Back in 2002, Fed Chairman Ben Bernanke gave a speech entitled “Deflation: making sure it won’t happen here. It was a year after 911 and the US economy was dealing with the aftermath of the dot.com crash. Taken together, the two events pushed the US economy into a recession. With asset prices crashing, the Fed feared that the US might slip into a Japan-like deflation.
Here is what the man said about deflation back then:
“(The) US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, the US government can also reduce the value of a dollar in terms of goods and services, which is the equivalent of 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.”
Taking quotes out of context is often a dangerous thing. It is tempting to use this particular comment to label Bernanke as an irredeemable inflator. The quote, coupled with the drastic cuts in US interest rates provides a strong case against the Fed chairman.
However, a quick attack on the Fed’s irresponsible monetary stance is not the immediate objective here. Instead, we have a simpler purpose. Bernanke’s 2002 statement is one of the clearest statements of the power of central banks. Although talking directly about the Fed, Bernanke offered a telling description about the capacity of all central banks, including the Bank of England, to affect the price level.
As Bernanke points out, when a country has a government-controlled paper money system, then it can use the printing press to increase the relative supply of domestic currency. As the printing presses crank up, the price of money relative to goods and services falls. In other words, the domestic currency loses value as inflation takes hold.
Bernanke’s last sentence is positively chilling; “under a paper money system, a determined government can always generate higher spending and hence positive inflation.” His words are extremely precise, and worth close examination. The qualification “paper money system” is crucial. There are plenty of monetary regimes where the government could not devalue the currency; for example; a gold standard, a silver standard; a fixed change rate; or a currency board. Unfortunately, a paper money system is exactly what we have here in the UK and in the US.
The phrase “a determined government” is also significant. Inflation is a policy choice not an accident. Even under a paper money system, avoiding inflation is a straightforward matter; just keep the printing presses under control. If a central bank keeps control of the money supply then inflation will not be a problem.
Bernanke then offers a strong clue why a “determined government” might want to debase the national currency. Such a government “can always generate higher expenditure.” Inflation allows higher government expenditure. Inflation is often a symptom of fiscal difficulties; when a government would like to spend more than it receives in taxes.
Higher inflation erodes the real value of government debt and makes borrowing very attractive. Inflation also directly works as a tax. Governments pay their workers and suppliers in pieces of paper that are costless to produce and in return, it receives labour services and goods. If someone holds a note issued by the government, in an inflationary environment, over time the value of the note falls. That loss of value accrues to the government. If the government ever had to redeem those notes, in real terms it would return less once inflation has done its work.
However, Bernanke’s most important words are in the last sentence – “can always generate…higher inflation”. It the “can always” part that needs emphasizing; a determined government can always generate inflation. If a government finds itself in a deflationary cycle, it is because it has chosen to be there. It can always find the exit door; it is marked “print more cash.” In other words, deflation is an extremely unlikely occurrence.
This recent fear of deflation is actually a cover for inflation. Greenspan used it during the post dot.com bubble as an excuse to cut interest rates to 1 percent and inflate the real estate bubble. At the time, Greenspan used monetary policy to dodge a deep post-911 recession. He succeeded but at the expense of creating a huge real estate bubble that is now crashing with terrible consequences.
So long as he does not look too far into the future, a little inflation would help Bernanke right now. Higher prices and negative interest rates would rob savers and relieve the debt burden on irresponsible borrowers. Since defaulting borrowers threaten to bring down the US financial system, a little debt relief via some inflation would be most welcome.
The benefits would not stop there. The biggest and most irresponsible borrower has been the US government. With debt levels rising, higher inflation would also rip off US government bondholders, and would deflate the real value of government debt. Higher inflation would reduce the value of the dollar, giving US workers a pay cut in terms of import prices.
For banker or politicians who are unwilling to tell the US taxpayer that government liabilities are unsustainable and that expenditure must fall or taxes must rise, then the case for inflation is a compelling one. If, on the other hand, you are a worker or a saver, then the Fed is about to roll you over.
What is true for the Fed, is also true for the Bank of England. Our banks are in trouble; government indebtedness is rising; and sterling is overvalued. A little inflation here might help enormously with some short run difficulties.
However, there is nothing short-run about the impact of inflation. Once it takes off, people quickly begin to expect it. Savers demand higher interest rates to compensate for potential inflation. Workers demand inflation indexation. Long-term contracts become untenable, while investment is discouraged. Inflation quickly destabilizes economies, and impoverishes anyone living on a fixed income.
The 1970s was the last time determined governments took the inflationary option, with 1975 being the high point. It took about 20 years before central banks brought inflation back down to the levels experienced in the mid-1960s. While inflation may offer a few quick fixes, in the end it is a disaster. However, today central banks today seem willing to trade off some short run convenience for long run pain.