While Congress spent another day playing political "Clue" -- Senator Dodd -- with the red pen -- in the backroom, Ben Bernanke reminded us once again why the Federal Reserve is currently the most powerful institution on the planet. Many of us have been led to believe that the foundation is being laid for economic recovery, however recent acts by the Fed amount to a significant escalation in our war against deflation and are additional indications that our economic situation may be more grave than most of us believe.
In many ways, there are few individuals in the world better equipped to handle the current situation than Mr. Bernanke. Unlike many of our current politicians, Bernanke not only has a very deep understanding of the causes and effects of a deflationary environment, but spent significant time considering potential responses to those causes long before anyone had heard the phrase "sub-prime crisis". In a 2002 speech, he listed in great detail how the Fed could fight the forces of deflation and this speech reads like a blueprint for what has occurred since late 2007.
The primary tenet of Bernanke's strategy is succinctly summarized in this paragraph:
Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Prior to today, the Fed had already employed almost every other weapon in its arsenal. Short term interest rates are effectively zero. Banks and other financial institutions can sell or borrow against almost any type of collateral at record low rates. Government spending has been significantly increased. Evidently the sum of all these efforts was judged as not enough.
The announcement today that the Federal Reserve will begin purchasing US Treasuries was confirmation that the electronic printing presses are now running at full throttle. Markets reacted as expected, the US dollar plummeted against major currencies, Treasuries rose in the face of $300 billion in additional demand from the government and Wall Street cheered -- driving up stock prices -- all on news that Bernanke has chosen the nuclear option -- to print money.
There is no doubt that preventing and fighting deflation is paramount to US economic recovery and the steps taken today reaffirm that. However, just as the use of Little Boy and Fat Man on Hiroshima and Nagasaki defeated an enemy, the unleashing of such powerful weapons proved anything but a panacea. We need to be equally vigilant about this new weapon, for like radiation, the long term impacts of new weapons are rarely fully understood.