Bernanke's Rhyme

So cronyism took a day off. Ben Bernanke, President Bush's nominee to replace Alan Greenspan as head of the Federal Reserve, is no Harriet Miers. And he was probably the best choice Bush could have made. But does that mean smooth sailing ahead for the economy and the asset markets?

The pundits spent today downplaying these high-profile comments Bernanke made on November 21, 2002:

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.

Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior). Normally, money is injected into the economy through asset purchases by the Federal Reserve. 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. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

This was part of a longer speech Bernanke made titled "Deflation: Making Sure It Doesn't Happen Here", the text of which appears here. We can argue endlessly about deflation, what it means, and the importance of fighting it via monetary policy. Briefly, I believe that "deflation" has acquired far too broad a definition over the past few years. It's come to mean "falling prices." Guess what? Falling prices are good. They occur---or at least used to occur---after periods of malinvestment and speculative frenzy. They also occur because of competition or disruptive technologies like the internet. Falling prices are a manifestation of efficiency, both in production and allocation of capital. They are an integral part of capitalism. But due in large measure to the policies the Fed has followed under Alan Greenspan, capitalism doesn't work as it used to. Monetary policy has become a tool of the "nanny state"; at the first sign of trouble during the past ten years, the Fed has hurled liquidity at the financial system. This is extremely dangerous on many levels, which I explain in this recent post.

Today I heard some pundits proclaim Bernanke to be a hawk on inflation, meaning he'll favor specific inflation targets and make fighting inflation a priority. Don't believe the hype. The market's perception of Ben Bernanke was cast in stone with his "printing press" comments above. That's one reason why this morning---when it became clear that Bernanke would be the nominee---gold rose $8 from its low on Friday and now sits close to an eighteen-year high. It's one reason treasury yields increased today. And it's the main reason the stock market shot up today. In the nanny state, falling prices--whether for stocks, houses, food, health care, tuition, energy---aren't allowed.

Bernanke, of course, it well aware of how his "printing press" comments affected his reputation. So when he takes over for Greenspan, his initial priority will be to establish credibility on inflation, particularly with the bond market. That means higher interest rates. Similarly, when Greenspan became Fed head in 1987, his immediate goal was to establish credibility in the wake of Paul Volcker, a renowned inflation fighter and the most respected Fed chief in history. Greenspan became Fed chairman on August 11, 1987. The price of gold had risen that year from $400 to $465 on Friday, October 16, 1987. On October 19---just two months after Greenspan's first day on the job---the stock market crashed, with the Dow losing 22% on the day now known as Black Monday.

Prediction (not advice): Ben Bernanke will be easily confirmed. And sometime between now and Bernanke's three-month mark as Fed chairman, the stock market will crash. If I'm wrong, fantastic. We'll see.

By the way, this year gold has risen from a low of $411 to---you guessed it---$465 today. History doesn't always repeat, but it sometimes rhymes.