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Not-So-Gentle-Ben

Obama's risky Bernanke gamble.

By and From the October 2009 issue

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Last December in these pages we concluded that George W. Bush’s economic legacy will be remembered in history as a failure, in no small part because of the collapse of the dollar and the tripling in gold prices over the course of his presidency. We wish that Barack Obama had paid attention to that column because by reappointing Ben Bernanke as Fed chairman, he has endorsed one of the two people in Washington who were architects of that Bush weak dollar policy (with Alan Greenspan being the other). So much for change you can believe in.

Mr. Bernanke fashions himself as the man who last fall saved America from another Great Depression and “saved capitalism” by helping design the bailouts, stimulus plans, and the gigantic surge in the money supply to try to flood the economy with liquidity and consumer spending power. The Washington tale being repeated like a mantra is that things would have been so much worse without the Bernanke monetary stimulus on steroids. It is hard to see how this “savior” tag can be accurate, given that the unemployment rate in the United States has doubled on his watch, with 7.5 million more Americans now without jobs, and the combined debt of the Fed and the federal government has leapt upward by at least $3 trillion over the past 18 months.

One key measure of the Fed’s performance is how the financial markets perform during a chairman’s tenure. Using this barometer, Bernanke has been an unquestionable failure. After all, the great crash that began in earnest in September 2008 and liquidated $11 trillion of wealth happened on Bernanke’s watch. This was a classic credit bubble over-inflated by an overly easy money policy that the Fed began around 2003 under Mr. Greenspan and dutifully continued without reservation under Bernanke. During 2003–2007, when the federal funds rate was held at a preposterously low 1 percent, inflation ran at roughly 3 percent, meaning that the Fed was subsidizing banks to make loans—essentially paying them to do so. We now know that this flood of money went into mortgages that never should have been made and catastrophically overinflated the housing bubble. The Wall Street Journal editorial page had been warning of this for month after month but was regarded as the skunk at the housewarming party.

The dollar has been in a steady state of decline during the Bernanke tenure as well. The flood of money, combined with Obama’s trillion-dollar deficits, has moved America away from the Reagan-Volcker-Greenspan-Clinton maxim of keeping the dollar “as good as gold.”

We are told that Mr. Bernanke is a student of the Depression and knows how to steer us clear of the mistakes of the late 1920s and the 1930s. But it was FDR’s strategy circa 1934 to devalue the greenback versus gold. The price of gold rose from $20.67 an ounce to $35 an ounce in that year. So even as the unemployment rate ranged from 14 to 20 percent, the inflation rate came in at 7 percent—a double dose of economic cyanide.

Which brings us to our central complaint about Mr. Bernanke’s monetary philosophy. He is a true believer in the idea of the Phillips Curve—i.e., that there is an inverse relationship between unemployment and inflation. When one goes up, the other comes down. It’s an idea that gained currency in the 1960s and then wrecked the economy in the 1970s when it helped generate the great inflation. In a famous 1980 column for Newsweek, Paul Samuelson, Nobel laureate and author of the Economics 101 textbook that taught a generation of students about, well, economics, observed that to reduce the 1970s inflation we would need “five to 10 years of austerity, in which the unemployment rate rises toward an 8 to 9 percent average and real output inches upward at barely 1 or 2 percent per year.”

To Samuelson and most establishment economists of that bygone era, economic growth was the cause of inflation. This lunacy was accepted by almost all economists, except, thank God, for one who earned his degree at Eureka College. Reaganomics buried for good the faulty Phillips Curve—one would have thought. After all, from 1983 to 2000 the U.S. economy grew more or less without interruption (a minor recession in the early ’90s the exception), with falling inflation the rule. Gold is arguably the best indicator of inflationary pressures, and after hitting a high of $875 in 1980, by 2000 an ounce of the yellow metal was trading in the $300 range. As economist Arthur Laffer has explained it a thousand times: when an economy produces more apples, the price of apples falls, it doesn’t rise. Mr. Laffer has history on his side. Since 1950 inflation and unemployment rates have generally moved in tandem, not in opposite directions. Growth is anti-inflationary, but Bernanke seems not to believe this.

In a July 2005 op-ed for the Wall Street Journal just a few months prior to his Fed nomination, Bernanke asserted that there is a “highest level of employment that can be sustained without creating inflationary pressure.” And more recently, in another piece for the Journal, Bernanke reaffirmed his Phillips Curve bona fides with his suggestion that once “recovery takes hold,” there could be “an inflation problem down the road.” This is right out of the Samuelson 1970s textbook. Yikes.

It gets worse. When the economy was flat on its back in the first half of this year, the Bernanke Fed opined that economic weakness will tame any pricing pressures. In Bernanke’s model, unused labor and capacity is inflation’s cure in much the same way Samuelson felt economic sluggishness would break inflation’s back nearly 30 years ago.

As the Washington Post’s Annys Shin has described it, economists at the Fed feel that “a tepid recovery will keep inflation in check.” Further evidence of the Fed’s thinking comes from a recent press release from the Fed’s Federal Open Market Committee, which noted that due to “increasing economic slack here and abroad, the Committee expects that inflation will remain subdued.”

The problem with the Fed’s thinking is that just as strong economic growth cannot cause inflation, flagging economic health can in no way cause deflation. Putting people out of work reduces demand, true, but it also reduces supply, which works to increase prices.

A related myth the Bernanke Fed has embraced is that savings are bad and that consumption is good for the economy. Saving in no way detracts from demand. Money saved is merely lent out to others, some with near-term demands. If a household increases its savings, that money then becomes a pool of capital available for businesses to borrow to build factories, hire more workers, invest in computers—all of which are forms of “demand.” Savings help reduce the price of borrowing and are a solution to the credit freeze, not a contributor to it.

Mr. Bernanke seems to believe that money creation is the long-term solution to all economic problems. And while printing money may sound good in theory, it’s easy to see why what Bernanke presumed as a cure may wind up being quite hazardous. Money is not wealth, but a lubricant that enables the exchange of wealth. And just as a car engine can be ruined by being flooded with oil, so can an economy suffer from having too much money pumped into it. Bernanke essentially put the cart before the horse in assuming that the printing of undefined money—and lots of it—would take the place of actual productivity.

Sound money types have correctly blanched at all the unwarranted money creation, and have pointedly asked Bernanke how he intends to remove all the dollars that his Fed pumped into the system. In testimony and in print, Bernanke has said that he can reduce the quantity of money now in U.S. banks through interest paid on dollars returned to the Fed.

No doubt this would in the near-term reduce money quantities in our banks, but only in the near-term. That is so because the dollar is the world’s currency. For evidence we need only remind ourselves that two-thirds of all dollars are overseas. If and when dollar shortages reveal themselves stateside, the shortfall is made up with inflows of dollars from foreign locales.

So when Bernanke suggests he can contract U.S. bank reserves and lending through interest payments on dollars returned to the Fed, he is not speaking truthfully. Just the same, if the Fed increases reserve requirements on banks in order to reduce lending and the money supply, there will similarly be no decrease in dollars lent in the U.S. despite Bernanke’s protests otherwise.

Bernanke cheerleaders will doubtless point to low government measures of inflation as a counterargument to the Fed’s policies, but we would argue that the correct measure of dollar stability and flat prices is the price of gold, not the Consumer Price Index. The gold price is double today what it was in 2005. So even as an inflation fighter, Bernanke’s record is oversold.

We worry as well about Fed mission creep under Chairman Bernanke. The Fed has now declared that not only should it fight inflation, and fight unemployment, but that it is now responsible for preserving “financial stability.” It has added roughly $1.2 trillion to its balance sheet with almost one-half trillion of mortgage-backed securities, many of which will default. The Fed is micro-engineering the economy to a greater extent today than at any time in its 80-year history. Is it any wonder as the Fed takes on extra-constitutional powers that members of Congress ranging from Barney Frank to Ron Paul want to require more transparency and congressional oversight?

Looking at unemployment on his watch, it was 4.8 percent when he took over, yet the latest reading for August was 9.7 percent. If we’re to judge the Bernanke Fed on two key measures as mandated by Congress, the case for Bernanke gets no better.

Under a stable dollar regime, the financial crisis that has hopefully passed wouldn’t have occurred to begin with. When money values are unstable, investment is invariably distorted and what von Mises termed “malinvestment” occurs. Allowing for the truth that the Bush Treasury was more than accepting of the dollar’s decline on Bernanke’s watch, it can’t be stressed enough that the irrational rush into housing by individuals who couldn’t afford it and the resulting spike in mortgage defaults that crippled the banking system wouldn’t have occurred had the dollar been strong and stable.

Regarding the disaster that is TARP, it is well documented that Bernanke played a major—even coercive—role in its imposition and subsequent emasculation of the banking system. If we ignore that the Bernanke Fed was caught asleep at the wheel by a looming financial crisis among banks that it’s charged with regulating, it should at the very least be said that the Fed’s solutions have greatly weakened the banking sector, thanks to the latter’s inevitable bailout-induced politicization.

The Fed’s main policy tool is of course the short money rate that it sets. That it now sits at zero is not a compliment to our Fed chairman, but instead a strong signal from the Bernanke Fed that it has failed. Had monetary policy been rational and bank oversight sound (the latter perhaps an oxymoron), the Fed would never have had to reduce the funds rate to its present level.

In openly politicking for reappointment, Ben Bernanke made plain that a price rule is not in the cards, and that he’ll continue in his vain attempts to manage economic growth and the supply of money. The suspicion is that Messrs. Bernanke and Obama have gotten on famously because of the accommodative Fed policies that have opened up the floodgates. As the dimwitted “cash for clunkers” program showed, Americans love free money and incumbent politicians love easy money.

Here is our profound fear: Rather than saving capitalism, Bernanke’s hyper-interventionist policies and unbridled money creation over the past year have simply laid the groundwork for future economic crises. With large financial institutions well aware that their mistakes will be cushioned thanks to the misnomer that is “systemic risk,” the Bernanke Fed would better be described as a systemic risk generator than capitalism’s savior.

It is telling that Mr. Bernanke is now one of the few holdovers from the Bush years. No doubt when the combination of a blitzkrieg of fiscal stimulus from Obama and open floodgates of money from the Fed fail, the White House will blame the Bush administration.

Uh-uh. It’s the Obama-Bernanke economy now—for better, but more probably, for much worse.

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About the Author

Stephen Moore is a member of the Wall Street Journal editorial board.

About the Author

John Tamny is editor of RealClearMarkets. He can be reached at jtamny@realclearmarkets.com