Thursday, October 2, 2008

The Naked Emperors — Ben Bernanke

Or, How an Ivy League Professor Deals With Economic Woes

Two figures at the heart of the current financial situation are Ben Bernanke, Chairman of the Federal Reserve since Feb, 2006, and Henry Paulson, Secy of the Treasury, who assumed office in July, 2006.

Neither, of course, is wholly responsible for the mess in which we now find ourselves. Those who turbo-charged Fannie and Freddie, Greenspan with his seesaw interest rate policies in his final years as Fed chairman, and a great many others are more directly at fault. But it has fallen to Bernanke and Paulson to deal with it. Both have fallen down. Here's why.


I said several days ago that the Feds can never manage the economy properly, in part because they are too stupid. There are no exceptions to the first assertion, but there are to the second. Ben Bernanke is unquestionably a very smart guy. BA from Harvard, PhD from MIT and, for several years prior to joining the Fed, a professor of economics at Princeton. They don't just hand that stuff out to kids from Dillon, South Carolina. But smart or not, his economic philosophy is flawed.

One way to demonstrate that is through his understanding of the Great Depression, a specialty of his. He said, according to a recent article in The Economist,
[R]ecovery began in 1933 with large infusions of federal cash into institutions, through the Reconstruction Finance Corporation, and households, through the Home Owners’ Loan Corporation. They were, he wrote, “the only major New Deal program which successfully promoted economic recovery.”
The RFC was a creation of Herbert Hoover, the man who more than any other managed to stretch a business downturn into the longest, most severe economic depression in modern history. That Bernanke thinks the government solved the Depression is a significant reason for the present halting steps to right the economy.

His statement is the usual attempt to grant credit to the Federal Government for solving the problems it created by intervention through more intervention. Since it is presumptuous, to say the least, for me to correct a man of Dr. Bernanke's eminence, for the opposite view, I refer you to Dr. Rothbard's book on the subject, America's Great Depression. [In PDF format.] The shortest relevant explanation I could find is contained in his much shorter work, written in 1969:
As the boom proceeds, our hypothetical bank will expand its warehouse receipts issued from, say 2500 ounces to 4000 ounces, while its gold base dwindles to, say, 800. As this process intensifies, the banks will eventually become frightened. For the banks, after all, are obligated to redeem their liabilities in cash, and their cash is flowing out rapidly as their liabilities pile up.

Hence, the banks will eventually lose their nerve, stop their credit expansion, and in order to save themselves, contract their bank loans outstanding. Often, this retreat is precipitated by bankrupting runs on the banks touched off by the public, who had also been getting increasingly nervous about the ever more shaky condition of the nation's banks.

The bank contraction reverses the economic picture; contraction and bust follow boom.
This is exactly what we are seeing, with the 'public' in this case being the banks themselves, and their reluctance to lend among one another.
On September 18th companies could no longer issue commercial paper. [Short term, unsecured debt.] Banks, anticipating huge demands from companies seeking funds, began hoarding cash, sending the federal funds rate as high as 6%. That week, no investment-grade bonds were issued, for the first time (holidays aside) since 1981.
The panic has not yet spread to the general public.

Bernanke appears to be trying hard to see that happen, though. He continues to create fiat money at an ever-accelerating pace. Some figures in the drama have been widely reported: the $85 billion loan to AIG, the $200 billion backstopping of Fannie and Freddie, etc. But it has been busy elsewhere, too.
By September 17th [the Fed's balance sheet] had grown to $1 trillion, up by 10% in a fortnight, with most of it tied up in loans to banks, investment banks, foreign central banks, AIG and Bear Stearns.
It gets worse. The Fed will shortly "triple the supply of 84-day loans to $225 billion, from $75 billion."
All told, the total amount of cash loans - 84-day and 28-day - available to banks will double to $300 billion from $150 billion.

Moreover, the Fed will make a total of $620 billion available to other central banks, expanding ongoing currency "swap" arrangements with them where dollars are traded for their currencies. That's up from $290 billion previously in such arrangements.
Lest anyone naively think that all this funny money is going solely to Americans and that, therefore, we will just "owe it to ourselves," Bernanke's actions also involve supplying ample liquidity to foreign banks.
The Fed said it has established reciprocal-currency arrangements with the central banks of Australia, Denmark, Norway and Sweden.

The agreement allows the Fed to make up to $30 billion available to the central banks. The central banks of Australia and Sweden will be provided with $10 billion each while institutions in Denmark and Norway will get $5 billion each. In return, the Fed will receive the reciprocal amount of foreign currency from each country.
Under the reciprocal-currency plan announced last Thursday, the European Central Bank will get up to $110 billion, the Swiss National Bank up to $27 billion, the Bank of Japan up to $60 billion, the Bank of England up to $40 billion and up to $10 billion from the Bank of Canada.
And what is Chairman Bernanke's excuse for all this largesse?
"What we're trying to do is follow the mandate that Congress gave us," Bernanke said. "And the mandate that Congress gave us is to look at employment and inflation as measured by domestic price growth. And as I talked about today, and I think you would agree that we do see risk to inflation and we are taking those into account and we want to make sure that prices remain as stable as possible in the United States."
That is the core error. Prices in a free market are never stable. That is one of its strengths. Artificially rigging them through monetary policy can only lengthen the pain and spread it more widely. Creating money out of thin air does not increase the number of automobiles, corn stalks, or gold bars in the world. It only serves to kill the value of savings. It can not create real wealth.

The ultimate end of all this will appear the height of irony some day, given Bernanke's promise to Milton Friedman on the occasion of his 90th birthday celebration, in November, 2002:
"Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve System. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."
Prof. Bernanke, I desperately hope you keep that promise.

[Paulson's Plan next time.]

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