True, the Fed has not promised to do that, but it seems a likely outcome, to me.

If the Fed isn't going to buy these bonds (or finance banks to do the same) who will? Assuming the CBO is correct, the fiscal deficit for 2009 (which begins Oct. 1, 2008) will easily exceed $1T, or more than 2.5 times the 2008 deficit. To put it another way, $700B worth of bonds is just under 5% of US GDP and if this is added to the CBO's earlier projection of a $438B deficit the total comes to 8.1% of GDP.

To be perfectly clear- in most media reports I've read, clarity is lacking- the "taxpayer" isn't going to be paying more. That is, taxes are not going to rise, yet. Somebody needs to come up with 5% of US GDP.

If the Bonds are sold domestically (barring a substantial increase in US domestic savings rates) the "crowding out" theory comes into play- dollars which would have gone into private investment will instead be diverted into the Bonds (or worse, interest rates could jump). A collapse in private sector investment (or jump in interest rates) is exactly the opposite of what the the Treasury wants.

Alternatively, (again, barring a substantial increase in US domestic savings rates) the Bonds can be sold to foreigners and the current account deficit would increase, dramatically.

Given that the rest of the world is none too keen on recent developments in the US, with Russian and China calling for a revamp of the international financial architecture, and even our allies chiding with "I told you so," a repeat of the Reagan era "twin deficits" response seem unlikely.

That leaves the Fed, and the "Helicopter Drop."

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