Nomura’s Richard Koo may be right about the Bank of Japan when he says that “everybody knows that the Bank of Japan has no tools to achieve an inflation target with the monetary multiplier zero negative”, but that observation can’t and shouldn’t be applied to the U.S.
In fact, back in November 2002, then Fed Governor Ben Bernanke gave an entire speech on the topic to the National Economists Club, titled, “Deflation” Making Sure ‘it’ Doesn’t Happen Here.” The complete speech is worth reading at http://www.federalreserve.gov/boardDocs/speeches/2002/20021121/default.htm, but all you really need to know is that Bernanke is on record as noting that (a) the Fed’s charter includes fighting deflation as well as inflation, (b) buying government securities of all maturities is only one of many anti-deflationary options available to the Fed when short-term interest rates approach zero and there’s no borrrowing/lending of bank reserves, and (c) “the conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning”, because all the Fed has to do is create such a massive supply of fiat money that its price falls relative to other assets. Dr. B goes on to promise that while “of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behaviour.”
We should all hope that the U.S. economic situation never reaches the point where the Bernanke Fed has to launch the black helicopters into the sky filled with bags of currency, but I am highly confident that the Bernanke Fed is all too willing to take any extreme action it thinks is necessary to stop deflation – and unlike Koo, I’m convinced that a Federal Reserve determined to create a higher price level can in fact make it happen. That said, it’s also highly likely that the side effects from the Bernanke cure for deflation will be almost as bad as the disease itself.
Looking ahead, we’re going to need more words to describe higher price levels than just “inflation”, or maybe “hyper-inflation”. In this environment, where bank reserves are multiplying like lemmings but there is little borrowing or lending activity to boost the money supply and drive demand, it will be very hard to engineer enough economic activity to avoid deflation. So traditional inflation isn’t the concern – the problem is that if/when the Fed starts printing fiat money to raise the U.S. price level, the dollar will collapse, interest rates will spike and we’ll get some horribly ugly inflation in between the plain vanilla version and hyper-inflation.
As Woody Allen famously said, “One path leads to utter hopelessness and despair, the other to total extinction. Let us hope we have the wisdom to choose correctly.”
The author is a former healthcare analyst and is a mutual fund industry veteran…
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