With wholesale inflation running at a 12% annual rate, prices are raging out of control. But Fed Chair Ben Bernanke is wagering that the risk of economic contraction is greater than the damage from inflation. He might be thinking that it took 15 years to get us out of the Great Depression but only two years in the early 1980s of 19% Fed Funds rate to break inflationary expectations after a decade of the stagflationary 1970s.
In 2005, the Wall Street Journal reported that Ben Bernanke was a Great Depression "buff." This makes me think that he is trying to avoid making the mistakes that the Fed made in the 1930s. In so doing, he is spurring runaway inflation. For example, the price of gasoline is expected to rise to $4.00 a gallon this summer with help from $103-a-barrel oil. Back in January 2001, oil was at $24 a barrel -- it's increased at a nice 23% compound annual growth rate in the last seven years. Since oil is traded in dollars, Bernanke's interest rate cuts are spurring a weaker dollar, hence higher oil prices.
The Great Depression started in 1929 with a stock market crash. And it really didn't end until World War II -- which spurred enormous government spending to build a war arsenal. Bernanke believes that a major reason that the Great Depression lasted so long was that the Fed tightened credit, which cut off liquidity when it was needed most.
Perhaps he's right. But I wonder whether Bernanke is driving the Fed by staring in the rear view mirror. It's possible that the current economic situation is different from the Great Depression. Back then there was rampant stock speculation with limited financial disclosure and considerable insider stock price manipulation. It didn't help that banks were lending out depositor's money for this game so that when people wanted to get their money out, it wasn't there.
Now the same thing is happening to people who own a wide array of novel securities -- many of which are backed by subprime mortgage backed securities. For example, a Peloton Partners managed $1.8 billion hedge fund investing in such securities was liquidated this week. And, as I posted this week, a journalist found his Auction Rate Securities (ARS) account had been frozen when the auction for setting the rates for those securities failed.
The proximate cause of both these examples is the need for banks to write-down the value of their asset-backed securities (ABSs) and to replenish their capital in the wake of those write-downs. Since the banks are capital constrained, they stopped providing financing for the hedge fund so it closed. In the ARS market, the problem is that the fund managers lack the capital to bail out people like that journalist.
Does Bernanke think that the U.S. is at risk of a Great Depression and so he is determined not to repeat the mistakes of the past? If so, does he really think that the problems that caused the Great Depression are the same as the ones causing our current economic crunch? I really don't know.
But I think that he's decided that his sole means of exercising his power is to cut interest rates. If those rate cuts somehow helped the banks to recapitalize themselves after taking the write-downs for owning dodgy securities, I'd agree with the policy.
Unfortunately, that does not seem to be what's happening. Instead, those rate cuts are accelerating inflation and having a negligible effect on banks' balance sheets.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter
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Reader Comments (Page 1 of 1)
2-29-2008 @ 2:57PM
FOXYLYNX said...
HE SHOULD LEAVE IT ALONG - IT IS ONLY GOING TO MAKE THE COST OF OIL EVEN MORE AND THAT TRANSLATES TO EVERYTHING ELSE THAT WE EAT AND USE. PLUS THE OLDER PEOPLE WHO RELY ON SOME SORT OF DIVIDEND ON THEIR INVESTMENTS ARE BASICALLY NOT GETTING A THING - THEY ARE BEHIND THE EIGHT BALL. THIS WHOLE DEBACLE SHOULD HAVE BEEN AVOIDED.- IN THE FIRST PLACE.
2-29-2008 @ 3:07PM
clicclic said...
Rates are going to 1% or maybe even less. Soon (later this summer) the house flippers/speculators will fire up their Escalades and start inflating the property price appreciation bubble yet again. We'll all refinance our ARMs into even crazier ARMs that enable us to keep 0% in equity and -1% in savings.
Get ready for some SERIOUS fun...
2-29-2008 @ 3:52PM
Bill Olmsted said...
Bernanke is caught in the middle. If he let rates stay where they are (which he should do) The Street will lambast him. If he lowers rates futher, it feds inflation.
This all started with Alan Greenspan, the King of cheap money. I don't envy Bernanke having to clean up this mess. It's a lose-lose situation, IMHO.
2-29-2008 @ 4:28PM
Michael Schneider said...
The Great Depression had many causes including high taxes worldwide and a worldwide trade war. The problems were all related to tightness and the stifling of the business climate. Ben Bernanke is likely looking not only at the money supply but also prospects of more taxes and protectionist sentiments that threaten the financial system. But the credit situation is bad-- even as he cuts rates the mortgage interest rates have been rising which can't be good for housing.
2-29-2008 @ 7:05PM
william lindblad said...
I really think that we should get our history in order.
The market cash of 29 had numerous causes and among them were foreign investment, the failure of the Bundersbank, speculation, lack of government intervention and, most important the age mix of the U.S. population at the time. The "roaring twenties" came to be on the heels of the Spanish Flu pandemic. In 1919 when the flu was at it's height, the killing field was the 25-40 age group. Do the math and you will find that the majority of the population during the 20's was young and with this, optimistic. We also were coming out of this depression by 1939, without the aid of the 2nd world war. Still a lot of 1940 fords around. While this is the one that gets all of the attention the depression of 1893 was nearly as bad and lasted until 1910. So much for statistics. Major economic bumps have been around since 1740 and all are of different cause and really cannot be compared. If anything, today has some of the aspects of 1893 as we have trade imbalance and job loss as major players. Unfortunately, this, like all before, is a whole new ball game. The only thing that it has in common with the past is that it has all the ear marks of becoming a major historical marker - in the negative sense.