Vox Rationalis

Prophet Bernanke Plans for Inflation

This article seems either to be simplistic so that it can be frightening, or else frighteningly simplistic. The author seems to ignore the linkage between deflation and inflation; namely, that there is a point in between where there is neither inflation nor deflation. If a central bank is taking action to avoid deflation, it must risk overshooting its mark to be effective. Clearly, the Fed is more concerned with preventing a deflationary spiral than it is with causing higher than desirable inflation in the future.

However, this does not mean that high inflation is certain. To understand this, one must have a little basic knowledge about the money supply, and more than a cursory look at Bernanke's quotes above.

First off, there are basically two major economic actors when it comes to the money supply. There are the banks (collectively) and the central bank (the Fed). The former is far more powerful than the latter. The creation of money in the economy primarily occurs through banking activity; then a bank takes a deposited dollar and lends it, that loan is are subsequently deposited in another account, and where there was one dollar in deposits there are now two. When the banks stopped lending, this primary driver of money creation also stopped. Worse, as banks have collectively moved to shore up their capital positions, they have been reducing the money supply, which will tend to make money more valuable - deflation.

The Fed (backed by Treasury) is a much smaller player than the collective banking sector, and so to counteract the deflationary actions of the banks has had to move in unprecedentedly large ways. But these actions are not necessarily inflationary.

In a normal time, in fact, in any other time since 1933, recent Fed actions would have had huge inflationary impacts. But because of the shrinking the money supply resulting from the credit contraction, these actions are not currently inflationary. The question is what impact these actions will have in six months or a year or two years, as the credit markets heal and begin expanding again. The author, and lots of others, are quite sure that the answer is that we are certain to see very high levels of inflation.

But a more careful look at these carefully considered actions is warranted. After all, Bernanke's been studying the Great Depression, or more specifically the monetary aspects of the Depression, for virtually his entire academic career. Those who would assume he doesn't know what he's doing, or has not thought this through, or doesn't care about future inflation, don't really understand the problems and solutions.

The trick here is not in flooding the markets with Fed-derrived money to replace that lost through the credit collapse. The trick is on the other end, in removing the additional money as the banking industry moves back to a more normal money-creating paradigm. The combination of Fed actions to date and Bernanke's quote above show that the Fed is well aware of the upcoming problem.

The TARP preferred investments in the banks are a good example of thoughtful government action (even if it wasn't what they originally said, and even if the idea came from overseas). The banks will take the money and it will help them improve their capital positions, enabling them to get to normal lending faster (that it hasn't happened yet doesn't mean that it won't). As banks become more comfortable with their position, and more importantly with the economy as a whole, they have a strong incentive (high dividend payments) to pay back the government equity, which will take money out of circulation, which will be anti-inflationary.

Bernanke's discussion above about buying 2-year Treasuries to manage interest rates is also very thoughtful. The idea here is that a two-year period is long enough for the economy to recover from vitually any deflationary shock (if managed well on the front end through massively expansionary monetary policy). The Fed buys the 2-year-ish notes, injecting money into the economy, which then goes elsewhere. In two years, when the credit markets are recovering, the federal government pays off those notes, but instead of the cash re-entering the markets, it goes to the Fed instead.

Basically, the Fed puts money into the market now that would normally not re-enter the market for two years. The net result in the money supply in two years is zero, so that beyond the two-year period the action has no impact on inflation. In the short term, however, it is inflationary -- or anti-deflationary, which is exactly what is needed.

Basically, the Fed isn't run by a bunch of morons. Give them some credit for being thoughtful and being studied, and take some time to try to understand the forces at work. What they're doing may not work exactly, as crisis intervention is sloppy work. But it is NOT sure to fail.