Thursday, November 03, 2005


Fed Nominee Bernanke walks into a bar. The Bartender says that with the inflation of late, drinks cost more.
Bernanke replies “Don’t you read the newspapers. I turned back the inflation dial and now everything is cheap again.”
Bernanke walks out still thirsty and turns the inflation dial down some more.

Okay, so this is not a very funny joke. And only an economist or an interest rate guru would even chuckle at it. But the “joke” reflects a concern that some in the finance and economic arena are raising. This is the concern that the Federal Reserve nominee’s approach to inflation and interest rate management maybe either inadequate (given the current economic conditions) susceptible to mishandling, or both.

Ben Bernanke is slated to replace Alan Greenspan as the Chairman of the Federal Reserve Board of Governors. Bernanke is a current Federal Reserve Board Governor, a former professor at Princeton, and the Chairman of the President’s Council of Economic Advisors. His resume is impressive and his is one of the finest economic minds in the country. And he is a consensus choice.

James Grant is the author of Grant’s Interest Rate Observer. Grant is a brilliant financial writer and an inveterate contrarian. He is always entertaining when he appears on financial shows with his sly wit, dry and trenchant observations, and just a hint of smarmy sarcasm. In short, he writes and speaks in a manner and tone that the Author tries to emulate. In another life, Grant could write for “The Simpsons” cartoon show.

Grant wrote an Op-Ed piece in the October 26th edition of the New York Times. The Author has seen some of these arguments raised by other columnists. Grant’s points boil down to the following:

Set the Target Inflation Rate, turn the dial on the Fed Funds Rate and everybody goes to bed happy. Grant argues, and events are tending to demonstrate, that exogenous events worldwide and at home may control more events in the economy than the Federal Reserve Board can adjust. And in a similar vein, John Mauldin, in his article of October 28, 2005, “The Bernanke Era”, shares his concern about global deflation resulting from global overcapacity, lowered production costs and US trading partners devaluing their currencies.[i]

If we need more inflation, just open the Helicopter Doors. Bernanke is sometimes called by the derisory nickname “Helicopter Ben” for a statement he made in a 2002 speech. Bernanke said in the speech that currencies like the dollar (floating currencies, fiat currencies, currencies not backed by gold) are intrinsically worthless.[ii] Since the dollar is intrinsically worthless, the government can, and should, in limited instances (like deflation), “print more dollars”. The government, could, as Nobel prize-winning economist Milton Friedman once quipped, “drop money out of a helicopter”. Bernanke repeated this Friedman quote in the 2002 speech and has since been dogged by the nickname “Helicopter Ben”.

The concern that some see with this statement is that if deflation appears on the horizon, Bernanke will pursue a “soft money” policy at the peril of the consequences. In fact, in the 2002 speech[iii], Bernanke stated that in a paper-money system, the government could always generate higher spending and positive inflation [to combat deflation]. This conclusion harks back to the Keynesian managed economies of pre-1980, and is correct in that economic analytical context. But what if the deflationary pressures of Chinese excess productive capacity (and the capacity of other developing nations like India) overwhelm Federal Reserve Board tinkering? This is the threat the Grant implies in his article. And this leads into the next point, that world economic conditions are not under the unique control of Washington.

It’s Not Our Money Anymore. Balancing interest rates to time and preempt inflationary and recessionary cycles has never proven easy. If the Fed waits to long to curb inflation, inflation accelerates and is not swiftly or softly tamed. Keep the monetary brakes on too long when the country slips into recession and the recession could be deeper and longer. Favor one approach over the other, or apply them mechanically, and the market will soon discount your next move. [iv]

Most readers know that this nation floats on a global ocean of debt. To finance the Bush deficits and the massive balance of payment debts, the central banks of other nations hold U.S. Treasury debt. And these Treasury instruments pay low interest rates and carry high valuations as a consequence of paying low interest rates.


And as we know, when interest rates rise, the value of bonds falls. If inflation begins to take hold, interest rates will rise and bond values will fall. Foreign central banks will likely sell these bonds, decreasing the value of the U.S. dollar, raising the cost of imported goods, and driving up U.S. interest rates. A rather nasty affair. A nasty affair where the inflation dial may have little immediate effect, even if the inflation dial goes all the way past 10 to 11.[v]


[i] Thoughts From the Frontline,
[ii] This is a view that many hold. This is the idea that since dollars are no longer backed by gold, they have no intrinsic value. This statement is true as far as it goes. But the dollar, and most other currencies, have a different value, a more accurate value. Currencies have the values that international currency markets place upon them. The currency of a strong economy will have a high relative value. Weak economies will have lower relative values. That is the operation of the market and one that bears a far more rational relationship to economic reality than a shiny metal.

The Author does of course recognize that gold has value aside from the “intrinsically worthless” faith that people place in it as the ultimate neutral currency. Gold has value because of its malleability, its ductility (ability to be drawn into a wire), its non-reactivity and its conductive capacity. Gold makes good jewelry, tooth fillings, electrical contacts and such. But it has no more intrinsic value as a currency beyond that which custom places upon it.
[iv] This is the source of the “Greenspan Put” that the Author wrote about in the post of September 27th. The Greenspan Put was the observed conduct of the Federal Reserve Board under Chairman Greenspan that after a tightening of interest rates to head of incipient inflation, the Board would quickly roll back rates and bondholders would have the value of the bonds restored.
[v] In the timeless rock “mockumentary” film Spinal Tap, Nigel Tufnell (Christopher Guest) had a guitar amplifier that went past the ubiquitous 10 setting to 11.