Bernanke’s response

Ben Bernanke is doing a good job, so far, in carrying out Alexander Hamilton’s sage advice: keep politicians at a safe distance from monetary policy. He’s doing that by the simple act of ignoring a letter he received. I hope he continues using that approach.

However, I have been having a little fun imagining a parallel universe—one in which Bernanke patiently responds to the politicians, in an honest attempt to explain what the Fed is trying to do.

Imagine we are now in Parallel Universe Number Two. Here is Bernanke’s response.

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Dear Sirs:

Thank you very much for your letter. Past Chairmen would have ignored it under the guiding principle of keeping politics at arm’s length from monetary policy. However, I’ve decided break tradition by responding—particularly if my response helps to clear up any misconceptions.

I’d like to explain, as simply as I can, what the Fed is trying to do, in hopes that you will see that we are not on the path of creating Weimar USA; in reality we are trying to help achieve the goal of getting the economy moving again. “Jobs, jobs, jobs” is how everyone likes to put it these days. Please understand that, just as Congress sometimes has difficulty acting in unison, so does the Fed... occasionally. We all know these are difficult times; but we all have responsibilities to act, even if it cannot always be with unanimity.

Please bear with me. My explanation requires four steps and one simple algebraic equation; no calculus, I promise. I sincerely hope you will follow along as I take it one step at a time.

[As an aside, I have read Atlas Shrugged as I presume you have; but one aspect of the plot has always bugged me greatly. It has to do with the part about those little gold coins in John Galt’s intermountain utopia. I’ll get to that later, after covering the four-step explanation I feel I owe you.]

First is the equation that helps us envision how the real economy and the money supply interact with each other. It’s the simple “equation of exchange” we see in economics books. Here it is, below:

Next is a simple, color-coded explanation of each element. I’m sure you’ll all recognize the “P” (price level) component, because when a country makes the horrible mistake of hyperinflating its currency, “P” takes off like a rocket. But there are three other things in the equation of exchange: the money supply, the money velocity, and the quantity of real goods and services exchanged, as shown below:




Most people consider “T” to be the most important element—the total amount of production and exchange in the real economy. It is affected by virtually everything we do in monetary, fiscal, and regulatory policy.

The next logical step: how the Fed can try to help whenever fiscal, regulatory, and past monetary policies have failed to get the real economy (T) moving and growing again at a robust pace. (Whether the Fed should try is a different question; currently the Fed's mandate is to do something about both "P" and "T"; you can change that, of course, but that's the way it is now.)

 

The explanations use the scenario of an undesirable slowdown in real economic activity—today’s situation, including the effect of dormant excess reserves. In the alternate scenario of undesirable inflation, the Fed would reverse its action by “unprinting” money (i.e., by raising its target rate and selling assets as necessary), to keep the price level in line with what we all hope is robust activity in the real economy. 

Lastly, we have the equation to which I believe those who advocate the gold standard are mistakenly committed. Note the conspicuous absence of “T” and “V.”



It says that any increase whatsoever in the money supply is the very definition of inflation. (Never mind that we cannot actually measure the money supply, as the Volcker Fed discovered, after which the Fed began targeting the interest rate instead of the money supply.) The simplified equation says, to understand inflation, there’s no need to think about idle money sitting in excess reserves, and no need to think monetary policy can do anything about any sluggishness in the real economy. No, all we need is a known quantity of money, like the gold coins in John Galt’s intermountain utopia; monetary policy is as simple as that. [My view, and that of many others: it's an oversimplification.]

And that brings me back to the irritating flaw in the Atlas Shrugged plot—one that the economist in me couldn’t help but notice. Presumably, John Galt’s economy would attract many other high-integrity producer-consumers, and the utopian economy would grow due to increases in population, physical capital, human capital, and productivity. But with a known quantity of little gold coins (M) in a growing economy (T), the prices (P) would be forced to fall (deflation)—which in turn would require smaller and smaller gold coins as the economy flourished. Either that, or the economy would surely taper off, stagnating at a constant level of activity in a short period of time. How small could a gold coin get before the economy leveled off and everyone started demanding some new, better way to grow the money supply so that the real economy could start growing again? How much deflationary pain would it take for the citizenry to start demanding the innovation of fiat money, and the controlled, purposeful printing of same, in Galt’s intermountain utopia? Certainly the need for fiat money would cause an entrepreneur to invent it, at least by the time the gold coins got tiny enough to start leaking out of everyone’s pockets from between the stitches, if not long before, wouldn’t it? If not, Galt’s economy would be doomed--definitely NOT what Ayn Rand had in mind.

As I said, it’s an angle only an economist could conjure up.

In any case, sirs, I hope this response will help to reassure you that the Fed understands the problem, and is trying to do what it can to alleviate it, even though it is not always possible to act unanimously.

Sincerely,

Ben Bernanke
Chairman of the Federal Reserve Bank
United States of America, Parallel Universe Number Two


ps –
Effective fiscal and regulatory reforms would have the potential of eliminating the need for dramatic actioin in monetary policy.

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Comments

[Mike Spalding]

Thanks for the in depth discussion of these important issues. Many people miss the point that increasing the amount of money doesn't cause inflation if this increase is countered by a decrease in velocity. Hopefully Ben can sop up this excess fast enough when the velocity does start to increase.

As to the gold coins in Atlas Shrugged: Currently only 3% of the US money supply is actually in cash. Of course electronic transactions aren't hindered by the size of the coins. Also, you don't need a fiat system to handle the shrinking coin problem. Just use warehouse receipts, i.e. paper redeemable for gold. Although it is paper, it is not fiat as they are backed by gold in a vault and not the "full faith" of the local government.

[Optimist123]

Mike,

Good points; but paper redeemable for gold (a) is not what Ayn Rand described, possibly because (b) it's the beginning of the process that leads to fractional reserve banking. Those entrusted with gold deposits soon realize that, nearly 100% of the time, 10% of the gold is sufficient to satisfy depositors who want to redeem their paper for their gold. That's when they start creating "bank" money (from thin air) by lending out more paper than the gold they have in the vault.

The phrase "money from thin air" is a pejorative; but it means precisely the same thing as "money based on 2-way trust." Whether it is fractional reserve banking backed by gold, or by base money "printed" by the Fed, it is TRUST that underlies the entire system, NOT a shiny metal that has been hard to mine, seashells that have been hard to dive for, beaver pelts that have been hard to collect, or Marlboros that have been hard to counterfeit.

And if the gold bugs' true, underlying complaint is against fractional reserve banking... well, that's a different argument, and one that they'll have an even tougher time winning.

[woodchuck64]

Are the Republicans really concerned about the economy, or rather, concerned that the economy might improve before November 2012?

[Harterrt]

Great article, however, I seem to understand the threat of deflation differently. It is my understanding that deflation causes a feedback loop in which consumers postpone consumption due to the expectation of lower prices in the future which in turn accelerates deflation.

Although I do see traces of a feedback loop in this explanation, it seems to be focus on the inconvenience of gold coins and omits the role of expectations. More so, using the given example, I would not expect deflation to be a threat to the US economy given our current fiat money system, when in reality it can be.

[Optimist123]

A deflationary spiral is one of the fears of every central bank, because they have few tools to fight it. It can lead to double-digit unemployment, which leads to rioting in the streets, which leads to the overthrow of governments. Avoiding it is arguably a higher priority than avoiding unanticipated inflation (against which the central bank has tools to fight). Deflation is the other form of currency instability, but because it is so historically infrequent compared with inflation, we hear little to nothing about it. Nonetheless, the central bank's job is to avoid both deflation and unanticipated inflation -- even though we hear little else from the fear-mongers besides the inflation mantra.