Saturday, December 6, 2008

Understanding Bernanke

At a November 8, 2002 conference to honor Milton Friedman's 90th birthday, Ben Bernanke said: "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." Or... will we?

Mr. Bernanke has an academic and political career to think about, and thus will never emphasize some of the less politically correct points about the Great Depression.
He seems to have learned the wrong lessons from the Depression and from Milton Friedman. Here is an excellent essay by Lawrence W. Reed, which gives a great perpective on the business climate FDR created. I have taken the liberty to extract some points.

Herbert Hoover raised top marginal tax rate from 24 to 63%. FDR raised it further to 79%, then later to 90%. According to economic historian Burton Folsom, in 1941, Roosevelt proposed 99.5% marginal tax rate on all incomes over $100,000, and when questioned by an adviser, replied "Why not?". He followed this with an executive order to tax all income over $25,000 at 100%. He also lowered the personal exemption to $600, and hence most US households paid income tax for the first time. Congress rescinded the 100% tax, but went along with the exemption reduction. Furthermore, FDR also tried
in 1937 to "pack" the Supreme Court with a proposal to allow the president to appoint an additional justice to the Court for every sitting justice who had reached the age of 70 and did not retire. This failed in Congress, but until it was struck down, added further uncertainty in the investment climate. In his private diary, FDR’s very own Treasury Secretary, Henry Morgenthau, wrote: "We have tried spending money. We are spending more than we have ever spent before and it does not work. . . . We have never made good on our promises. . . . I say after eight years of this Administration we have just as much unemployment as when we started . . . . and an enormous debt to boot!"

Now back to present day, with Mr. Bernanke at the helm of monetary policy. As any macroeconomist, he surely looks at the MV=PQ identity. The perennial clash between monetarists and Keynesians focuses on whether V is stable (monetarists say more-or-less yes, and Keynesians more-or-less no), and whether Q is exogenous (monetairsts say Q is determined by "
land, labor, capital, and enterprise", and Keynesians say M can influence Q significanly). Bernanke is observing a credit crunch, i.e. V is tanking. Money is not moving. Even banks with ample liquidity are not lending. His response? Look here. But maybe, just maybe, he ought to re-visit the underlying assumptions for MV=PQ. Among those (not an exhaustive list):
1) Money supply is exogenous.
Well, yes, until is is not. When banks do not lend at any rate (and interests rates cannot get much lower), clearly the bank multiplier is not working right, and the Fed is shooting at a moving target - and one moving way too fast for their lousy shooting skill.
The mechanism for injecting money into the economy is not that important in the long run.
Well, no, until it is. The line for federal handouts/bailouts is getting longer by the week - banks, insurance companies, car manufacturers, states/municipalities...

Paulson and Co. let Lehman go under, which sent a chill down the spine of every financial professional in the world. Confidence in one's counterparty's solvency was shattered, and thus V tanked. Everyone and their grandmother is holding on to any cash they have, and will not lend at any rate. Now, I actually think it was right to let Lehman fail, but I also think many others should, and Bernanke is hellbent on not letting them, cost upon the taxpayers and their descendants be damned.

But, let's give Mr. Bernanke the benefit of doubt. Let's say he is desperately working on his part of the MV=PQ, and hoping the government has wisened up, and will not repeat the policy blunders from that 30's. This is probably naive, but at least somewhat defensible. Then logically he should be hoping to be able to mop up this monstrous amount of liquidity pumped into the system when things begin to pick up. When will that be? My pessimistic estimate: just about the time Mr. Obama will be thinking about his re-election prospects. And thus, the Obama administration will probably work feverishly to counter Bernanke's (more likely, his successor's) tightening efforts, which will probably be "too little too late" anyway.

My forecast: inflation will spike around late 2009 to early 2010, and (better, more likely, but still bad scenario) the Fed's efforts to contain it will kill a nascent recovery, or (worse scenario) the Fed will do little, and inflation will rampage at a level the US has not seen yet. I hope I am wrong, but I will be properly positioned short T-bonds and long gold (or any better inflation hedge I may think of).

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