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The Threat of Hyper-Depression
In the Keynesian heydays of the 1950s and 1960s, most economists and policy makers believed in the "Phillips Curve," which was the (alleged) tradeoff between unemployment and price inflation. The idea was that the Federal Reserve could cure a recession by printing money, or that the Fed could cure runaway inflation by jacking up interest rates. Each of these moves had its downside, of course, but the point was that the Fed could choose one poison or the other.
This Keynesian orthodoxy was shattered in the 1970s when the United States suffered through "stagflation," which was high unemployment and high inflation. This outcome was not supposed to be possible, according to the popular macroeconomics models, and it left policy makers with no clear choice. If the Fed raised rates to stem the inflation, it would hurt the economy even more, but if the Fed cut rates (through printing more money) the inflation problem would worsen. The vacuum created by this crisis in both theory and policy was filled by the Reagan Revolution and supply-side economics.
At this stage nothing is certain, but the country is currently headed straight into a period of very rapid price hikes and a very bad recession. It would not surprise me at all if the national unemployment rate and the annualized rate of consumer price inflation both broke through into double digits by the end of 2009. Moreover, regardless of when it actually starts, I predict that things will get much worse before they get better, and that the United States will be mired in a malfunctioning economy for at least a decade, with price inflation in the double-digits (possibly higher) the entire time. We can call this condition "hyper-depression."
As with stagflation during the 1970s, hyper-depression will blow up the prevailing "cutting edge" models of the macroeconomy. Back when he was an academic, Fed Chair Ben Bernanke was actually an expert on the Great Depression. Bernanke adheres to the (alleged) lesson taught by Milton Friedman and Anna Schwartz in their classic A Monetary History of the United States. F&S argued that Fed officials bore a large share of the blame for the Great Depression, because they did not pump in enough liquidity. The quantity of money actually declined by about a third from 1929-1933, as panicked customers withdrew cash from the banks. (In a fractional reserve banking system, when people withdraw deposits, the banks have to shrink their outstanding checking balances because of reserve requirements.)
As the following chart illustrates, Bernanke has taken Friedman's warning to heart: The Fed has more than doubled its balance sheet since the financial crisis began, leading to an unprecedented jump in the monetary base:
Thus far, this enormous injection of new reserves into the banking system hasn't caused the CPI to explode, but that is because (a) the banks are mostly sitting on the new reserves because they are all terrified, and (b) the public's demand for cash balances has risen sharply. But using very back-of-the-envelope calculations, there is now enough slack in the system so that if banks calmed down and lent out the maximum amount of reserves, the public's total money stock could increase by a factor of 10. There is no way that the public will simply add that new money to its checking accounts or home safes without increasing their spending. Eventually, prices quoted in U.S. dollars will start shooting upward.
All of the financial analysts are aware of this threat, but they foolishly reassure us, "Bernanke will unwind the Fed's holdings once the economy improves." But this commits the same mistake as the Keynesians during the 1970s: What happens when the CPI begins rising several percentage points per month, and unemployment is still in the double digits? What would Bernanke do at that point? Expecting the Fed chief to relinquish his new role of buying hundreds of billions in assets at whim, in the midst of a severe recession, would be akin to hoping that a dictator would end his declaration of "emergency" martial law in the middle of a civil war.
There are even many free market economists who are predicting that the Fed's massive money-pumping will "fix" the economy, at least for a while, but at the cost of high price inflation. Yet these analysts don't realize that they are buying into -- what we all thought was -- the discredited Phillips Curve. The 1970s proved that the Fed cannot fix structural problems with the economy by showering it with new money. Hyper-depression is simply stagflation squared.
People need to stop wondering, "When will the market find its bottom? This month? Next?" The federal government has already done an incalculable amount of damage to the American financial sector, and the insults keep growing.
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This Keynesian orthodoxy was shattered in the 1970s when the United States suffered through "stagflation," which was high unemployment and high inflation. This outcome was not supposed to be possible, according to the popular macroeconomics models, and it left policy makers with no clear choice. If the Fed raised rates to stem the inflation, it would hurt the economy even more, but if the Fed cut rates (through printing more money) the inflation problem would worsen. The vacuum created by this crisis in both theory and policy was filled by the Reagan Revolution and supply-side economics.
At this stage nothing is certain, but the country is currently headed straight into a period of very rapid price hikes and a very bad recession. It would not surprise me at all if the national unemployment rate and the annualized rate of consumer price inflation both broke through into double digits by the end of 2009. Moreover, regardless of when it actually starts, I predict that things will get much worse before they get better, and that the United States will be mired in a malfunctioning economy for at least a decade, with price inflation in the double-digits (possibly higher) the entire time. We can call this condition "hyper-depression."
As with stagflation during the 1970s, hyper-depression will blow up the prevailing "cutting edge" models of the macroeconomy. Back when he was an academic, Fed Chair Ben Bernanke was actually an expert on the Great Depression. Bernanke adheres to the (alleged) lesson taught by Milton Friedman and Anna Schwartz in their classic A Monetary History of the United States. F&S argued that Fed officials bore a large share of the blame for the Great Depression, because they did not pump in enough liquidity. The quantity of money actually declined by about a third from 1929-1933, as panicked customers withdrew cash from the banks. (In a fractional reserve banking system, when people withdraw deposits, the banks have to shrink their outstanding checking balances because of reserve requirements.)
As the following chart illustrates, Bernanke has taken Friedman's warning to heart: The Fed has more than doubled its balance sheet since the financial crisis began, leading to an unprecedented jump in the monetary base:
Thus far, this enormous injection of new reserves into the banking system hasn't caused the CPI to explode, but that is because (a) the banks are mostly sitting on the new reserves because they are all terrified, and (b) the public's demand for cash balances has risen sharply. But using very back-of-the-envelope calculations, there is now enough slack in the system so that if banks calmed down and lent out the maximum amount of reserves, the public's total money stock could increase by a factor of 10. There is no way that the public will simply add that new money to its checking accounts or home safes without increasing their spending. Eventually, prices quoted in U.S. dollars will start shooting upward.
All of the financial analysts are aware of this threat, but they foolishly reassure us, "Bernanke will unwind the Fed's holdings once the economy improves." But this commits the same mistake as the Keynesians during the 1970s: What happens when the CPI begins rising several percentage points per month, and unemployment is still in the double digits? What would Bernanke do at that point? Expecting the Fed chief to relinquish his new role of buying hundreds of billions in assets at whim, in the midst of a severe recession, would be akin to hoping that a dictator would end his declaration of "emergency" martial law in the middle of a civil war.
There are even many free market economists who are predicting that the Fed's massive money-pumping will "fix" the economy, at least for a while, but at the cost of high price inflation. Yet these analysts don't realize that they are buying into -- what we all thought was -- the discredited Phillips Curve. The 1970s proved that the Fed cannot fix structural problems with the economy by showering it with new money. Hyper-depression is simply stagflation squared.
People need to stop wondering, "When will the market find its bottom? This month? Next?" The federal government has already done an incalculable amount of damage to the American financial sector, and the insults keep growing.
.
.
.
.
.
.
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