Is Bernanke Smarter Than We Thought?

by: Cam Hui, CFA

Many analysts, myself included, have watched in horror as the Bernanke Fed seems to have ignored the perils of incipient inflation and monetary debasement in implementing QE and later QE2. Lately I've been thinking that Ben Bernanke is an evil genius with a secret agenda that is more brilliant than anyone has conceived before.

Nick Rowe, writing at Worthwhile Canadian Initiative, inadvertently laid out Bernanke's nefarious scenario. First, he wrote,

There's a general principle in economics: first you eat the free lunches; then you look at the hard trade-offs. Functional Finance says "first eat the free lunches". The Long Run Government Budget Constraint says "then look at the hard trade-offs".

Everyone likes a free lunch. The Washington Post reported that in a poll, Americans would like to cut the budget deficit, but they oppose entitlement, defense and across-the-board tax increases cuts.

The survey finds that Americans prefer to keep Medicare just the way it is. Most also oppose cuts in Medicaid and the defense budget. More than half say they are against small, across-the-board tax increases combined with modest reductions in Medicare and Social Security benefits. Only President Obama’s call to raise tax rates on the wealthiest Americans enjoys solid support.

In other words, they want a free lunch. (Consider, for example, this more realistic assessment of the budget from former Reagan budget director David Stockman where he blames both sides of the aisle.) Rowe postulated that there are certain circumstances where the American People could have their free lunch:

Suppose, just suppose, that if you kept on doing what you were planning to do, you never had to worry about inflation. Not now, not in the future, not ever. Because Aggregate Demand was too low now, and was projected to be too low forever. So you are not worried about inflation. Instead you are worried about deflation. And you were a government that could print your own money. What would you do?

You would print money and spend it. Or print money and use it to finance tax cuts. And you would keep on doing it, more and more, until you got to the point where you did start to worry about inflation. You first eat all the free lunches.

When the US Dollar is the de facto reserve currency of the global economy, there is a free lunch of sorts. But what about the consequences? Rowe has an answer to that as well, given that the global economy collapsed in 2008 and remains very fragile [emphasis added]:

Suppose inflation isn't a problem right now, because Aggregate Demand is currently too low. Does that mean the government should print money and spend it? Not necessarily. Print money yes, but instead of spending it on goods, or on tax cuts, it might be better to use it to buy back some interest-paying government bonds. Because even though inflation isn't a problem right now, it may be a problem some time in the future. So you can buy the money back in future, by re-issuing the bonds (and save on interest in the meantime) without having to raise future taxes or cut future spending.

Isn't that what the Fed is doing, in its own way, with QE2? Okay, it's not retiring government debt but putting the paper on the Fed's balance sheet. Nevertheless, the Treasury can now finance new debt at lower rates because Aggregate Demand is so weak.

Is this the evil genius Dr. Bernanke at work? Or just the government acting rationally? Either way, it's utterly brilliant!