Is the Bernanke Doctrine a Disaster?

When Ben S. Bernanke gave a speech on "Deflation - making sure "it" doesn’t happen here" in 2002, he was sure that the chances of deflation were extremely small, for two principal reasons he cited. The same is given below.

The first is the resilience and structural stability of the U.S. economy itself. Over the years, the U.S. economy has shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow. Flexible and efficient markets for labor and capital, an entrepreneurial tradition, and a general willingness to tolerate and even embrace technological and economic change all contribute to this resiliency.

The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself. The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation.

We have already seen how the resilience of the U.S. economy was broken and it was in a free fall during Q4 2008 and Q1 2009. This, I must add, is not a particularly bad thing. Every economy has booms and recessions. What is bad is to try and avoid recession at any cost like it is being done now. It does not let the system clean out its excesses and the problems with the economy remain even after the brief recession is over.

However, till date, we have seen the resilience of the Federal Reserve to prevent deflation. Mr. Ben S. Bernanke has outlined several formulas to prevent deflation in the speech in 2002 which I wish to discuss in this article.

The first formula, in Mr. Bernanke's own words, is given below:

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.

Mr. Bernanke further goes on to say that:

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.

My observation on the above comments

At least here, Mr. Bernanke proves that he is a man who keeps his words. Since October 2007, Mr. Bernanke has been running the printing press he talked about in 2002 and has been successful to some extent in making the value of each Dollar go down. I must mention that he is not finished yet and he will do the same in the near future as well.

On the other hand we have U.S. Treasury Secretary Timothy Geithner who is talking about a strong Dollar policy. However, Mr. Bernanke had stated in 2002 that even by threatening to increase the number of Dollar in circulation, one can reduce the value. I think Geithner is trying something similar. Just by projecting that U.S. wants a strong Dollar, he is trying to lift sentiments on the Dollar to some extent.

I would also like to add here that money has three primary functions:

• It is a medium of exchange

• It is a store of value

• and It is a unit of account

Mr. Bernanke, by working overtime in his printing press has ensured that the Dollar is no longer a store of value and a unit of account. I would not be surprised if he wins a Nobel Prize for trimming down the functions of money.

Second Formula for avoiding Deflation

Recently, the Fed announced that they would keep interest rates low for an "extended period". If we go back to Mr. Bernanke's speech in 2002, we would get some idea of the intention and objective the Fed is trying to achieve through this statement.

Below is an extract from the speech:

There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years).

My Views on this Statement

The Fed has already announced its genuine intentions of keeping interest rates low for a long period. However, Mr. Bernanke likes the second option more then the first. Thus, it would not be surprising to see him implement this policy in the future as well. If the yields on the longer term treasury bonds keep going up (as it has been since December even after debt monetization), then the Fed might fix a upper ceiling for the rates. This would obviously lead to a sell off in the bonds but the Fed is there to buy the bonds and keep the rates fixed at the levels it wants it to be at.

This move would be targeting flooding the markets with Dollars again as the Fed would buy up the bonds and print some more money to pay for that purchase. This, according to Mr. Bernanke should help in preventing deflation and re-start the spending spree (the fall in which lead to deflation).

However, the manipulative ideas and strategies don't end here. The next one is a big of a shocker.

Third Formula to avoid deflation:

To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities.

Thus, the Fed has the power or potential to manipulate privately issued debt securities. At zero interest rates, by giving banks the money, the Fed can purchase private bonds impacting or lowering their yields. Besides making them unattractive, the Fed can also inject more money into the system by this method.

I have no evidence to prove that the Fed is doing this already. But it can't be ruled out as Mr. Bernanke has taken this speech of his seriously and has already implemented some of the measures talked about in the speech.

So, with the power to print any amount of money, the Fed can manipulate or at least try to manipulate many asset classes. I am not sure what this will lead to in the long term. But it surely will not have positive effects. There are discussions and debates for more regulation in the financial system. In my opinion, in order to prevent a disaster, one needs to regulate the Fed. There is an urgent need of more disclosure from the Fed in terms of their policies and actions.

If this is not done then Mr. Bernanke can prove to be a lethal weapon for the Dollar and also for further problems in the U.S. economy. President Obama, by giving Bernanke another four years has ensured that he tries everything he has talked about in this speech and maybe something more.

Comments

[Tom Armistead:]

Bernanke has given many speeches since 2002. Two themes he has mentioned repetitiously in the past year are 1) the need for the financial regulatory framework to be less pro-cyclical and 2) the recommendation or suggestion that the US exercise fiscal restraint as soon as realistically possible.

The corrective action on pro-cyclicality will need to be implemented as financial institutions gain strength and the economy recovers: it will consist of increased capital requirements and stronger prudential regulation during times of prosperity.

The fiscal restraint is not something Ben Bernanke controls: that is the hands of Congress and the President. Obama is starting to raise the subject, with his call for a 5% reduction in the Federal budget. There is easily enough pork that if it is trimmed out the 5% can be met.

Circumstances control human behavior: if Bernanke does not have other alternatives, he will use the power of the printing press. If, on the other hand, the financial regulatory system is rationalized and reconstructed along counter-cyclical lines, and the USG exercises fiscal restraint, Bernanke have other and better options.

Nov 15 08:22 AM

[Sandor:]

Fed tinkering and manipulation of interest rates and the free market (for example - gold naked-short selling at the COMEX through their fronts at J.P Morgan Chase and Goldman Sachs to keep prices artificially low) have compromised this economy...and America. We're in a lot of trouble.

End the Fed now.

Nov 15 08:45 AM

[Mr. G:]

Given the current massive financial crisis we now experience, FED policy to combat the crisis appears tripartite. First, maintaining a 0.25% borrowing rate for banks to lend is intended to stimulate business expansion. This may not work well if banks, jolted by their financial losses,do not participate in maintaining low interest rates to their borrowers. This is why mr. Geitner keeps commenting on bank lending policies. The alternative of lifting rates to support the dollar would not expand the economy at this time and would tend to lift lending interest rates.

Second, economic stimulus, which requires printing more money is attempting to support the unemployment rate by encouraging consumption and consumer spending.

Third, selling tips and treasuries during dollar deflation assists not only financing govt operations, but attempts to support economic stimulus.

The policy is designed, as I see it, as a good faith bet on stimulating capitalism to pull the US out of our financial crises. If the housing crises finally resolves, the unemployment rate goes down, our GDP expands, and the current account deficit does not expand out of total control, FED policy may work. I keep challenging the readership to design a superior FED policy, but I have not seen any constructive comments that discusses a comprehensive policy. I would not Mr. Bernankes job, but so far, I have to back the play. GI

Nov 15 11:30 AM

[LCACM:]

Very good analysis by the author. However, Mr. Bernanke does not have a choice regarding what policy to follow considering the situation at hand. The US Industrial and Manufacturing base has been destroyed by multinational mega corporations by large scale transfer of companies overseas to to benefit from non-existent labor and environmental laws. This transfer of manufacturing to Communist China has primarily benefitted company CEOs/CFOS, at the cost of the company employees. To prevent further suffering amongst employess Mr. Bernanke has no choice but to inflate the economy by printing dollars.

Nov 15 12:29 PM

[bob adamson:]

It is unclear from this article what Mr. Humayun thinks the US Fed and Treasury should have done in the weeks following September of 2008 when the prospect of a deep deflationary collapse was a clear and present danger or what he thinks should be done now. He writes approvingly about the benefit of the constructive destruction that a recession engenders and, accepting that this is a saving grace during mild recessions, does he really hold that the destruction during a deflationary depression would be limited to this constructive sort? Wouldn’t the sound as well as the inefficient or ineffective players in the economy all be caught up in the chaos of such a meltdown to no good end? Don’t we now have a sufficient depth of recession to achieve constructive destruction and wouldn’t deepening the downturn now simply start the destruction of factors that will be needed for a sound recovery?

If Mr. Humayun in his criticism of Dr. Bernanke is simply making the point that monetary loosening alone (or fiscal and monetary stimulus alone, although this is not the focus of the article), is not the solution to the current recession and economic malaise for the US, most would agree that many reforms and initiatives are also needed and that many of these will be difficult and painful. Monetary policy is only one tool and not the solution. That said, to take extracts from earlier statements in which Bernanke was showing that he was a man of resolve and making some abstract points about the possible role of monetary policy in extreme situations and then, as this article does, to impute to him an intention to implement such policies now to the full is simply to set up a straw man. Now setting up straw men is a useful ploy in order to set the stage to present arguments for another and hopefully better approach but this article doesn’t take this next step.

Nov 15 02:03 PM

[mdmrjsds:]

Excellent analysis. Thank you for the article.

On Nov 15 11:30 AM Mr. G wrote:
> The policy is designed, as I see it, as a good faith bet on stimulating
> capitalism to pull the US out of our financial crises.

I agree with you. The only caveat I would add is, 'within the limitations of their understanding'. I also think they have a bias towards the wealthy, couching the bias in language that implies it is for our own good, but a bias nevertheless. This bias is built into the system as well.

> ... If the housing
> crises finally resolves, the unemployment rate goes down, our GDP
> expands, and the current account deficit does not expand out of total
> control, FED policy may work. I keep challenging the readership to
> design a superior FED policy, but I have not seen any constructive
> comments that discusses a comprehensive policy. I would not Mr. Bernankes
> job, but so far, I have to back the play. GI

The problem is that the structure of our control system for the economy is unstable. It either is spiraling up until the falsity brings it down, or spiraling down until debt is resolved and it begins growing again. What the fed is trying to do here ( and has for several recessions) is pump enough money into the economy to keep the downward spiral from happening. But that can only work if people return to the beliefs that created the bubble in the first place (unlikely in the extreme), or a new bubble takes its place. The fundamental problem they can't escape, as the article alludes to, is that the dollar has been abused as a store of value and as a unit of account metric during the upward spiral. Thus, they are between Scylla and Charybdis. Either they allow the debt to unwind and bring the dollar back into line, or they inflate until the bubble starts over. If the US was Argentina, the second option wouldn't exist, because the currency wouldn't be the world reserve currency. For us, it does, until people gain an alternative. Thin ice.

By the way, you can see an outline of my proposed solution to this mess at
seekingalpha.com/user/...

It doesn't meet your challenge because it is not a FED policy. The FED is a boondoggle, and should be eliminated. It is part of the problem, not part of the solution. And no, it does not suggest we go back on the gold standard. That also has problems. It is suggesting that we utilize the thousand fold increase in human knowledge since the creation of the fed to design a better system.

If I *had* to keep the current system, my solution to the current problem would be to damp the downward spiral unwind, so it occurred over 3 to 5 years instead of as an instant crash. That is, now that the system is stable again, withdraw the support in stages and let the natural unwind take place slowly. That renews the system for a new spring forward. Will this happen? No chance, politically untenable. Our politicians are not statesmanlike enough to do what is best for the country rather than themselves. And most of them probably don't have the ability to understand these types of arguments. Their skills are interpersonal, getting elected, forging coalitions, etc. not technocracy.

Nov 15 02:09 PM

[Mr. G:]

Removing the independant power to regulate bank lending rates, and involving political regulation in the structure of the FED would lead to a disaster. Independant thinking in economics is necessary to achieve regulation of our complex economy, not political agenda. GI

Nov 15 02:32 PM

[mdmrjsds:]

On Nov 15 02:03 PM bob adamson wrote:

> It is unclear from this article what Mr. Humayun thinks the US Fed
> and Treasury should have done in the weeks following September of
> 2008 when the prospect of a deep deflationary collapse was a clear
> and present danger or what he thinks should be done now. He writes

It is not what the Fed and Treasury should have done after the problems began. It is what they should have done to prevent the problems from occurring. Should not our 'experts' in the economy have seen the collapse coming months or even years in advance? I was hearing my coworkers talk about the 'housing bubble' around the water cooler in 2005 and 2006. Couldn't we have expected our 'experts' to also have known this and taken appropriate measures?

> approvingly about the benefit of the constructive destruction that
> a recession engenders and, accepting that this is a saving grace
> during mild recessions, does he really hold that the destruction
> during a deflationary depression would be limited to this constructive
> sort? Wouldn’t the sound as well as the inefficient or ineffective
> players in the economy all be caught up in the chaos of such a meltdown
> to no good end? Don’t we now have a sufficient depth of recession
> to achieve constructive destruction and wouldn’t deepening the downturn
> now simply start the destruction of factors that will be needed for
> a sound recovery?

My opinion is that no, we do not have sufficient depth of recession to start recovery. The people who have experienced sufficient pain are not those who caused the problem; those who caused the problem haven't experienced sufficient pain. In particular, we have not cleared up the debt bubble, but are reinflating it. And the same players that *caused* the debt bubble are still in place. So, to summarize, we have already experienced inequitable distribution of pain, in my opinion caused by the inaction of the Fed in the first place. And we are exaggerating that inequity with our current policies. No sound recovery can occur from here without addressing these issues, rather than papering them over. The Fed and treasury are doing the equivalent of putting a clean bandage on an infected wound. It looks OK, but it is going to cause problems later.

Nov 15 02:42 PM

[E Nuff Sed:]

Faisal: The problem with your thesis the money supply is not growing.
Most of the money supply (created by the expansion of the Fed balance sheet) has been soaked up by the banking system which is trying to stay solvent. There is little credit available (compared to 2005- 07) on the street to fuel inflation. It will be a while before credit begins to seep back into the street to reignite inflation.

Nov 15 04:05 PM

[bob adamson:]

To mdmrjsds: -

I would agree that what the Bush administration (which only left Office in February of this year) and Greenspan did and did not do while they held the leavers of power in their respective fiscal and monetary spheres must be severely criticized for establishing the foundation for the crisis that peaked in October of 2008 but their successors in office had to address the unfolding crisis as they found it on taking office. To his credit Bernanke began in July of 2008 to take decisive steps to end destructive investment banking practices even though this served to trigger instability in many of the investment banks and hedged funds whose practices were at the heart of the rapidly mounting problem. Clearly there were no clear, easy, painless or cheap solutions to be found when Bernanke and Obama respectively assumed office and they took the stimulus route, hopefully as a first step towards a more fundamental and detailed set of reform measures which have yet to be presented. One can question whether they needed to have been as accommodating to the movers and shakers in the investment banking industry during the emergency stabilization phase in the last quarter of 2008 and the first quarter of 2009 and whether many of the details of the stimulus package were well conceived and executed but you and Mr. Humayun appear to have a fundamental objection to the stimulus strategy itself. Fine, but you should explain what should have been done last year and must be done now going forward in place of that strategy. It is not sufficient to conflate the Greenspan/Bush and Bernanke/Obama approaches and simply assert that the basis for the crisis should never have been allowed to develop.

You appear to endorse triggering a deeper recession to target those in the investment banks, hedged funds and other near banks that caused the debt bubble that created the basis for the crisis. Why is that the best way to target these wrong doers and how can others who are not guilty of this wrongdoing to be shielded from the full brunt for what then must be a brutal recession/depression?


On Nov 15 02:42 PM mdmrjsds wrote:

> On Nov 15 02:03 PM bob adamson wrote:

Nov 15 04:09 PM

[Mr. G:]

I enjoy reading the opinions of our financial problems. I think the root of the problem began when both parties, encouraging more home ownership, the "american dream", deleveraged the entire lending industry. As an attorney, I crossexamined a mortgage broker in 2006 and listened in disbelief as he testified to loans based on "stated income"(loans without verification) and no money down loans, loans based on 125% of the home value etc. I walked out of court thinking he must have been lying.
When I refinanced my own home, I was swamped with offers from lenders offering option arms(choosing payments with no principal reduction or negative amortization while tacking principal to the end of the loan). WOW! I chose a 30 year fixed interest rate loan.

The other problem unknown to the public in general is how the lending industry subdivided secured trust deeds and mortgages into investment parts based on future interest expectations and sold these parts on a global basis. AIG WAS INVOLVED IN ISSUING CREDIT DEFAULT SWAPS WHICH operate like insurance against foreclosure.

The entire system imploded as real estate began losing value. Investors of almost every class participated to some degree and on a global basis. The exponential quality of these new and exotic products practically bankrupt our entire lending industry which gives one an idea how massive this really was. You probably had no idea who was holding your mortgage or how many different investors were involved in it. The original lender simply stayed on board as the collection agent.

I hope this gives some insight into the global financial crises. This is why I say the FED became hostage to capitalism gone wild. This is why I rail at supply side economics which prefers no regulation of the industry. Deregulation of risk clearly has the potential to bring down our entire financial system. GI

Nov 15 08:29 PM

[William M. ...:]

Good article. Many excellent educational comments.

I do agree that as the article concludes "Mr. Bernanke, by working overtime in his printing press has ensured that the Dollar is no longer a store of value". But we must keep in mind it's not the Job of Fed. Chairman to maintain the USA dollars value. It's his job to maintain Inflation in check and to help the economy grow and employ workers. Inflation is in check but employment is not.

While I agree with many of the negative comments against such an easy money policy and would add it comes at the expense of savers (with trillions in MMFs and low yielding savings accounts) Bernanke is just doing his job.

Can you image what the press and public would now be saying about Ben Beranke had he said, "Hell no I will not lower interest rates" back in early 2008?

Nov 18 12:30 PM

[Faisal Humayun:]

Actually if you look at whom high interest rates would have hurt the most...it might be the private sector to a large extent...High interest rates would have been good for a majority of the 300 million Americans...

Moreover, how has low interest rates benefited?

It has just helped big banks and IB's to get cheap money and speculate worldwide...I am not there in America but you will be able to tell me how has low interest rates benefitted the masses...

Also, I doubt there is no inflation in the U.S....I think an average household has at least 5% inflation...if not more...It would not be a great idea to take Government numbers...As far as I can see, healthcare cost is going up...insurance cost is going up...education cost if going up...and food cost is also going up...

I also think that if the government wants to do something then no amount of opposition can stop them...and if they dont want to do something then they take refuge in oppositions...So Bernanke would have lowered rates anyways...If he did not....some big players would have cried out...but it would have helped the masses...


On Nov 18 12:30 PM William M. Wright wrote:

> Good article. Many excellent educational comments.
>
> I do agree that as the article concludes "Mr. Bernanke, by working
> overtime in his printing press has ensured that the Dollar is no
> longer a store of value". But we must keep in mind it's not the Job
> of Fed. Chairman to maintain the USA dollars value. It's his job
> to maintain Inflation in check and to help the economy grow and employ
> workers. Inflation is in check but employment is not.
>
> While I agree with many of the negative comments against such an
> easy money policy and would add it comes at the expense of savers
> (with trillions in MMFs and low yielding savings accounts) Bernanke
> is just doing his job.
>
> Can you image what the press and public would now be saying about
> Ben Beranke had he said, "Hell no I will not lower interest rates"
> back in early 2008?

Nov 18 01:03 PM

[William M. ...:]

Faisal, you make many good points. And given I'm also one of those who saved and have large sums earning nothing inside MMF's I'm often thinking as you do that this in the long-run is not good for USA dollar and future inflation potential. And in the short run it has cost me many thousands of lost income. Frankly for me this would be so much better if we were back to 1982 high interest rates and high inflation. Not only would I be 27 years younger but I'd be making 10% on my savings and the market would still be going up in a bad economy so I'd have the same opportunity to make money for people on stock holdings too. I certainly do not like being forced to put all my investment and savings eggs into Stocks for a chance to earn a return.

Still, I feel Bernanke is just doing his job and I doubt he has invested in gold as his motivation for keeping rates low.

Now how one stimulates the economy I would agree is up for total debate and I certainly do not agree that Free-Markets needed all this bail-out money nor if GM is not to big to fail then I see no reason why Citi can't be allowed to fail. The AIG $80 billion bail-out benefited Wall Street not Main Street. So like the Iraq War I see it as a total waste of taxpayer money. But again these are not do to Uncle Ben.

You also said "Also, I doubt there is no inflation in the U.S....I think an average household has at least 5% inflation...if not more...It would not be a great idea to take Government numbers...As far as I can see, healthcare cost is going up...insurance cost is going up...education cost if going up...and food cost is also going up..." How inflation is measured has always been up for debate but atleast it's been relatively consistent. I'd say each family has a different inflation index. No question American Health Care and Higher Education Cost have been totally out of control. But that's a whole another problem which I'm not sure we can blame on low interest rates and easy money policy. Although the American Universities and For Profit USA schools have benefited big time from making it easy for students to go into big debt with no risk to the University. Again I think this is wrong...but Uncle Ben didn't create this problem.

Nov 18 03:55 PM