Interest rates are market prices, and you interfere with them at your peril!

Bernanke’s blind side

by DETLEV SCHLICHTER

The world financial system is skating on thin ice, and that ice can crack at any moment.

The instabilities of the global paper money economy are evident everywhere. In Europe, the debt crisis is picking off one euro-member after another like the protagonists of a teenage horror movie, leaving us in no doubt what the final destination for the core is going to be. Yet – bizarrely and inexplicably – German Bundesanleihen still play the role of safe haven. In the U.S. of A., years of near-zero interest rates and two rounds of unprecedented “quantitative easing” have engineered a suspicious-looking rebound in equity markets and other financial assets, yet the victory of the interventionists over market forces looks hollow. Three years into the recovery, the economy is still sick. Manipulating financial markets seems one thing, generating prosperity quite another – only on Wall Street are the two the same. But according to the central bank’s chairman, if a policy fails it means you simply have to do more of it.

Only the intellectual and institutional inertia of the bloated financial industry, overfed on a rich forty-year diet of cheap money and ever-rising asset prices, is – for now at least – preventing a widespread rush for the exit. The industry is sitting on such a massive pile of inflated paper assets that there seem to be few alternatives to further feeding gluttonous governments and their clueless politicians. Additionally, things have gone from pretty bad to mind-blowingly worse too fast for most portfolio managers to comprehend – leading many to cling to the straws of time-worn investment routines and established asset allocation patterns. Did they not all learn back in money-manger school that government bonds were “safe assets”?

Smart ‘private money’ – nimbler, less consensus-oriented and, importantly, eager to sustain real spending power for the long run rather than beat some nominal index over the short run– is already running for the exit. Just look at the gold price and the prices of certain other real assets.

The tunnel vision of macroeconomics

My prediction is that things will get much worse very rapidly, and one of the reasons why I think this is inevitable is the inability of large sections of the political and financial establishment to even grasp what is going on. Of course, the reason for this is not any lack of intelligence. These are smart people. The reason is the oppressive dominance of an economic belief system that only provides a very narrow perspective on the full effects of an expanding supply of money.

And you want to know what really scares me? That the money-printer-in-chief, the man in charge of the printing press for the world’s dominant paper currency, the chairman of the U.S. Fed, not only shares this limited view of the effects of easy money, he is so completely beholden to the mainstream macro consensus that he is entirely incapable of even comprehending that his policy could do more harm than good.

Just look at this video of last week’s congressional hearings. The exchange between Congressman Ron Paul from Texas – the libertarian, Austrian-schooled Republican who is the only politician who ‘gets it’ – and the Fed chairman has been making the rounds on the web, and provoked already a lot of commentary. But what strikes me is not so much Bernanke’s struggle with explaining the monetary function of gold but something else. Something that indeed scares the living bejeesus out of me whenever I hear a Bernanke testimony.

Before I tell you what it is, let me stress that I don’t much like the widespread demonization of the Fed chairman. I have never met him but I cannot say that he comes across as an unpleasant individual. To the contrary, he seems to be a smart and decent person. Call me naïve, but I do not think that he is part of some conspiracy or any backroom dealing, or that he is in the pockets of the big Wall Street banks. I think he was sincere when he said that he never particularly cared about the management or the shareholders of the Wall Street firms he invariably bailed out and is still generously subsidizing with super-low funding rates and periodic debt monetization. He really believes that what he is doing is helping the U.S. economy and the U.S. people.

The problem is not that he is evil or dumb – I think he is neither – the problem is much bigger. Evil and dumb people can be dealt with. The deeply-convinced do-gooders in positions of almost unchecked power, those are the ones we should worry about, those who are full of good intentions but suffer from tunnel-vision, incurably in awe of their own theories and incapable of even beginning to grasp how what they are doing could make things worse. For keeping rates artificially low and bank reserves generously expanding is a form of constant market manipulation, and it is creating momentous dislocations and vast problems with as yet incalculable consequences – even if it does not presently generate instant hyperinflation or an intolerable expansion of the wider monetary aggregates, and thus looks deceptively harmless through Mr. Bernanke’s narrow prism of national account statistics.

Mr. Bernanke suffers from a blind side – there is an area of monetary phenomena, real and powerful phenomena, that are simply outside of his vision. It is the monetary blind side that all modern macroeconomists suffer from. For them two effects of an expanding money supply are visible, and only two:

1) The growth effect. Injecting more money lowers interest rates (temporarily) thus stimulates lending and borrowing, and leads to a (temporary) growth spurt. This effect is deemed unquestionably positive.

2) The inflation effect. More money means – all else being equal – that the purchasing power of the monetary unit drops. Prices tend to rise. Is this good or bad? Well, according to Bernanke and the mainstream consensus that he belongs to, the answer is, it depends. If there is a risk of that dreadful and debilitating deflation taking hold in the U.S. economy that seems to keep the chairman awake at night, then rising inflation is a good thing. But too much of it can be a bad thing.

So the two effects of the Fed’s money printing are higher growth and higher inflation. But here is the problem. This view is too narrow. It leaves out a very important, maybe the most important and potentially most damaging effect of money printing: the distortion of relative prices and the disruption of resource allocation and capital formation.

The Fed makes things worse

As I explain in detail in my upcoming book Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, ‘elastic’ money is always destabilizing. Any expansion of the money supply (including bank reserves) must distort relative prices. Always and everywhere. Even if some fortuitous rise in money demand helps cushion the inflationary impact of expanding money and if inflation measures therefore remain contained. Even if the economy is weak and money printing is supposed to be a ‘stimulus’.

Specifically, every money injection must disrupt the market’s setting of interest rates and thus disorient the process of coordination between true savings and investment and capital formation.

Interest rates are market prices, and you interfere with them at your peril!

Of course, I did not discover this. This was in principle already explained by the so-called British Currency School in the nineteenth century. But it was most clearly and fully elaborated by the Austrian School of Economics, in particular by Ludwig von Mises and the young F.A. von Hayek.

Ron Paul understands this, Bernanke doesn’t.

Bernanke upholds the original mission of the Federal Reserve, which is to avert credit contraction and debt deflation at all cost – although Bernanke can’t comprehend any cost involved in what he is doing. During the Q&A, he pointedly remembered the laissez-faire man Paul of the bank runs of the nineteenth century. Instability in banking  - and in the wider economy as a result of banking – should come as no surprise to anybody who understands the practice of fractional-reserve banking. As I explained before, banks augment their lending business via the creation of a specific form of money – deposit money. Deposit money is nothing but book-entry claims to proper money – either gold, in the olden days, or state paper money today. Although bank deposits theoretically constitute a more or less instantly exercisable claim to ‘real’ money, banks – to this day and never more so than today – only back a tiny fraction of these claims with money proper. That is the fractional reserve. This practice is profitable to the banks. They become money-producers.

But there is a problem: whenever the economy slows, the public gets nervous about the banks and ditches deposit money for ‘real’ money – money that is not simultaneously somebody else’s liability, such as gold or, in fact, state paper tickets. The banks then have to contract the supply of deposit money thus shrinking the supply of what is used as money in the economy and thus exacerbating the recessionary forces in the economy.

Could recessions not be avoided, or at least lessened or shortened if this credit contraction could be avoided? That was, in principle, the idea behind the Federal Reserve: what is needed is some form of elastic money so that in economically challenging times the banks do not have to contract the supply of credit.

It is almost comical how Mr. Bernanke seems to say, why are you criticizing me? I am spending all this money but it doesn’t add to the federal deficit. I am printing this myself. I just press a button. Money printing is costless. And I can help the economy.

Here is the catch. Back to fractional-reserve banking. What the Austrians have taught us is this: the economic downturn that is ultimately such a powerful threat to the banks is brought about by the banks themselves! The lowering of reserve ratios and the creation of deposit money lead to a credit boom, which always creates imbalances – in the saving-investment equation – and thus must end in a bust. In short, the ‘Austrian’ message is this: Credit based on true savings gives you sustainable growth and prosperity; credit based on money printing gives you boom and bust.

What the Fed is trying to do is destined to fail. It cannot solve the problem. It must exacerbate the problem. Extending the credit boom ever further by giving low cost, fully elastic, and practically unlimited reserves to the banking system is not leading the economy back to sustainable and balanced growth, it just extends the accumulation of imbalances and dislocations that so characterize the credit cycle. Bernanke believes that with his all-powerful printing press he can always buy another recovery. For him his job appears to require simply an astute balancing act between the two phenomena his macro-tunnel vision allows him to see: the trade-off between growth and inflation, both – so he believes – nicely captured and thus neatly observable with macro-statistics – the present-day fetish of the economics profession. He cannot grasp the distortions in prices he creates, the misallocations in capital he constantly furthers, and the accumulation of debt he encourages. None of them register on his statistical radar.

Forget the debt-ceiling debate in the U.S. It’s trivial. What really matters is this: as long as there is a Federal Reserve and as long as it is run by men like Mr. Bernanke – dedicated, smart but hopelessly committed to a flawed belief system – the economy will not be a capitalist one, benefiting fully from saving, entrepreneurship and true capital accumulation but will always be addicted to easy money, cheap credit and propped up asset markets.

But it gets scarier: To the extent that Mr. Bernanke does perceive of any price distortions his policy generates, he thinks he can fully calculate their effect on the broader economy, and he cheerfully concludes that they are all positive!

“…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.”

More investment funded by printed money, not by saving! More borrowing and more debt! Again artificially propped up stock prices, courtesy of easy money from the Fed! – Hey, what could go wrong?!?!

This is precisely the policy that got us into this mess. More of it – and necessarily ever more of it – is now going to get us out of it?

You may call my position extreme. I know it is controversial. But I think a very nasty end to all of this is inevitable. Paper money collapse.

What will happen next?

The economy will stay in the dumps. And like a little hamster in his hamster wheel, Mr. Bernanke will only run faster and faster. Next, the interest rates that banks get on their deposits at the Fed will be cut to encourage more lending. The Fed will conduct QE3, and then QE4, and so forth. Maybe they will not call it that, but in effect that is what the Fed chairman’s own belief system will force him to do.

Some day inflation will rise to uncomfortable levels, and inflation is a macro-phenomenon that does appear on the Fed chairman’s radar screen. But then it is too late. The size of the accumulated dislocations is already too gigantic today to allow any politically acceptable correction. Nobody had the stomach for it at the time of Lehman. Nobody has the stomach for it today. But every day the Fed’s policy stance adds to these imbalances. In the monetary environment that the Fed maintains presently with everything at its disposal, deleveraging will never be accomplished. Mr. Bernanke is constantly digging himself a deeper and deeper hole that he won’t get out of when the market really demands higher interest rates to maintain any confidence in the paper dollar.

Paper money systems collapse – and they have all collapsed, throughout history and without exception – not because the money printers don’t understand inflation. They simply always reach a point when they fear the immediate impact of turning off the monetary tab more than the further printing of money. Of course, the disaster in the end is only bigger.

Mr. Bernanke is ultimately a tragic figure. He is no James Bond villain out for world domination or even a big Wall Street payout. He is more the mad professor in some sci-fi B-movie, unwittingly in cahoots with the forces of destruction not out of mean-spiritedness but out of intellectual hubris and infatuation with his own theories and technical wizardry.

This also explains Bernanke’s incomprehension of some people’s desire to go back to stable, inelastic and apolitical commodity money, money that is not a tool for bailing out banks, stimulating artificial growth or boosting select asset prices. Utterly convinced that he has worked out all the effects of his manipulation of the money supply and of interest rates, he can’t see why anybody would not want him to go on manipulating.

In the meantime, the debasement of paper money continues