Bernanke: Pedal to the metal Editor: Ben Bernanke devoted much of his academic career to studying the causes of the Great Depression. In an interview in March 2009 Bernanke said, that he learned two important lessons from his studies of the Depression. “The first is that monetary policy needs to be supportive, not contractionary. The Federal Reserve didn’t understand what was going on, they were pursuing very orthodox policies constrained by the gold standard, and the effect of their policies was to create a powerful deflation of 10% a year in the US between 1930 and 1933, which was extremely damaging. The second lesson is that when the financial system breaks down and becomes highly unstable, then that has very severe adverse effects on the economy, and once again the Federal Reserve did not intervene to stop the failure of about a third of the banks in the US… It was the financial crisis and the collapse of banks and other institutions in late 1930 and early 1931 that made the Great Depression great. And so we must have a commitment to stabilize our banking system to prevent the failures of any large systemic and critical firms.” Bernanke and the Federal Reserve will undoubtedly be paying close attention to the collapse in money velocity, which, unchecked, would have a powerful deflationary effect on the economy. We can be confident that the Fed will not withdraw support until they are certain that the US economy can stand on its own two feet and it is certainly not there yet.

Seems whatever financial media you go to, the discussions are about speculation that Bernanke and his cohorts at the Fed’s Federal Open Market Committee (FOMC) are considering cutting back on quantitative easing, which is now running at $85 billion a month.  ($45 billion in Treasuries, $40 billion in mortgage debt.)

The media’s chic question is whether Bernanke will “lift his foot off the QE pedal.”  I say nay.  QE is now as integral to federal financing as credit cards are to consumers.  However, Bernanke and his minions are not above using the media in attempts to achieve the results that they deem desirable.

For instance, as stocks (in the US) keep knocking out new highs, fears of another bubble are actually discussed in financial circles.  So, what dampens enthusiasm for stocks?  Talk that the FOMC may slow or cut short QE3.

Last night, Reuters (India) issued a report regarding Japan’s Monday decline in Japanese stocks.  “Asian shares began the new month with a cautious tone on Monday as uncertainty over how much longer the current U.S. stimulus would continue. . .” (Emphasis added.)

Even the Bank for International Settlements, the so-called central banks’ bank which is based in Basel, Switzerland, last week warned that stock prices are under a “cheap money spell.”

What will the Fed do if stocks enter a protracted decline for fear of an early end to QE3?  Quite possibly issue statements that the Fed stands behind its original position to continue QE3 until there is a “substantial improvement in the jobs market.”  Such statements are not only reassuring to investors, they become talking points for the media.

Without actually changing quantitative easing, the Fed can influence investor sentiment by permitting changes in perceptions about what it intends to do.  Undoubtedly, the Fed wants stocks to remain strong as rising stock prices create a “wealth effect,” which makes investors optimistic and results–in theory–in increased consumer spending.

The Fed does not want stocks to overheat.  Bernanke has already warned that low interest rates for long periods can result in bubbles.  While the Fed can’t do away with recurring comments about a Treasuries bubble, it can influence sentiment about stocks as more Americans are attuned to stock prices than to Treasuries prices.

“Pedal to the metal” means there will be no “unwinding of the Fed’s balance sheet.”  Discussions of unwinding of the Fed’s balance sheet are commonplace in economic classes, where theory and reality are blurred, but the Fed selling assets is a fairy tale as is Peter Pan.  (Think of Ben Bernanke as Tinker Bell sprinkling pixie dust.)

The Fed is not going to unwind its balance sheet.  Even Chicago school monetarists, who are advocates of free markets (except for money) say there is no need to unwind.  (Remember the Keynesian theory that the money borrowed for deficit spending during periods of recession would be repaid during economic booms?  Another fairy tale.)

The situation in Japan illustrates why the Fed will continue QE.  For a excellent discussion of Japan’s plight, read John Mauldin’s Central Bankers Gone Wild.

One hundred years ago, Andrew Dickson White, co-founder of Cornell University, warned that once a nation starts down the road to fiat money all the country’s brilliant minds cannot stop it.  This warning came in his Fiat Money Inflation in France, which was the result of his detailed study of France’s ruinous paper money scheme amidst the French Revolution.

France’s disastrous experience with paper money during the French Revolution was not its first.  Seventy years prior, John Law had put the French through a devastating bout of paper money, which resulted in an economic debacle.

History is replete with examples of ruinous results of paper money.  Yet that doesn’t keep politicians from repeating that mistake again and again.  There is no reason to believe that Bernanke and Co. will change course on its quantitative easing.   As I wrote five years ago, the sad history of paper money is that politicians print it until it is worthless.   We need to invest accordingly.

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