'Helicopter Ben' Was Prophetic in 2002

Federal Reserve chairman Ben "Printing Press" Bernanke and his fellows around the FOMC oak table may appear to be behind the curve since the onset of the debt crisis in August 2007. Their erratic rate policy followed loud calls from Wall Street pundits, establishing such nicknames like Nanny Benny or even Ben Dover.
But one has to wonder whether the Fed has really been all that clueless about the disastrous implications of a property market gone white hot, fuelled by cheap credit and next to no loan requirements.

Re-reading Bernanke's most infamous speech titled "Deflation: Making Sure 'It' Doesn't Happen Here" from November 2002, I am surprised to say that Bernanke was actually quite prophetic about the future policy of the Fed.

Bernanke had already tabled the idea that the Fed could become a participant in the commercial paper market, buy long term US Treasuries and distribute government money willy-nilly (stimulus checks).

At the same time, he also touched on the issue of having a zero interest rate policy (ZIRP), saying that the Fed could manipulate the long end of the market in order to keep financing costs low.

Bernanke has certainly made good on his promise to prevent deflation, continuing the easy money policy his predecessor Alan Greenspan had conducted in order to prevent all possible market meltdowns that came along. From Black Monday in '87, the mini crash of '89, the Asian currency crisis in the mid 1990s, Long Term Capital Management in 1999, to the dot.com bubble in 2000 and the property bubble in this decade, the Fed has always thrown fresh credit at every problem that came along.

Read the following excerpts from Bernanke's speech that established his image of an inflationista and earned him the nicknames "Helicopter Bernanke" and "Ben electronic printing press Bernanke."

On deflation and zero interest rate policy:

A deflationary recession may differ in one respect from "normal" recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero. Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the "zero bound."

...Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern--the limitation that it places on conventional monetary policy. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate--the overnight federal funds rate in the United States--and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.

Running Out of Ammunition

Bernanke then also admitted that a ZIRP diminishes the arsenal of weapons the Fed has. Now they boast of unspecified tools ready to direct interest rates:

Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory.

...However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.

Preventing Deflation

Suffering from deflation-phobia, Bernanke then relied on the Fed's supervisionary powers in order to stabilize financial markets:

The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. And at times of extreme threat to financial stability, the Federal Reserve stands ready to use the discount window and other tools to protect the financial system, as it did during the 1987 stock market crash and the September 11, 2001, terrorist attacks.

Well, this obviously did not work in the current crisis where supervisors and authorities sat on their ears, eyes wide shut.

Curing Deflation

Being by now the absolute high priest of ever expanding credit, Bernanke sees his main task in growing debts to combat the ghosts of deflation.

Under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

In order to keep the party fueled by spending, Bernanke mainly wants to push aggregate demand:

To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities.

On Fiat Money and Gold

Ironically Ben's most immortal quotes about helicopters and the electronic printing press are linked in context with the virtue of gold, which is in contrast to Federal Reserve Notes (FRN).

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.

This may be the shortfall in Bernanke's thinking, which is fixated on creating new credit. But growing government expenditures are certainly not the way to erode America's mountain of debt. Oh, and for the record, here again is Ben's helicopter quote, where he referred to Milton Friedman's helicopter drop in order to keep the economy going.

A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.

Do you still have any doubt that Bernanke will ultimately be the death knell of the Fed, having created hyper-inflation instead?

Comments

[SW Richmond:]

No, I have no doubt at all. As you've pointed out, he told us that deflation is his ultimate fear, and then he told us what he would do about it should it appear, and now that it has appeared he is demonstrably doing exactly what he said he would.

Deflationists just don't get it.

2008 Dec 21 05:43 PM

[herbert hoover:]

Welcome the the Weimer Republic of America. Get your wheelbarrow-wallets now while you can get one for less than a million bucks. Hyperinflation will destroy this country more thoroughly than any "islamo-fascist" attack.

2008 Dec 21 06:04 PM

[jepittman:]

It is amusing to me that most people posting opinions on these boards believe Federal Reserve policy is either NOT going to work at all and there is nothing anybody can do to prevent the global economy from spiraling down into a depression or that it WILL work but send us spiraling up into hyperinflation. If this author is right and inflation occurs there will be a heck of a stock market rally along the way. No mention is made of that. Furthermore, he offers absolutely no suggestions as to specificly what his recommendations would be to address the recession and subsequent unemployment. All I see is criticism of an inflationary monetary policy. It seems to me this is precisly what is called for. The alternative is what brought us the depression of the 30s.

So assuming the author is corrrect then the current monetary policy will work like a charm. So well in fact that acellerating inflation occurs in the future. So what happens prior to that? ECONOMIC RECOVERY. Exactly what is desired. Why no mention of it? Why only derision and personal critcism of Chairman Bernanke who is using his authority to reduce the severity of a job killing recession?

Either the monetary policy will work or it will not. I am in agreement with the author that it will. An economic recovery will occur fairly soon. When THAT occurs, be prepared for the Federal Reserve to address the money supply issue. They will no more stand for runaway inflation than they will for runaway deflation.

2008 Dec 21 06:52 PM

[Tom Ford:]

Bernanke didnt figure what would happen when he raised the fed discount 17 times in 11 months. What an ass! The reality is that he derailed the entire economy. Where do you think all those people are going to live now that they are losing their houses? Housing is esential. Greenspan wasnt wrong. The economy is like a slow moving freight train. Slow to go up and slow to go down. When he raised the rates so quickly he derailed the train and like humpty dumpty you cant put it back together again. Give everyone thw ability to borrow on a home loan at the 4 to 4.5% range and it will give people the faith in the system to start buying again. It may take awhile but it will recover. Dont just help the ones in foreclosure but set the rate for everyone that is willing to buy a home. The housing floor will be st the day thats announced and will recover from there.

2008 Dec 21 07:43 PM

[Analyste de...:]

"[If] inflation occurs there will be a heck of a stock market rally along the way. No mention is made of that."

You imply that's a silver-lining? On what empirical evidence is that based? How many periods of inflation with FIAT currencies are evaluated, for you to reach that conclusion?

See Page 2 "Inflation and Stock Prices" by: George R. Hoguet, CFA, FRM, Global Equities, SSgA

"The 1970s were a period of accelerating inflation and poor equity returns in the US. By December 1980, the federal funds rate stood at 20%, and the ten-year Treasury peaked at 15.3% in September 1981. From December 31, 1968 to December 31, 1981, the S&P500 returned 1.28 % per annum in nominal terms and -6% in real returns. Put another way, a dollar invested in the US stock market at the end of 1968 twelve years later was worth roughly 45 cents in real terms."

2008 Dec 21 08:07 PM

[Steven Hansen:]

"Deflationists just don't get it." SW Richmond

they have not given me a club pin yet but i have deflationist tendencies. i have read most of Bernanke's writings and i know what he is trying to do. would i care to guess what will happen - no.

if they can re-ignite the economy within the next 12 months, i will buy an inflationary argument. but if they cannot, under what rock can inflation emerge?

2008 Dec 21 11:19 PM

[orca:]

Just so we are on the same page, the FED is n.o.t. the Central Bank of the USA, it is a group of commercial/investment banks. Therefore the entire alphabet-soup of emergency programs coming out of the institution (and the Treasury), leading to a transer of assets and liabilities from one balance sheet to another, is nothing more or less than an optical illusion.

2008 Dec 22 06:52 AM

[mrpitchfork:]

What most people don't realize is that the Federal Reserve is a PRIVATE organization that created this whole mess in the first place. They're the ones that cause inflation and deflation. Our economy will always be this way as long as the Federal Reserve calls the shots. They are the ones buying up America. WE THE PEOPLE are the only ones that can stop these thieves.

2008 Dec 22 09:11 AM

[Chris B:]

OK, so if you believe the Fed is creating too many dollars in order to fight inflation, and that they will purposefully overshoot just to make sure the deflation monster is dead, it makes sense to believe that higher than average inflation could result in the short term (2009 or 2010). I agree. Short treasuries if you want to bet money on it.

However, hyperinflation (50%+ per year) or high inflation over long periods of time (say, 7-10% for 10 years) is another topic with another set of causes.

To use today's low interest rates and asset purchases to argue that these phenomenon are imminent is to assume that the Fed could not or would not do the exact opposite of what it is doing now if inflation became a problem in a couple of years. That is, they could not raise interest rates to high levels in order to control inflation (a la Volker, early 80's) and they could not just sell all the assets they bought in order to reduce the number of dollars in circulation.

The comments above don't sound that alarmist to me - they just state the fact that the Fed has a lot more tools to affect inflation rates than just interest rates. What the panicked author doesn't get is that all those tools (except the relatively minor "stimulus" checks) can easily be made to run in reverse if needed to stamp out inflation. Only political interference, gross incompetence, or overwhelming externalities could prevent this. The possibility of such is yet another subject, but the author doesn't even get to this much more interesting point in the discussion.

2008 Dec 22 09:40 AM

[Fabien Hug:]

I read a lot of comments about the actions of the FED, actions being necessary now and the FED will quickly reverse course by tightening when its current policy bears results. If I believe on one hand that the FED's current policy will sooner that later bring results I am not so optimistic about the reverse. After the very cold shower of 2008, they will be so scared to stop any recovery that they will not tighten before it is too late. Furthermore, you have to add to that extreme political pressure for the FED not to tighten. I bet that when we are out of that deflation spiral, unofficial inflation will be back big time like under Greenspan.

2008 Dec 22 11:02 AM

[OldLimey:]

Agree entirely with fabien hug. One additional thought: given that officially reported inflation is calculated in a much more 'forgiving' way than a couple of decades ago, the Fed anyway has some room for maneuver before it will perceive a need to start raising rates.

This is one of those occasions when being agnostic makes perfect sense. To argue strongly that we're headed into a deflationary abyss or a period of inflation (hyper- or otherwise) ignores the fact that we're in uncharted territory as far as the actual practice of monetary policy in the United States (and Britain) is concerned. I tend to the view that if a government wants to inflate, it will get its way - provided it doesn't leave things too late. The speed of decline in global economic indicators over the last few weeks does raise the question of whether or not despite the relative speed of the Fed's responses it is simply being overwhelmed by events. Only time will tell. Come what may, if things work out just OK - a 'goldilocks reflation' - it's likely to be due as much to luck as to judgement.

2008 Dec 22 02:39 PM