In Praise of Bernanke

Long time readers will know of the Markets and Money’s tradition to stand up for the downtrodden. Fraudsters, dictators, thieves and rogue traders have made the cut before. This time, though, it’s a stretch.

Poor old Ben Bernanke has been criticised from the left, right and centre. So what can be said for his merit? Well, the latest bundle of comments to stir outrage occurred during a Congressional hearing, where Bernanke was questioned on the prospects of inflation.

“My concern is that the costs of the Fed’s current monetary policy – the money creation and massive balance sheet expansion – will come to outweigh the perceived short-term benefits,” Representative Paul D. Ryan of Wisconsin, the new chairman of the House Budget Committee, said in his opening remarks.
Mr. Ryan expressed alarm about “a sharp rise in a variety of key global commodity and basic material prices,” as well as the recent rise in yields in longer-term Treasury securities.

Bernanke’s reply was that of a skilled central banker – shift the blame elsewhere. He pointed to several culprits. By mentioning surging demand for commodities, and restricted supply, he satisfied the intellectual demands of classical economists. Then he blamed foreign inflation on the foreign central banks who had printed too much money. That one was for the Monetarists. The Keynesians, of course, see inflation as a good thing, so they weren’t bothered. That leaves us, the Austrian Economists.

The hypocrisy of blaming inflation on foreign central banks is obvious when you look at the amount of US dollars created on Bernanke’s watch. Besides, criticising your partners in crime seems a rather odd way to go about saving the world from deflation. But if you take a moment to look at Bernanke’s reasoning, he does have a point.

In a free market, countries who continuously import more goods than they export must send their money overseas to pay for all the consumption. This devalues their currency, which encourages exporting and discourages importing. The effect is an inherently stabilising and self-correcting trade balance.

In keeping the Yuan pegged to the US Dollar, the Chinese have hindered this self-correcting mechanism between the two nations from taking hold. Each time Americans run trade deficits and dollars rush out of the US economy into world markets, the value of the dollar falls. To maintain the peg, the Chinese print Yuan and buy Dollars. This props up the Dollar’s value and brings the exchange rate back to where the Chinese want it. The result is to encourage Americans to buy Chinese goods, which remain cheap. But by printing Yuan to maintain the peg, the Chinese create domestic inflation.

Bernanke’s money printing has added to the natural pressure of dollars flooding world markets to pay for America’s imports. Dollars are not only falling in value because Americans are buying foreign goods, but because Bernanke is creating more of them.

This added pressure means China will have to create even more Yuan to maintain the currency peg. This will stoke even more inflation in China.

Who is to be blamed for Chinese inflation, then? The Americans for printing money to devalue their currency, or the Chinese for printing money to maintain the peg? In this case, it only takes one to tango. If Ben stopped printing and Americans continued to buy Chinese goods, the Chinese central bank would have to print less Yuan to maintain the peg, but it would still have to print.

Bernanke is merely forcing their hand. The Chinese didn’t bow to market forces quickly enough for his liking, so now Bernanke is on the case. Eventually, inflation will be too much to bear and the Chinese will have to let their currency appreciate. This will mean printing less Yuan and inflation in China will fall. And, theoretically, it will encourage Americans to buy American goods, which will have become relatively less expensive than Chinese goods.

So, it seems, Ben Bernanke is doing the free market’s work. At least backing it up. But the issue is that the domestic effects of Bernanke’s money printing will come home to roost if the Chinese stop buying Dollars to maintain the currency peg. If they give up on the peg, as Bernanke is trying to force them to do, the US Dollars he is creating will create inflation in America.

It is much the same situation as this person encountered.

For now, China is attempting to fight off inflation by increasing interest rates. Ironically, real rates are still negative (inflation is higher than the interest rate).That means Chinese rates are in fact stimulating the economy, not slowing it. But, if China does revalue the Yuan in a sincere effort to fight off inflation, watch out for some serious inflation in America. Unfortunately, it’s likely that such inflation will outweigh the benefits of the devaluation of the Dollar to American industry.

So, as well intentioned as they are, you probably can’t expect Bernanke’s efforts to be fruitful. For Americans, that is. How all this could affect Australians is a different matter.

If the US goes into high rates of inflation and China’s export market can’t afford its goods, that doesn’t bode well for anyone here in Oz. Still, it’s preferable to be sitting on a pile of resources rather than a pile of paper assets (China) or debt (US).

Imbalances like this tend to get settled by sovereign defaults, which tend to follow banking crises. What a coincidence.

GDP in 2011

2011 is going to be a good year for economists. Not so good for the rest of us though. Why? Because economists, for the most part, think GDP is important. Why is a bit of a mystery considering what actually makes up GDP. Do jobs factor in? Nope. How about productivity? Nope. When you buy chicken, forget about it until it starts to smell and then throw it out? … Yup, that’s GDP! Hmmm.

Let’s look at why American GDP is expected to jump in 2011.

Last December, Congress decided to reduce the payroll tax, which pays for Social Security, by 2 percentage points for one year, meaning it went from 6.2% to 4.2% of taxable income. This jump in disposable income will go straight to the likes of Wal-Mart, where it will add to the GDP.


The amount that the government will have to borrow to fund the shortfall in revenue is not subtracted from GDP…

An even better example of creating GDP, also recently implemented in the US, is when the government decides to declare depreciation expense a tax deduction. That encourages business to buy those things the government has applied the deduction to, which spurs GDP.


Again, the government’s additional borrowing to fund the shortfall in revenue is not considered.

It’s probably not too much of a stretch to say that GDP is about the easiest thing in the world to create. But are you doing your bit for your country’s GDP?

When you go home to cook dinner, remember you are not increasing GDP in doing so. You did when you bought the food, but not if you grew it. And cooking and eating won’t show up in the statistics, unless you go to a restaurant.

Put another way, if we wanted to create GDP, you could cook my dinner and I cook yours, and we each charge each other the same amount. Voila! We have created GDP! (And taxable income.)

So, there you have it. GDP can be produced at the whim of the government and has little to do with what people actually do in their lives. And yet economists are citing GDP as proof of a private sector recovery, lauding politicians for their efforts to create it.

But what happens when the tax deductions mentioned above end? Not only will GDP fall. Investment and consumer spending will contract by the amount the “stimulus” allowed it to grow. And much of it will turn out to be a waste. Government will have encouraged unsustainable spending. That means the resources will be unprofitable. Uh oh.

For an example of how efforts like this play out, think back to the US government-engineered housing bubble and its dramatic “pop” in the late 2000s. Although that episode still hasn’t ended. Reuters reports:

The Obama administration will propose raising the cost of loans backed by the Federal Housing Administration as part of a plan to reduce government support of the mortgage market to below 50 percent, said sources familiar with the plan.

Below 50%! The government supports 50% of the mortgage market?

No, “The government currently backstops more than 85 percent of the $10.6 trillion mortgage market.”

Wow, no wonder there was a bubble.

But efforts are being made to implement America’s capitalist beliefs. The hike in FHA costs will “give the private sector a dominant role”.

Do you think the private sector has a dominant role in a 50% government-backed market?

Worth Noting

We would like to mention two asides today.

First of all, inflation is not as hidden a hidden tax as you might think. Not only do governments and banks get to spend new money at unadjusted prices, but they also profit from the central banks efforts to implement monetary policy.

The Federal Reserve’s revenue from holding securities, which now include all sorts of exotic securities alongside government debt, goes to the Treasury in so called “remittances”. A transfer of wealth from the economy, which in 2009/10 totalled about $125 billion! That’s 0.9% of US GDP. Add to this that the Fed is now the largest holder of US government bonds, which means the Treasury is paying itself a large part of the interest on its bonds. In other words, the Fed has turned a $125 billion cost into a $125 billion profit for the Treasury without anyone’s approval or oversight.

The second aside is a warning. The so-called inflation hawks on the Federal Reserve’s board are being shot down systematically. Reuters reports the last one is set to step down in March. It’s all remarkably similar to Stalin purging the Soviet government of anyone who wasn’t prepared to agree with him.

Nick Hubble
For Markets and Money Australia

Nick Hubble
Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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