Monday, March 17, 2014

Where's the Inflation At?: A Review of and Thoughts on Hummel's "Ben Bernanke Versus Milton Friedman"

Leading into the recent crisis, and especially after the Federal Reserve responded with “quantitative easing” [QE], the press was a flurry in talks about inflation. Over 5 years after the first QE, commodity prices have not risen in proportion to the increase in the monetary base. The hyperinflation predicted by many has failed to materialize. Why is this so?

Anyone who has taken a course in macroeconomics is probably familiar with the quantity equation.
MV = Py
Note that P = MV/y. An increase in the money stock, all else equal, leads to an increase in prices in the long run. But all else is not equal. Or so says Jeffrey Rogers Hummel in “Ben Bernanke Versus Milton Friedman: The Federal Reserve’s Emergence as the U.S.Economy’s Central Planner” Hummel writes that Bernanke believes that
a disruption of what he calls ‘the credit channel’ in effect will induce households and firms to hold more money rather than spend it on consumption and investment. True to his New Keynesian inclinations, what Bernanke is thus saying is that the failure of banks brings about a prolonged, negative velocity shock, although he never expresses this idea in such straightforward terms.
The collapse of major financial institutions may result in fear-induced cash holding – “a negative velocity shock.” This negative velocity shock is special in that it acts as a black hole for increases in the money stock. Someone beckons Keynes’s ghost.

“What was the norm during the previous chairmanship at the Federal Reserve?”, you ask. It was essentially that sudden changes in V should be stabilized by M (this is only approximately true, but you will see what I am getting at soon). Under Alan Greenspan, the Federal Reserve met negative shocks to V with increases in M. Hummel notes three instances:
  1.    .   Black Monday (1987)
  2.        The Y2K Scare (1999/2000)
  3.         9/11

During all of these crises, the Federal Reserve temporarily raised the rate of increase of the monetary base. (You won’t observe an increase in the chart in 1987 as the intervention employed purchases that were bought back within two weeks.) The sharp increases in liquidity stabilized the markets.

Ben Bernanke’s tenure reflected a different approach. From the start of his chairmanship, the rate of growth of the base money stock dropped steadily. Bernanke was aware that a potential crisis was on the horizon, though the size of its impact was unclear. Hummel quotes Bernanke,

As late as May 17, 2007, Bernanke was predicting that troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.’

The course he charted, however, did not involve an increase in the rate of growth of the base money stock. Instead, he redistributed credit and continued to let the rate of growth of the base money stock drop.

By summer of 2008, lending to banks through the Term Auction Facility ahd climbed to $150 billion, and discounts added another $18 billion. Other things being equal, this lending would have brought about a substantial bulge in the monetary base. But other things were not equal. For pari passu, Bernanke was pulling money out of the economy by selling Treasury securities. As a consequence, during the year ending in august 2008, the monetary base had increased less than $20 billion, a mere 2.24 percent, which was well below its average annual growth of 7.54 percent during Greenspan’s nineteen years in charge… Bernanke was not injecting liquidity, just redirecting it.

Even when Bernanke’s actually expanded the monetary base, the expansion was actually another rendition of credit reallocation. He accomplished this by initiating a policy of paying interest on reserves held at the Federal Reserve. The entirety of the QE1 expansion did nothing to increase market liquidity directly. Instead, the new credit remain latent, collecting interest at the Federal Reserve. Oddly enough, management of credit by Bernanke created a nearly perfectly elastic demand for money by banks, much like the problem that he believed caused the Great Depression. He created a liquidity trap!

Management was a hallmark not only of Bernanke’s chairmanship, but his philosophy. Hummel again quotes Bernanke,

‘What we do know is that the central bank of the world’s economically most important nation in 1929 was essentially leaderless and lacking expertise. This situation led to decisions, or nondecisions, which might well not have occurred under either better leadership or a more centralized institutional structure [emphasis Hummel’s].’

Hummel continues in his own words,

These are not the words of a sedate central banker reluctantly intervening in a crisis but rather of an activist regulator who views the economy as requiring expert, detailed management with constant, coordinated control. Still more recently at Princeton University, Bernanke explicitly called for improved ‘economic engineering’ and ‘economic management’ by the regulatory authorities.

One might find this indictment harsh, but it is difficult to deny that Bernanke’s policies have reflected such an attitude. What has resulted is an empowered Federal Reserve and several years of lackluster growth under Bernanke. The economy would likely have faired better if, upon the first signs of crisis, the Federal Reserve provided a one-time spike in the base money stock that did not become locked away behind its own doors. I expect that we would have seen some failures, but that the market would have steadied and recovered in a more a robust manner than we have experienced thus far.

Originally posted here.

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