Monday, May 11, 2009

...As Fed Fights The Last Depression Is It Losing The Inflation Battle?

General Bernanke and his Federal Reserve now find themselves hip deep in the time honored military tradition of fighting the last war, and as with all armies who fight the last war General Bernanke is in danger of losing his current battle with inflation. While fighting a deflation with an increase in the money supply is a correct policy action, seeing a deflation where there is none, the Fed Chairman reveals that he has read his history of the Great Depression and learned the wrong lessons from it.

This problem of seeing falling prices as deflation and not the result of economic contraction can't be helped as long as he views events through the lens of a Keynesian Economic Model. Keynesians see only inflation and deflation. In their economic world view they don't grasp the differences between contraction and deflation, nor expansion and inflation .

The problem he faces is similar to that of a fireman who doesn't understand the difference between the paper fire in a kitchen trash can and the grease fire on a stove. Dousing both with water, he puts one out but intensifies the other.

Had the economy actually been in a deflation, the extra liquidity the Fed added would have been the correct monetary lever to bring relief . The problem for the Fed was that we were not in a deflation, but a contraction, which can also be marked by falling prices, but will not be fixed by additional monetary ease. As a result, even with the Fed's massive expansion of it's balance sheet, prices continued to fall.

The sharp contraction of the economy, ignited by a breakdown of the loan securitization market, helped to cause falling prices. The financial hardship of falling home and securities prices, while painful to many, was providing the economic cure to the recession by once again rationalizing market prices. This, in turn, would bring private capital back to the markets in search of newly created value. The Fed, in trying to prevent the deflation that wasn't, by injecting additional liquidity into markets that didn't need it, took exactly the wrong course of action. The Fed's misstep is resulting in a fanning of the sparks of a new inflation that, along with the recovery, is just now getting underway.

As the economy slowly continues to show signs of a recovery, the Fed needs to quickly do an about face and withdraw it's monetary surge, or the battle to tame inflation will be long and hard fought, but ultimately a losing one. The Federal Reserve should then play it's part in securing our economic future by once again fixing the value of the dollar,thereby eliminating the risk of inflation and assuring economic actors that the profit negotiated in today's contracts will not be diminished by the hidden tax of inflation. Economic growth and a return to a sound currency would unwind a lot of the negative effects of the increased liquidity the Fed has produced.

What was, and is still needed, are incentives to encourage risk taking by investors and entrepreneurs. Increasing the after tax returns to capital for successful risk takers is the road to an expanding economy that will create real jobs in the private sector. Economic expansion, along with the growing profits it produces, would also provide the additional revenue the Treasury seeks. Instead, we hear talk of higher taxes, closing loopholes, and hiring additional IRS agents to beef up enforcement . None of these are pro-growth policies. Unfortunately, pro-growth incentives will probably not be forthcoming from this Congress, as Government is firmly stuck in the muddied Keynesian view that the economy is suffering from a "shortfall in aggregate demand", which in their construct can only be addressed by additional government spending when the private sector retreats.

My guess is that when the economic history of this period is written, the Feds policy of fighting a contraction with monetary stimulus, coupled with the unusually large government interventions in just about every aspect of the economy, will show that it actually resulted in prolonging the depth and breadth of this recession .

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