Friday, 1 February 2008
by Ambrose Evans-Pritchard from The Telegraph 9 December 2008 We are beyond the extremes of the 1930s. The frontiers of monetary policy are being pushed to limits that may now test viability of paper currencies and modern central banking. You cannot drop below zero. So what next if the credit markets refuse to thaw? Yes, Japan visited and survived this policy Hell during its lost decade, but that was a local affair in an otherwise booming global economy. It tells us nothing. This time we are all going down together. There is no deus ex machina to lift us out. Certainly not China, which is the most vulnerable of all. As the risk grows, officials at the highest level of the British Government have begun to circulate a six-year-old speech by Ben Bernanke - at the time of its writing, a garrulous kid governor at the US Federal Reserve. Entitled Deflation: Making Sure It Doesn't Happen Here, it is the manual of guerrilla tactics for defeating slumps by monetary means. "The US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost," he said. Critics had great fun with this when Bernanke later became Fed chief. But the speech is best seen as a thought experiment by a Princeton professor thinking aloud during the deflation mini-scare of 2002. His point was that central banks never run out of ammunition. They have an inexhaustible arsenal. The world's fate now hangs on whether he was right (which is probable), or wrong (which is possible). As a scholar of the Great Depression, Bernanke does not think that sliding prices can safely be allowed to run their course. "Sustained deflation can be highly destructive to a modern economy," he said. Once the killer virus becomes lodged in the system, it leads to a self-reinforcing debt trap - the real burden of mortgages rises, year after year, house prices falling, year after year. The noose tightens until you choke. Subtly, it shifts wealth from workers to bondholders. It is reactionary poison. Ultimately, it leads to civic revolt. Democracies do not tolerate such social upheaval for long. They change the rules. Bernanke's central claim is that the big guns of monetary policy were never properly deployed during the Depression, or during the early years of Japan's bust, so no wonder the slumps dragged on. The Fed can create money out of thin air and mop up assets on the open market, like a sovereign sugar daddy. "Sufficient injections of money will ultimately always reverse a deflation." Bernanke said the Fed can "expand the menu of assets that it buys". US Treasury bonds top the list, but it can equally purchase mortgage securities from US agencies such as Fannie, Freddie and Ginnie, or company bonds, or commercial paper. Any asset will do. The Fed can acquire houses, stocks, or a herd of Texas Longhorn cattle if it wants. It can even scatter $100 bills from helicopters. (Actually, Japan is about to do this with shopping coupons). All the Fed needs is emergency powers under Article 13 (3) of its code. This "unusual and exigent circumstances" clause was indeed invoked - very quietly - in March to save the US investment bank Bear Stearns. There has been no looking back since. Last week the Fed began printing money to buy mortgage debt directly. The aim is to drive down the long-term interest rates used for most US home loans. The Bernanke speech is being put into practice, almost to the letter. No doubt, such reflation a l'outrance can "work", but what is the exit strategy? The policy leaves behind a liquidity lake. The risk is that this will flood the system once the credit pipes are unblocked. The economy could flip abruptly from deflation to hyper-inflation. Nobel Laureate Robert Mundell warned last week that America faces disaster unless the Bernanke policy is reversed immediately. This is a minority view, but one held by a disturbingly large number of theorists. History will judge. Most central bankers suffer from a déformation professionnelle. Those shaped by the 1970s are haunted by ghosts of libertine excess. Those like Bernanke who were shaped by the 1930s live with their Depression poltergeists. His original claim to fame was work on the "credit channel" causes of slumps. Bank failures can snowball out of control as the "financial accelerator" kicks in. The cardinal error of the 1930s was to let lending contract. This is why he went nuclear in January, ramming through the most dramatic rates cuts in Fed history. Events have borne him out. A case can be made that Bernanke's pre-emptive blitz has greatly reduced the likelihood of a catastrophe. It was no mean feat given that he had to face down a simmering revolt earlier this year from the Fed's regional banks. The sooner the Bank of England tears up its rule books and prepares to follow the script in Bernanke's manual, the more chance we too have of avoiding a crash landing. Monetary stimulus is a better option than fiscal sprees that leave us saddled with public debt - the path that nearly wrecked Japan. Yes, I backed the Brown stimulus package - with a clothes-peg over my nose - but only as a one-off emergency. Public spending should be a last resort, as Keynes always argued. Of course, Bernanke should not be let off the hook too lightly. Let us not forget that he was deeply complicit in creating the disaster we now face. He was cheerleader of Alan Greenspan's easy-money stupidities from 2003-2006. He egged on debt debauchery. It was he who provided the theoretical underpinnings of the Greenspan doctrine that one could safely ignore housing and stock bubbles because the Fed could simply "clean up afterwards". Not so simply, it turns out. As Bernanke said in his 2002 speech: "the best way to get out of trouble is not to get into it in the first place". Too late now.