John Tamny’s article last week at Real Clear Markets explains why Bernanke’s exit strategy won’t work:
In his Journal piece, Bernanke re-affirmed his Phillips Curve bona fides with his suggestion that once “recovery takes hold”, there could be “an inflation problem down the road.” To restrain future inflation, the Bernanke Fed “will need to tighten monetary policy”. The problem here is that not only does economic growth not cause inflation, but the Fed can’t control the supply of money in the way Bernanke suggests.
Much of what the Fed (and many economists) believes about the economy is based on the model of a closed economy. While that may be useful in the lab, it doesn’t mean much in the real world. As Tamny points out, it’s a global economy:
Sports giant Nike is based in Oregon, but it has never manufactured any of its products in the United States. Airplane manufacturer Boeing is now based in Chicago, but the 787 Dreamliner is being built in six different countries. If it’s acknowledged that labor and capacity aren’t finite, then it should also be said that neither is our capacity to innovate. The fact that most of us never deal with a live human being when we buy movie or airplane tickets, or when we deposit money at the bank is proof positive that markets maneuver around all manner of labor shortages.
So while the Fed can surely retard economic growth through its rate machinations, it can’t control the monetary phenomenon that is inflation by targeting the economy. It can’t precisely because it cannot control labor and capacity inputs outside the United States. In that sense the Fed’s use of its rate target to manage inflation will never work in the way Bernanke would like it to.
The global market is also the reason Bernanke can’t just withdraw all that cash he’s showered on the banks:
Looking at what Bernanke terms an “exit strategy”, specifically a drawdown of the trillion dollars the Fed added to the banks under the absurd notion that money creation equals economic growth, this won’t work either. And if Bernanke doesn’t know why it won’t, his ignorance as to why serves as another reason for his Fed Chairmanship not to be renewed.
Put simply, the dollar is the world’s currency. For evidence we need only remind ourselves that 2/3rds of all dollars are overseas. If and when dollar shortages reveal themselves stateside, the shortfall is made up with inflows of dollars from foreign locales.
So when Bernanke says he can contract U.S. bank reserves and lending through interest payments on dollars returned to the Fed, he is not writing truthfully. Just the same, if the Fed increases reserve requirements on banks in order to reduce lending and the money supply, there will similarly be no decrease in dollars lent in the U.S. despite Bernanke’s protests otherwise.
That is so because there exists a large reserve of dollars that the Fed does not control. Specifically, our largest money center banks have outposts around the world. Most notably through the Eurodollar markets, major U.S. banks can easily work around any supposed tightening by the Federal Reserve by accessing dollars from banks the Fed does not regulate. Smaller regional banks can borrow from the larger ones.
If you think back to Greenspan’s conundrum – long term interest rates didn’t respond to the Fed’s manipulation of short term rates – you know this is true. Greenspan and Bernanke have both called this a savings glut in economies outside the US, but it was really nothing more than a glut of dollars. And as Tamny points out, even when the Greenspan/Bernanke fed wanted to reduce lending, they weren’t effective because dollars from overseas offset any contraction by the Fed within the US.
What the Fed should really be focusing on is the value of the dollar:
Rather than worrying ourselves over the supply of money, we need to remember what the late Jude Wanniski repeated over and over again: it’s not the quantity of money that matters, but the quality of money. By quality Wanniski meant the value of money, and this is something the Treasury and Fed can control by simply making the dollar as good as gold.
Indeed, if our monetary authorities would communicate to the markets a dollar price rule whereby the dollar could be exchanged for gold, demand for our suddenly credible currency would skyrocket and the trillion dollars the Fed pushed into banks would suddenly not be enough. Monetarists, including perhaps Bernanke, would squeal about the inflationary implications of money growth, but with the dollar stable in value, there would be no inflation to speak of.
In his semi annual testimony to Congress, Bernanke was asked about this by Ron Paul. I can’t find the video, but to paraphrase, Paul asked Bernanke if the goal of monetary policy was a stable value for the dollar. Unfortunately, Bernanke said no, that the goal was price stability and maximum employment. Monetary policy cannot accomplish the first goal consistently without stabilizing the dollar. As for employment, monetary policy cannot effect employment in the long term and any short run effects are illusory. Just ask anyone who once worked in real estate.
One last thing. Jude Wanniski, who John mentions in his article, had a huge influence on how I viewed the world. His book,The Way the World Works, is what started me on a lifetime of studying economics. Unfortunately, he passed away a few years ago so we can’t get his views on the current environment, but John Tamny’s commentaries are probably as close as we can get.