Tuesday, 22 July 2008

Bernanke and the power of central banks

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.


Mark Wadsworth said...

"The power of central banks ..." to make things worse.

The best central bank does as little as possible, preferably not even bothering to set a base rate, leaving that to the markets.

Anonymous said...

Without reference to why the Japanese government was unable to create inflation this article falls down.
One country has been unable to cause inflation, accordingly, if the UK can inflate then there must be some key difference to allow the inflation.
There is no key difference mentioned. Personally, I think that this is a matter of extremes, of course the government, all other things being equal, can inflate. However, to inflate they need to provide -more- than is lost through the credit contraction. Even if government borrowing goes to 200%, they still do not compensate for credit contraction.
Once the people stop borrowing, debt based fiat money systems go into deflation. Maybe we won't have this until 2010. Maybe people will start borrowing again. The government alone can't do it.

Anonymous said...

I don't borrow money because I am waiting to buy a house in 2011.
Any money that comes my way I save.

I am therefore both a dampener on economic activity and a cause of a recession, a restriction on the ability of others to repay loans, and a beneficiary of their previous willingness to borrow.

There are more and more people like me, doing this to get a home, and collectively we are a short squeeze on existing borrowers. Even if the government reflates, I will still save that money not spend it.

So where is the way out? I can't see one.

(same poster as above)

Anonymous said...

Agreed, but like the previous poster I think you've missed part of the story:

1 - The Bank can create money but can't determine where it goes. See how Bernanke's attempt to reflate housing went into commodities

2 - The Bank can take the horse to water but not make it drink. In an environment of falling asset prices the Bank can't force banks to lend and speculators to borrow, thus velocity drops. This happened in Japan. Watch it become obvious once the oil bubble bursts

3. Look at how much short term debt a government has. Inflation increases borrowing costs for the government. If it needs to roll over alot of its debt soon (like the US) then the advantages of inflation are offset by increased borrowing costs.


Edward Harrison said...


Another great post.

I agree with Nick that "The Bank can create money but can't determine where it goes. See how Bernanke's attempt to reflate housing went into commodities."

In response to Anonymous on Japan's attempts to reflate, its money DID go somewhere - not anywhere domestically. Ever heard of the carry trade?

Anonymous said...

In a functioning democracy, 'a determined government' would also need to be a government determined to be kicked out of office. I think what Bernanke really means is "A determined central bank"

Unless you are Robert Mugabe, allowing inflation to get out of control without the corresponding wage inflation is political suicide, as Brown is discovering.

The political consequences of printing money to inflate become far more pressing far earlier than the economic 'benefits' for the incumbent government.

aSteve said...

A great post, Alice, and a fantastic personality on whom to focus - and a very famous quote too.

There are some areas, however, where my analysis differs from yours.

First, crucially, I do not believe that central banks can "print" money - they can only lend, which simultaneously increases debt and money - debt on which governments hold their citizens to account. Governments are different... they can "print"... especially the US government - since there is no more dominant authority to hold them to account for their debts.

So, with respect to expanding the money supply using interest rates, there is a double-edged sword. It is not the looseness of the monetary policy itself that is relevant - but the perception about the future trend. When interest rates are low, the only direction is up... and when they are high, the converse. If this idea becomes subliminally implanted - where people think first about capital and second about debt service - the loose money game is up. If the implosion of US real-estate affects the national psyche, the fear of substantial debt may well be more significant than the lure of the benefit from borrowing money at below the rate of inflation.

I think this is key to why Bernanke talks about determined governments. You can't force people to borrow money, but a government can borrow on their behalf and spend it now against tomorrows taxes. I understand this to be the traditional Keynesian perspective - essentially arguing that the government needs to "kick-start" the economy by coercing participation.

I do not believe that Keynesian economics passes a 'common sense' test... we already know that governments are not capable of efficiently spending money in the modern world... this is the reason tendered for the failure of the USSR and for the radical departure of China from its former economic regime. If governments rather than people spend the money, we can be assured a poorer future.

Somewhat worryingly, it seems that the British cabinet believes in Keynesian economics. I think this even more of a concern in the context of a global economy... Britain, one might say, is no-longer an island - and we certainly have less credibility than the USA if push comes to military shove in order to ensure that foreign regimes accept our currency in payment.

It is worth noting, however, that Greenspan came to advise the British government in 2007 - and commented that the US's (and I presume Greenspan's) preferred central bank policy was not the one being adopted by the UK. Greenspan said that he considered King to be brilliant, but that he couldn't "beat the market." It left me wondering if the King, the BoE and most of the MPC is inclined to fight the corner for inflation (bear with me on this) while the cabinet clamours to spend to placate voters.

These are certainly interesting political times.

Anonymous said...

Central banks can print money - but only to lend it out. If no one wants to borrow, then the money supply will not expand.

However, a determined government can always spend. The problems become:

1/ can they spend enough and quickly enough to counteract the fall in the nominal (wide) money supply

2/ can they spend enough and quickly enough to counteract the fall in the value of money that constitutes the money supply.

You only need the first for inflation - and (for example) Zimbabwe has it.

You need both for a boom, and Zimbabwe does not have both.

The difference between us and Zimbabwe is debt. Banks and people in Zimbabwe didn't have much debt, because nobody would lend them any money.

As of middle of May this year, M4 was 37 times greater than M0. Or in other words, if the amount of credit in financial institutions drops by 3%, then the Government will need to more double the amount of circulating notes and coins in order to compensate.

Or put another way £50,600,000,000 needs to be spent by the Government on something. Maybe 30 of the new white-elephant aircraft carriers perhaps?

But of course that falls foul of the "quickly enough" rule. These things take time to build.

And that's only with a 3% drop...