The coming monetary mess

Since the announcement of the Troubled Assets Relief Program, I have written sparingly on the wisdom – or lack of wisdom – of the Federal Reserve in its attempts to jolt the economy back to life. In October, when the Fed and the Treasury Department abandoned the idea of buying the rotten assets that are the proximate cause of woe in the banking industry and instead opted to prop up the banks with direct capital infusions, I voiced some mild complaint, writing:

…it’s hard to see how the Fed can adequately bail out financial institutions and provide a last-resort buyer for commercial paper without stoking some seriously high inflation rates.

Since October – and certainly since the initial rolling out the TARP – the bureaucrats in charge have exposed themselves through their various half-actions and policy reversals. It is now clear that they have no real idea what to do and are frantically pulling levers and pushing buttons, hoping that something, anything, might halt our collective slide toward an economic catastrophe.

Despite the fancy rhetoric and what seems like sober, reasoned analysis, the upshot from all this frantic activity appears to be something quite simple: we will continue to expand the money supply at unbelievable rates in order to bail out any and all business enterprises deemed “too big to fail.” This is an unsustainable course of action, although for slightly different reasons than I articulated in October; however, the end of this course in my judgment is still the same – seriously high inflation.

Much of the cognoscenti still fail to appreciate the potential for high inflation in the near future. Like James Grant wrote in this weekend’s Wall Street Journal, many folks still see the danger being too far off to worry about, or as Grant had it, “Frostbite victims tend not to dwell on the summertime perils of heatstroke.” Still others believe inflation could be a useful tool in curing our current distress – we can simply “inflate our way out of the mess” by devaluing our currency such that existing debts shrink (while wages, prices, rents, and corporate earnings rise).

Technically, this is, of course, not incorrect. Inflation does have a way of reducing debt ratios, but we should be careful what we wish for. By following this strategy to economic health, we are creating two possible future scenarios that are every bit as debilitating as our current sorry state. In the first instance, when a recovery does begin, the excess liquidity and hot economy will produce great inflationary pressure. That’s just simple economics. At that point, the Fed will be in a pickle. Raise rates too much, too fast, and you risk quashing the long-hoped-for recovery; do nothing and you will see historically high inflation, which will likely destroy wealth more quickly than it can be created.

And in any event, none of this accounts for the very real possibility of high inflation occurring while the economy is in recession, so-called stagflation, the double whammy of wealth destruction.

The Art of Misremembering

In every action contemplated or executed by the government thus far, the overriding desire has not been to develop long-term viable solutions, but rather to avoid the so-called Hoover Syndrome. No one wants to be the Herbert Hoover of the current crisis, meaning, no one wants to be seen as standing idly by while the economy burns down around them. According to the New York Times, this was precisely the rationale used by Vice President Dick Cheney when he lobbied forcefully on Capitol Hill for the Detroit bailout before the US Senate earlier this month. The Times reported:

The decision came after a tense standoff this week in which senior White House officials pleaded with Senate Republicans not to block the measure, including a warning by Vice President Dick Cheney that they would be remembered for decades as the party of Herbert Hoover if the industry collapsed.

It is believed – at least, on a political level – that it is far better to run around the financial barnyard like a headless chicken than to do nothing for lack of good ideas.

I think this demonstrates how we become trapped, imprisoned, by our own cultural narratives, and no one is more apt to be trapped in this way than Fed Chairman Ben Bernanke. There might not be another person on the planet who has more subtle knowledge of the Great Depression than Bernanke, a lifelong student of the financial and political decisions that played into Depression economics, and while his opinion of Hoover is probably more nuanced than most folks, it certainly is not lost on him how Hoover’s reputation has never quite recovered from his handling of the Depression crisis.

But just as our cultural narrative of Herbert Hoover skews too much toward the negative, our narrative concerning the post-Hoover New Deal is skewed too much toward uncritical acceptance. For many years in the academy, it was anathema to even suggest that the New Deal added up to a lot less than was generally thought, that it actually prolonged the economic crisis of the 1930s. To the starving farmers and unemployed factory workers of the day, I’m sure such federal largesse was a lifeline in an otherwise bleak existence, but until World War Two provided real economic stimulus, the New Deal economy was a sclerotic mess, not that other economies around the world were doing much better. Our historical narrative, however, only captures the positive: Franklin Roosevelt, the daring and decisive man of action; the federal labor details building stadiums, bridges, etc.; the army of desk jockeys competently pushing paper in the Rooseveltian alphabet soup of new federal agencies.

There was a lot to admire in the New Deal – and a lot more to avoid. As we journey ever closer to a New Deal II under the Obama administration, we would do well to question the received narrative concerning the 1930s.

James Grant’s weekend piece in the WSJ attempts to sound the alarm bells. After all, in Roosevelt’s installment of the New Deal, at least we had to labor under the restrictions of the Gold Standard. This time around, no such restriction exists…we are free to print money until we’re drowning in the stuff. What all that cash will be worth, however, is anybody’s guess.