By Neville Bennett Last week, the Fed gave markets their biggest shock in living memory. I believe Bernanke tried a de facto devaluation, one he could not admit lest others follow suit. To prove it, I trolled though his works finding a 2002 speech foreshadowing drastic action. In 2002, Ben Bernanke claimed that deflation was a remote because the American economic and financial system was flexible and strong. He even expected inflation to be around 2.9% during the next five to ten years. He claimed modern central bankers could easily avoid deflation: a helicopter could, if absolutely necessary, drop money. The next day the press facetiously called him "Helicopter Ben". They were joshing. Actually, Bernanke scares me. Deflation: cause and effects
Deflation is a general decline in prices, usually following a collapse of aggregate demand. There is a severe drop in spending: producers have to cut prices to find buyers. This has the effect of causing recession, high unemployment and widening financial stress. A deflationary recession may involve a zero interest rate. Deflation savage enough to bring interest rates close to zero poses great problems for the economy and policy. If the rate of deflation is 10% (as happened in the 1930's) a borrower at zero percent faces a real cost of funds of 10%, because the loan has to be repaid in currency whose currency's purchasing power is 10% greater than the dollars originally borrowed. Thus, in a very deflationary episode, the real cost of borrowing can be prohibitive. This forces a decline in spending on homes and consumer goods as well as curtailing capital investment. In Japan, consumers put off purchasing because their expectation was that the cost of goods would depreciate. Deflation worsens the economic downturn. Deflation is an excruciating experience for households, business and governments that had accumulated debt before deflation's onset. Servicing the debt is difficult because the loan increases in real value. There are defaults; people walk away from houses and farms that are under-water. This strains a banking system burdened by delinquent or defaulted loans. Many banks today still have eroding balance sheets. New Zealand's governments adopted harsh social policies in the 1930's arose partly because its first charge was servicing loans to the UK (NBR Nov 20, 2008). Central banks are severely constrained in policy options when nominal interest rates are at zero. It is often thought that they have "run out of ammunition" because they cannot lower rates to stimulate aggregate demand. Bernanke conceded in 2002 that this meant that banks had exhausted traditional means of stimulation. However, there was still some room for action. Preventing Deflation Bernanke thought deflation could be avoided by supporting aggregate demand consistent with fully utilising resources and low and stable inflation. The Bank could provide a buffer by not pushing inflation to zero and thereby avoiding problems if there is a large unanticipated drop in demand. The Bank should also ensure that the financial system and capital markets are functioning properly to defend against deflationary shocks. Bernanke knew the Fed should use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. Clearly he did not meet his own expectations. But he did cut interest rates when the economy deteriorated. Perhaps he complacently believed significant deflation in the United States in the foreseeable future (is) quite unlikely. Curing deflation Bernanke denied that the Fed would run out of ammunition if rates were at zero. A government, he said, "would always be able to generate increased spending and inflation". "Deflation is always reversible". He proceeded to make remarks that would chill the Chinese Government and gold-bugs especially: the U.S. government has a technology, called a printing press ... that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation ... the government can also reduce the value of a dollar in terms of goods and a service, which is equivalent to raising the prices in dollars of those goods and services "¦ under a paper-money system, a determined government can always generate higher spending and inflation. He denied that the US would "print money and distribute it willy-nilly" (although there are aspects of the Obama package that sail close to these rocks (see "carpet-bombing" February 13). The Fed would buy assets or make low-interest loans to banks. If the economy, nevertheless, fell into deflation, 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. Bernanke shocked markets last week by lowering interest rates across the board. The dollar took a massive hit. The "helicopter speech" foreshadowed this: One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure -- that is, rates on government bonds of longer maturities. He also thought yields on privately issued securities could be reduced by offering loans to banks with private assets being accepted a collateral. He mentioned the possibility too of buying foreign government debt without explaining precisely how it would inject money in the economy. But he insisted that intervening to affect the exchange value of the dollar has been an effective weapon. Franklin Roosevelt devalued the dollar by 40% against gold in 1933-4: The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934. Ben Bernanke added that 1934 was one of the best years in the century for the stock market. He also advocated tax-cuts as a "helicopter drop" of money. He believes Japan's difficulties with deflation are bound up with political constraints "rather than a lack of policy instruments". Ben Bernanke has now almost exhausted his strategies, one trembles in anticipation of more easy money drops whether by helicopter or a broad carpet-bombing. The antidote to Bernanke's mayhem is to invest in inflation-proofed assets like precious metals. --------------- * Neville Bennett was a long-time Senior Lecturer in History at the University of Canterbury, where he taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared.