Scary Bernanke

We recently came across a news item and an editorial, both of which discuss the merits of monetary pumping by central banks. The news item was posted at Zerohedge and reported on a recent meeting between hedge fund manager David Einhorn's and Ben Bernanke. Einhorn afterward averred that he found the former Fed chairman's views 'scary' and we can only agree. One item stood out specifically:


EINHORN: I asked several things. He started out by explaining that he was 100 percent sure that there’s not going to be hyperinflation. And not that I think that there’s going to be hyperinflation, but it’s like how do you get to 100 percent certainty of anything? Like why can’t you be 99 percent certain and like how do you manage that risk in the last 1 percent? And he says, well, hyperinflations generally occur after wars and that’s not here. And there’s no sign of inflation now and Japan’s done a lot more quantitative easing than we’ve done, and they don’t have it. So if there is a big inflation, the Fed will know what to do. That was kind of the answer.”


There are several things that are problematic about Bernanke's answer, even though we would agree that hyperinflation is unlikely to be an imminent problem for the US at this point in time. First of all, hyperinflation does not require war, and it is also not the 'result of war'. Was Zimbabwe at war? Is Venezuela at war? The only way in which war can possibly play into it is by causing the monetary authority to inflate in order to fund the war. If war expenditures were funded entirely by taxation, no inflation would occur. A secondary influence on prices may be the possible destruction of production capacity (when fewer goods are produced, their prices will rise, ceteris paribus), but primarily it is the monetary authority's decision to inflate that creates the conditions that can lead to hyperinflation. Bernanke is only correct insofar as fiat money, central banks and fractional reserve banking were all introduced, respectively tolerated, because politicians realized that funding wars by printing money is not as unpopular as funding them by taxation.

No-one ever embarked on hyperinflation intentionally. It was either not properly understood by the perpetrators that printing a lot of money could lead to a breakdown of the currency system, or they believed that they could keep things under control – until control was lost anyway (i.e., just like Bernanke, they were “100% certain”).

As to Japan, either Bernanke is deliberately obfuscating, or he really doesn't know that 'QE' in Japan works slightly differently than in the US. Neither possibility is very comforting. The difference in brief: when the Fed engages in 'QE', it creates almost dollar for dollar as much deposit money as bank reserves. This is not the case in Japan, where the BoJ creates only reserves when it buys securities directly from banks, while concurrent deposit money creation is confined to its purchases from non-banks. The reason why it is different in the US is that the primary dealers are legally non-banks, even though most of them belong to banks. Hence, 'QE' by the Fed has created a lot more money supply growth than 'QE' by the BoJ, in spite of the fact that the BoJ's 'QE' program is nominally much larger (currently, the year-on-year growth rate of Japan's money TMS is 5%, which is fairly high for Japan, but still well below both US and euro area money supply growth).



Japan-TMS-growth y-y-aJapan, money TMS, year-on-year growth rate. At its highest point over the past decade, it was just below 6%. Currently it stands at 5% – click to enlarge.


US-TMS-2-y-y-ann-bUS TMS-2 (without memorandum items) year-on-year – even after slowing massively from its peak growth rates, it is still growing at a faster pace today than Japan's money supply grew at the most recent peak – click to enlarge.


Bernanke's reply is however erroneous in other respects as well, which we will discuss further below.


Abenomics Works! Who Knew?

The other item we came across was an article by Peter Tasker entitled “Is Abenomics Working Too Well?”. We find this extremely funny, because we recently wrote several articles about the many ways in which we believe “Abenomics” is failing. Here is a recent example: “The Abenomics Surprises Just Keep Coming…”.

Here is an excerpt from Tasker's article, who evidently holds that monetary pumping is going to prove a panacea for Japan:


“In the battle for top spot in the Economics Premier League, Monetarist United has pulled well ahead of big-spending Keynes City and the hard men of Vienna F.C. That is the message from Japan, where the reflationary policies associated with Prime Minister Abe are producing results much faster than expected. Workers and job-seekers are benefiting, but the effect on the stock market is ambiguous.

From the dawn of Abenomics, the nay-sayers and doomsters were out in force, offering a variety of reasons why it could never work. According to former governor of the Bank of Japan, Masaaki Shirakawa, deflation in Japan was demographic in origin and therefore pre-destined. According to bearish macro traders, apocalypse in the Japanese bond market was a matter of months away.

The general consensus was that “money-printing” on its own would accomplish little. Without “third arrow” structural reforms, the whole project would fall flat on its face.

Amidst all the pessimism, one eminent economist called it right, even though he’d been dead for several years. As long ago as 1997,Milton Friedman offered the following prescription to Japanese policy-makers –

“The surest road to an economic recovery … is to shift from tight money to easy money, to a rate of monetary growth closer to that which prevailed in the golden 1980s, but without again overdoing it… There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so… A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.”

It took an awfully long time, but Friedman would be happy to know that his advice was eventually heeded.”


He then enumerates the many ways in which he believes “Abenomics” is 'succeeding' (looking at the utterly dismal economic data emanating from Japan lately, we could have been fooled…), with the stock market's recently rather mediocre performance considered the only possible drawback. A single random anecdote is offered to buttress the point. Tasker seems not to have  looked at any of the recent data aside from the recent increase in CPI, which he of course approves of.  Alas and alack, the increase in consumer prices has so far only made the Japanese less well off, as their real incomes have taken a big hit as a result.

However, there is a more profound error here, in fact, there are two profound errors, and  this is something Bernanke and Tasker have in common. We are committing these errors ourselves in the paragraph above, by stressing recent data points.


Theory is Antecedent to History

The problem with economic statistics is that they cannot possibly be used to prove or disprove a point of economic theory. This should be clear simply by considering the above. For instance, Japan's current demographic situation is an important datum unique to Japan. Its government has recently hiked the sales tax. Its nuclear power stations have been turned off since March of 2011. We could list many more items, all of which are influencing recent trends in Japan's economic data and are unique to it.

By contrast, economic theory is clear on what money printing and interest rate manipulation must do in each and every case. What it cannot furnish us with is a precise prediction on how the future will play out in detail on account of the policies undertaken. For instance, it cannot tell us if there will or won't be hyperinflation, since that will depend on the unknowable future decisions of policymakers. It can however tell us that inflation of the money supply will lead to a price revolution throughout the economy, as Ludwig von Mises once put it. The natural interest rate will be suppressed and relative prices will be altered. Economic calculation will be falsified, and malinvestment of capital and capital consumption will inevitably result. New money enters the economy at specific points and percolates outward from there, which also ensures that wealth be redistributed from later receivers to earlier receivers of the newly created money. A central bank can create additonal money, but it cannot create additional capital. It can therefore not possibly make society as a whole more prosperous. How bad things eventually get largely depends on how soon the inflationary policy is abandoned again. Hyperinflation is an extreme case that occurs when the inflationary policy is simply not abandoned at all, until the underlying currency system is destroyed. Whatever the precise end result, one thing is certain: there will be impoverishment relative to what would have occurred otherwise.


Time Lags, or Milton Fails in the End

However, even those insisting on some unequivocal empirical evidence that the inflationary policy will end in disaster must keep in mind that it can take a very long time for the disaster to become obvious. As a rule of thumb, the longer it takes, the more profound the disaster will usually be.

No-one can actually come to a conclusion on whether the policy initiative is a success or a failure on the basis of empirical data after just one or two years. That makes no sense due to the often very large time lags involved. Let us look at two examples, one a very recent one and one a more temporally distant one.

When tech stocks collapsed after the 2000 peak, Greenspan embarked on heavy monetary pumping. At one point in late 2001, the true money supply reached a year-on-year growth rate of almost 20% (see chart above). Success was soon celebrated far and wide. Greenspan was lauded as the 'Maestro'.

Fed members were doing victory laps and patting themselves on the back for four years running between 2004 and 2007 (they were also laughing a lot at FOMC meetings). We still remember Bernanke's 'Great Moderation' speech (delivered anno 2004), in which he allowed that they may have 'just gotten lucky', but made it clear that this was not his preferred interpretation. “Scientific” monetary policy had triumphed! Even if most of it was decided by relying on Greenspan's gut feelings.

But as we all know now, judgment day eventually came, and all the presumed 'economic gains' achieved by Greenspan's pumping evaporated in a flash. It was all revealed to have been an illusion, the wealth, the employment, the profits, all of it. The damage was vast: to this day the economy is displaying sub-par performance. So at what point in time did the evidence allow one to pass judgment on the policy? A year or two after it was started was obviously too early, although those relying on correct theory did forecast early on that the outcome would be dire. Their warnings were of course studiously ignored. Later, mainstream economist and policymakers alike would insist that 'no-one could have seen it coming', but a number of people did in fact 'see it coming'.

A more distant and also far more extreme example is the Reichsbank inflation which began in 1914 in order to fund the war. This is in keeping with Bernanke's idea that hyperinflation and war go hand in hand, but the fact remains that it was not the war as such that 'caused' hyperinflation down the road. It was the policy of the Reichsbank.

If one looks at Germany's post war economic data, one is struck by how magnificent many of them looked at times on a superficial level. At one point in 1922, the unemployment rate had declined to just 1%. This is not a typo, one percent! Of course there were a few slight problems, such as a decline in real wages by 40% since 1913 and no-one brewing any beer or making any clothes, while steel and coal were piled ever higher. Also, the Reichsmark's exchange rate was plunging and prices went ever higher. But business was reported to be 'euphoric'. The stock market rallied magnificently. By that time the monetary experiment was nine years old, and surely it looked 'much better than the critics would have predicted'.


Weimar, 1920-1922German economic data, 1920 to 1922. By 1922, unemployment had declined to just 1%, the Reichsmark was weakening,  the stock market was booming and business was said to be 'euphoric' according to newspaper articles that appeared at the time – click to enlarge.


A year later complete and utter catastrophe struck. Similar to Greenspan's housing bubble, the whole edifice was revealed as an illusion as well. It was an illusion so profound that one cannot really speak of a genuine economic recovery until about 30 to 35 years later. Unemployment soared to almost 20% within a year, the currency collapsed completely as inflation became hyperinflation, and when the authorities finally no longer had a choice but to introduce currency reform, a 'stabilization crisis' struck (this period was however marked by a number of positive developments, harsh as it was in some respects).

We could go on with similar examples. The 'New Deal' recovery is another one for example: it was also bought with a combination of monetary pumping and deficit spending and collapsed in a heap as soon as the pumping and spending were slowed down (by 1937 the authorities became worried that inflation would get out of hand, and rightly so). The time lag in this case was five years.


In other words: 'Milton Fails in the End'.


fullMilton Friedman, 1912-2006. He apparently believed Japan should inflate itself back to prosperity. We don't think so.

(Photo source unknown, The Web)



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