Mainstream Economics

Ben Bernanke is the epitome of the modern-day mainstream economist.  He holds countless honors, has studied under famous, or at least fairly well-known, economists – as Mark Thornton relates here, his thesis adviser was Stanley Fisher (currently Governor of the Bank of Israel), and his committee comprised Fisher, the late Rüdiger Dornbusch and Robort Solow (a Nobel Prize winner). Bernanke has been widely published in academic journals and remains among the top 20 published authors to this day.


As Thornton relates in summing up:


“Just to be clear, Bernanke received a top notch education in mainstream economics at Harvard and MIT under the direction of leading professors in the economics profession. He also taught at premier institutions and held key leadership roles in the profession. He is considered one of the most important researchers and publishers of his generation and is best known for his research on the Great Depression, where he added a distinction to the contributions of Milton Friedman and Anna Schwartz


'Mainstream' in this context means: representing in some shape or form an economic theory that purports

A) that market processes can be successfully expressed as mathematical equations;  in addition maintains that

B) government intervention in the economy is both desirable and necessary.

This latter feature springs from a perception that markets are 'imperfect' and can not be trusted to deliver smooth economic progress.

We should add here a third point  which may be regarded as a sub-header of point B), and which we believe to be central to the debate, namely

C) does not question the current institutional arrangements of fractional reserve banking, central bank issued fiat money and other monopolies the welfare/warfare State has arrogated to itself at all.

Among the theoretical strands accorded 'mainstream' status, the Friedmanite monetarists came closest to at least question one of these institutional arrangements, namely the issue of fractional reserves banking. However, it should be noted that while Friedman pondered the desirability of a 100% reserve for demand deposits at banks, he never questioned the necessity of a central bank and for state-issued and controlled fiat money. He merely proposed a set of rules the central bank should follow in order to avoid a 1970's style flare-up of inflationary effects on the general price level. Notably he also proposed what the central bank should do to counteract a deflationary depression similar to the 1930's one. He and his followers were also in favor of lowering taxes and government spending in order to give market forces more room to breathe.

This is just about the greatest extent to which mainstream economists have dared to venture into critically appraising the State's role in the economy. The reason why it was possible for them to garner recognition was mainly the seeming failure of the system in the 1970's secular inflationary contraction.  Today, monetarist or 'supply side' economists are regarded as the 'free market right wing' of the economic mainstream, which is quite astonishing when considering that the same 'Chicago School' was regarded as 'leftist fringe' back in the 1940's.


The Greenspan Put

At the end of the 1970's, Paul Volcker was successful in saving the dollar-based fiat money system from immolation by jacking up interest rates and exerting tight control over money supply growth. It was one of the very few instances when the growth momentum of US money TMS actually turned negative for a short while.

Following the Volcker reign, Alan Greenspan at first continued implementing a tight money philosophy in the first few months of his tenure, but reversed course when the stock market crash of 1987 hit. One must remember that at the time, numerous market observers felt that the 1987 crash was the functional equivalent of the crash of 1929 – the opening salvo to an economic depression. Greenspan was determined to prove these observers wrong and flooded the system with money – the 'Greenspan put' was born.

What followed was an extraordinary stroke of luck for the central bank. The Soviet communist system collapsed, China's course of economic reform accelerated, and the widespread adoption of computer technology delivered an  enormous increase in economic productivity that left no sector of the economy untouched.

The entrance of hundreds of millions of laborers and consumers into the market economy and the vast improvement in economic productivity combined to allow the financial system to vastly expand loans and deposits without generating a 1970's style flare-up in easily visible inflationary effects.

There was so much genuine wealth creation underneath this credit and money supply expansion that it became possible to combat the occasional flaring up of financial crises by simply engaging in even more monetary pumping.

In the Greenspan era it became axiomatic for market participants and economists alike that no lasting damage to the economy and markets could ever occur again, since the central bank was able to successfully 'paper over' any crisis that  may happen.

Rüdiger Dornbusch, member of Bernanke's thesis committee, famously pronounced in 1998, in the wake of the Asian/Russian crisis:


 ““Not to worry, this expansion will run forever; the US economy will not see a recession for years to come. We don’t want one, we don’t need one and therefore we won’t have one. The reason is never mind how the expansion is threatened, we have the tools to keep it going.”


It is fair to say that by 1998, the belief that central monetary planning had finally vanquished the business cycle had become deeply ingrained dogma. Bernanke received his PhD in 1979, the year when Paul Volcker was appointed in order to save the dollar. He spent his entire post-education career in the era during which this Greenspan-put induced delusion grew and grew.

Not surprisingly, by the time he became a Fed board member, Bernanke had fully assimilated the idea that the period of low economic volatility following the Volcker years was primarily the  result of central bank policy. In his famous speech on the 'Great Moderation' he asserted:


“Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.

I have put my case for better monetary policy rather forcefully today, because I think it likely that the policy explanation for the Great Moderation deserves more credit than it has received in the literature.”


As a result of the 2008 crisis, we would suggest that the 'credit in the literature' Bernanke was hoping for will thankfully continue to remain sparse. However, the above paragraph gives us an excellent glimpse of Bernanke's mindset – the man has the utmost faith in the efficacy of central economic planning by the Federal Reserve , a faith erroneously acquired by confusing correlation with causation.


Stirred, but Unshaken

As noted above, Ben Bernanke is among the most respected mainstream economists in the nation – his top-notch education and his publication record attest to this fact.

His record as an economic forecaster and policy maker represents a rather stark contrast to that. As Mark Thornton reminds us in his article on Bernanke:


“Bernanke stated in 2006 that he believed that the mortgage market was more stable than in the past. He noted in particular that "our examiners tell us that lending standards are generally sound and are not comparable to the standards that contributed to broad problems in the banking industry two decades ago. In particular, real-estate appraisal practices have improved."[4] This is the equivalent of the Federal Reserve seal of approval being applied to mortgage lending at the pinnacle of the housing bubble.”


“In addressing his fellow mainstream academic economists, Bernanke was unusually bold in describing the Fed's access and ability to use information and data concerning financial markets. This knowledge and expertise includes the market for derivatives and securitized assets. He described the Fed as a type of superhero for financial markets. In discussing the Fed's role as chief regulator of financial markets, he made powerful claims concerning the Fed's ability to identify risks, anticipate financial crises, and effectively respond to any financial challenge.”


Chairman Bernanke is infamous on the internet because of the YouTube video that chronicles his rosy view of the economy from 2005 to 2007. He denied there was a housing bubble in 2005, he denied that housing prices could decrease substantively in 2005 and that it would affect the real economy and employment in 2006, and he tried to calm fears about the subprime-mortgage market. He stated that he expected reasonable growth and strength in the economy in 2007, and that the problem in the subprime market (which had then become apparent) would not impact the overall mortgage market or the market in general.

In mid-2007 he declared the global economy strong and predicted a quick return to normal growth in the United States. How many times have we heard about green shoots over the last two years, when possibly as many as 40 percent of Americans families have experienced unemployment, bankruptcy, foreclosure, or are currently in jeopardy of foreclosure?”


Here are Bernanke's own words , uttered at the annual meeting of the American Economic Association in January 2007reading this now after all that has since occurred is rather incredible. The chairman's faith in the Fed's omnipotence was apparently all-encompassing:


“In my view, however, the greatest external benefits of the Fed's supervisory activities are those related to the institution's role in preventing and managing financial crises.

Finally, the wide scope of the Fed's activities in financial markets — including not only bank supervision and its roles in the payments system but also the interaction with primary dealers and the monitoring of capital markets associated with the making of monetary policy — has given the Fed a uniquely broad expertise in evaluating and responding to emerging financial strains.”


One would almost be tempted to think after reading this that they must have planned the crash.

In view of his dismal forecasting record and the evident failure of the Federal Reserve to stop the crisis from playing out, shouldn't we expect a more humble Bernanke questioning the central bank's ability to successfully manage and centrally plan the economy? Following the 'QE2' announcement, finance ministers and central bankers of many foreign countries have let loose a barrage of criticism in the Fed's direction. They rightly fear that the Fed's monetary pumping will simply 'leak out' and swamp their own economies with a flood of money in search for the best returns. They fear that new asset bubbles will form as a result and that their economies will be overwhelmed by the inflationary effects of the Fed's loose monetary policy.

Germany's minister of finance, Wolfgang Schäuble,  went so far as to brand US economic policy 'clueless'.

As the Financial Times reports:


“Germany has put itself on a collision course with the US over the global economy, after its finance minister launched an extraordinary attack on policies being pursued in Washington. Wolfgang Schäuble accused the US of undermining its policymaking credibility, increasing global economic uncertainty and of hypocrisy over exchange rates. The US economic growth model was in a “deep crisis,” he also warned over the weekend.”


According to the Independent , writing on the same topic:


“Mr Schäuble, whose government has presided over a strong rebound in the German economy while calling for European nations to rein back on their budget deficits, said he did not believe the QE initiative would be successful in kickstarting the American recovery, as the Fed hopes.

"They have already pumped endless amounts of money into the economy with extremely high budget deficits, and with a monetary policy which has already pumped in lots of money," Mr Schäuble said. "The results have been hopeless. With all due respect, [the] US policy is clueless."


Zhou Xiaochuan, head of the Chinese central bank, said yesterday that the US had acted selfishly. "If the domestic policy is optimal policy for the United States alone, but at the same time it is not optimal policy for the world, it may bring a lot of negative impact," he said. China's Vice Foreign Minister Cui Tiankai added: "They owe us some explanation."


This outpouring of criticism,  in which the Germans and Chinese were joined by officials of virtually all emerging market economies, prompted Bernanke to defend his stance once again (in addition to his editorial in the Washington Post , which we discussed previously).

This was in the course of a speech he gave in front of students in Jacksonville, Fla. – most of the justifications for the 'QE2' policy were delivered in the Q&A session following the speech.

Here are a few of the things Bernanke said, as reported by Reuters:


“Bernanke, answering questions from college students, stressed that Fed policies aimed at giving a boost to the weak U.S. recovery would pay dividends around the world.

"I think it's important to emphasize … that a strong U.S. economy, a recovering economy, is critical, not just for Americans but it's also critical for the global recovery," Bernanke said.


Bernanke said U.S. policymakers were fully aware of the dollar's importance in the global economy as a reserve currency. The dollar has weakened sharply and did so again after this week's decision on a new round of so-called quantitative easing.

"The best fundamentals for the dollar will come when the economy is growing strongly," Bernanke said. "That's where the fundamentals come from."


Bloomberg, reporting on the same event, adds in the context of the enormous increase in commodity prices and the associated dangers to the Fed's 'inflation fighting credibility':


“Asked by a student if “skyrocketing” commodities prices may threaten his inflation outlook, Bernanke said rising commodities prices are “the one exception” to a broad reduction in inflationary pressures. Overall, excess slack in the economy will make it difficult for producers to push through higher prices to consumers, he said.

Emerging markets are growing quite quickly,” Bernanke said. “Demand for those commodities is pretty strong. That is going to be a contributor to inflation in the U.S. because it will affect gas prices, for example, and so on.”

Asked by a student about rising gold prices and concerns over inflation, Bernanke said the Fed wouldn’t sacrifice price stability in an attempt to boost growth.

Let me be very clear: We are absolutely committed to keeping inflation low and stable,” he said. “We have the tools to unwind and tighten policy at the appropriate time. We will honor both sides of our dual mandate.” 


In short, Bernanke's faith in the central bank's central economic planning abilities remains completely unshaken. He has not yet stopped to question the  theoretical underpinnings of this belief in light of the dismal record of his economic predictions and the lack of success of the actions undertaken by the central bank in the post crisis era to date. He has merely been stirred into defending these actions once again, with essentially the same arguments he has always used.

We want to briefly respond to his assertions here:

1.    'A strong US economy is critical to the outlook for the global economy':

This is probably true, although it becomes less so as time passes and the size of the US economy relative to global economic output shrinks. However, the implicit assumption that more money printing will deliver a 'strong US economy' is simply wrong. It will do the exact opposite. While it may create a short term illusion of prosperity, it will further undermine the economy structurally – more scarce capital will be consumed.

2.    'The best fundamentals for the dollar will come when the economy is growing strongly….that's where the fundamentals come from.'

The strength or lack of strength of the US dollar is not a result of 'economic growth'. The one 'fundamental' most important for the US dollar's exchange value is the relative pace of money printing in the US versus that in other nations. If Bernanke wants a stronger dollar, he needs to print less money. We would note in this context that in spite of Japan's economy having been extraordinarily weak over the past few years, the yen has been very strong. This is mainly due to very low money supply growth in Japan. So that's 'where the fundamentals come from'.

3.    'Commodities are the one exception to a broad reduction in inflationary pressures' and  'Demand for those commodities is pretty strong. That is going to be a contributor to inflation in the U.S. because it will affect gas prices, for example, and so on.'

The effect of inflation on prices is never uniform. When the money supply expands, it does not mean that all prices will rise at once. Whichever sector the newly printed money enters first will be where the first price increases will become visible. Bernanke should really know better than to go on about this alleged 'lone exception'. Even he should be aware of the lag effects of monetary pumping.  Or maybe not – his deflation phobia may well have blinded him to such simple economic concepts.

As to 'demand for commodities being a 'contributor to inflation in the US', this is the typical 'cart before the horse' circular logic with which central bank propaganda has for decades attempted to mask the responsibility for inflation. Here the effect of inflation (namely, rising prices) is presented as its cause. In short, if there is inflation, it is not the central bank's fault. It is the fault of 'rising prices'. He must think we're all stupid.

4.    'We are absolutely committed to keeping inflation low and stable…. We have the tools to unwind and tighten policy at the appropriate time. We will honor both sides of our dual mandate'.

Ah, the famed 'tools' that will spring into action to 'ward off inflation'  in a  timely manner. Let's not even mention that the true money supply has already been inflated by roughly 28% in two years. As we have said before, we don't believe it. There will always be new reasons to justify even more monetary pumping. The very idea that the Fed will one day engage in a voluntary, planned deflation of the money supply is preposterous. That's a fairy tale for children perhaps, but let's be real about it, shall we? Back when Volcker was called upon to save the fiat money system, there was no collapsing housing bubble rendering the banking system insolvent, there were no 100ds of trillions in outstanding derivatives notionals, and the nation's debt-to GDP ratio stood at a manageable 150% or so , as opposed to about 360% today.  The conditions pertaining today positively preclude any tightening of monetary policy , unless the Fed is prepared to sacrifice a plethora of bailed-out TBTF institutions to the vicissitudes of the free market , and is prepared to allow the housing market and financial markets  to find their clearing level on their own. Yeah, right.

Only one day earlier, Bernanke remarked in the WaPo:


“For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion. “


Once you start down the path of using the policy of inflation to create these effects, there simply is no going back, as the revolutionaries of late 18th century France found out to their chagrin. As soon as the inflationary push dissipates, you're right back at square one. The same problem presents itself again: either you allow the economy and markets to correct, or you inflate even more. After all, it is precisely because we have arrived at such a juncture that the  'QE2' policy has been announced. Once 'QE2' has percolated through the economy, the same juncture will be reached again. The Fed's 'tools' will accordingly  forever remain in their toolbox.

In summary, Bernanke has not yet learned anything new through the experiences of the past two years. He remains the world's foremost Apostle of Unsound Money.



Ben Shalom Bernanke: The world's foremost Apostle of Unsound Money.

(Photo Credit: AP)




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One Response to “The Apostle of Unsound Money”

  • Bearster:

    Good article Peter. But this “tool” will not be theirs forever. As you noted, they are causing capital destruction. If it doesn’t end before then, it will certainly end when there is no capital left to destroy!

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