Saturday, April 18, 2009


Bernanke-Fed won't keep rates too low for too long
2009-04-14 19:08 (UTC)

WASHINGTON, April 14 (Reuters) - Federal Reserve Chairman Ben Bernanke said on Tuesday that the U.S. central bank, which has cut interest rates almost to zero, will definitely reverse its monetary policy at some stage to prevent inflation.

The Fed will 'make sure we do raise rates at an appropriate time and make sure we don't leave rates too low for too long, because it can have adverse effects, at least on inflation,' Bernanke told students at Morehouse College in Atlanta.

quoted from

So if everything works out according to plan, we restore the economy back to where it was a year or two ago, before everything fell apart.

Well, then we'll be in trouble. Because if we get back to that time again, we will only be ripe for economic collapse again. Bernanke must know this. Central to the concept of fixing the economy is the notion of fixing the problem that created the problem. Not just fixing consequences we don't like.

Ben Bernanke has the most thrilling job in America, and I think he's the right man for the job. But I hope he's keeping secrets. Because the things he said at Morehouse College are just more of the same numb-brain, defunct-economist crap that got us into this mess in the first place.

In the good old days we were not a cashless society. Only a small percentage of our spending involved the use of credit. And most of the use of credit was for large-scale purchases -- homes and cars -- or for business expansion. So in those days when the Federal Reserve wanted to fight inflation by raising interest rates it mostly affected home and car sales, and business expansion.

Today we're a cashless society and we rely on credit for most of our spending. So now when the Federal Reserve raises interest rates it affects most transactions. It affects the whole economy. The policy that once worked so well, now has a totally different effect.

We need to stop solving the same problem the same way, over and over and over. We need a new way to fight inflation.

Bernanke's remark--hopefully, it's not the same as his actual plan--indicates that as soon as the economy gets going again, if there's any hint of inflation he will boost interest rates to fight inflation. That would be the wrong response. It is the old response, the old saw. We've been raising interest rates to fight inflation since the end of World War II. It worked for a generation or so, but it doesn't work any more.

That old saw worked well in an economy that relied on credit mostly for growth. But in an economy where credit is used for most transactions, the old saw has a completely different result. We need to stop relying on it, until we can reduce our reliance on credit to something like it used to be, say, in the 1960s. In the meanwhile, we need a different way to fight inflation.

The proper phrasing of a question sometimes makes the answer evident. In this case the proper statement of the problem makes the solution evident: We need to fight inflation, but we also need to reduce our reliance on credit. Permit me to pull the sword from the stone and cut the Gordian knot: I say, let us fight inflation by reducing our reliance on credit.

Square One: While the economy grows, our reliance on credit increases. When you borrow a dollar and spend it, you take a dollar from someone's savings, a sedentary dollar, and put it into circulation. You take money that is not in circulation, and put it into circulation. That credit-money then stays in circulation until you repay what you borrowed. In a very real sense, you have the same power to control the money supply that the Federal Reserve has. Except the Fed can handle bigger quantities of money than you or I can handle.

Once you spend that new dollar of credit, it's gone. It's gone into circulation. No one can any longer see that it is a dollar of credit. It looks like a dollar. And you have increased the quantity of money in circulation.

Now the Federal Reserve monitors the economy. And they notice the quantity of money going up. So they take some of their holdings of Treasury Bills and sell them. The money from this sale is put away somewhere, out of circulation. That's how the Fed fights inflation.

So you and I borrow, and the quantity of money increases. (This is how we make the economy grow.) And then the Fed sells securities and takes money out of circulation. (That is how they fight inflation.) We are left with more debt than before, but no extra money in circulation. The extra money we created, that we might have used to pay off debt, is gone. Do you see how out-of-balance this process is?

After the process is repeated over and over for most of a century, by more and more people, for an increasing variety of purchases, we end up with a lot of debt in the economy, and not a lot of money we can use to pay off that debt. This is the underlying process that eventually creates a credit crisis.

There is a better way. Suppose I borrow some money and spend it, which increases the quantity of money in circulation. But say the Fed doesn't take that money out of circulation. Instead, I pay back the money I borrowed. That's it: That's the plan. I pay back the money I borrowed, which takes dollars out of circulation and makes them sedentary again. The extra money comes out of circulation, and my debt is reduced at the same time. Do you see how beautifully balanced this process is?

But what makes me pay off my debt? Well, I'd pay it off anyway, sooner or later. And the Federal Reserve doesn't take the money away, so funds are more readily available. But the key concept is that new tax incentives are set up, incentives that encourage us to accelerate repayment of our debt. Tax credits that give you a break on your taxes when you make extra payments on your existing debts, or a tax rate that varies up and down somehow with your particular level of indebtedness.

These tax incentives will induce us to put more of our income toward the repayment of debt, and less toward additional spending that would otherwise contribute to inflation. And the Federal Reserve stands guard, with its old-saw powers at the ready, in case additional restraint is needed.

(c) 2009 Arthur Shipman

Edit: Crossed out a few words to eliminate distractions. 19 May 2014

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