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Deflation virus is moving the policy test beyond the 1930s extremes
Debt deflation is tightening its grip over the entire global system. Interest rates are creeping towards zero in Japan, America, and now across most of Europe.
By Ambrose Evans-Pritchard, International Business Editor
Last Updated: 9:43AM GMT 08 Dec 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.
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By Ambrose Evans-Pritchard, International Business Editor
Last Updated: 9:43AM GMT 08 Dec 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.
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