Expert Commentary

The Coming Change at the Fed

This article was originally published in The Elliott Wave Theorist on November 17, 2005. Eight months later housing prices peaked, and the first deflaionary crash carried into 2009.

The consensus appears to be that the long term expansion in the credit supply will continue or even intensify under the Fed chairmanship of Ben Bernanke. One reason many people share this belief is their recollection of Bernanke's November 2002 speech, "Deflation: Making Sure 'It' Doesn't Happen Here," in which he likens the Fed's printing press option to dropping money from helicopters. There are reasons to believe, however, that the outcome will not be as the majority expects.

One reason that Bernanke is likely to preside over a deflation in credit is that everyone believes the opposite. Investors have poured money into commodities, precious metals, stocks and property in the belief that if anything is certain, it is death, taxes and inflation. When the majority of investors thinks one way, it is likely to be wrong. This is basic market analysis.

But how can the majority be wrong this time, when Bernanke had vowed to shower the banking system with liquidity given any deflationary threat? Of course, people always ask such questions as a trend matures, whether the market is oil in 2005 ("How can oil go down when world production has peaked for all time?"), gold in 1980 ("How can gold go down with all this inflation?"), stocks in 2000 ("How can stocks go down in a New Economy?"), the dollar in 2004 ("How can the dollar go up when we have this huge trade deficit?") or inflation ("How can we have deflation? Bernanke won't allow it."). There is always a "fundamental" reason to believe that the trend will accelerate; that's what gets people fully committed. We truly need not provide any other answer, but we can.

A more complex answer begins with the understanding that analysts constantly confuse credit creation with money creation. In fact, just today an essay became available on the Internet that includes a presumptuous edit of a statement by the dean of Austrian economics, Ludwig von Mises. In Human Action (p.572), Mises said, "There is no means of avoiding the final collapse of a boom brought about by credit expansion." This statement is true and undoubtedly reads as intended. Yet the author of the article felt compelled to explain von Mises, with the following insertions: "There is no means of avoiding the final collapse of a boom brought about by [bank] credit [and therefore money] expansion." First, a credit boom does not have to be financed by banks. As Jim Grant recently chronicled, railroad companies financed one of America's greatest land booms, which, as Mises predicted, went bust. Second, credit is not money. Economists speak of "the money supply" as if they were referring to money, but they are not; for the most part, they are referring to credit. The actual supply of dollar-denominated money, legally defined in today's world, is Federal Reserve Notes (FRNs), i.e. greenback cash [and Fed reserves, which on demand would have to be paid in greenback cash]. That money provides a basis for issuing credit. Credit may seem like money because once extended, it becomes deposited as if it were cash, and the depositor's account is credited with that amount of money. But observe: the account is only credited with that amount of money; the actual money upon which that credit is based is not in the account. Every bank account is an I.O.U. for cash, not cash itself. Needless to say, the $64.3 billion in cash in U.S. bank vaults and at the Fed is insufficient backing for the 38 trillion dollars worth of dollar-denominated credit outstanding, not to mention at least twice that amount in the implied promises of derivatives. The ratio is about 1 to 600. This ratio has grown exponentially under the easy-credit policies of the Fed and the banking system.

When credit expands beyond an economy's ability to pay the interest and principal, the trend toward expansion reverses, and the amount of outstanding credit contracts as debtors pay off their loans or default. The resulting drop in the credit supply is deflation. While it seems sensible to say that all the Fed need do is to create more money, i.e. FRNs, to "combat deflation," it is sensible only in a world in which a vacuum replaces the actual forces that any such policy would encounter. If investors worldwide were to become informed, or even suspicious, that the Fed would follow the 'copter course, they would divest themselves of dollar-denominated debt assets, causing a collapse in the value of dollar-denominated bonds, notes and bills. This collapse would be deflation. It would be a collapse in the dollar value of the outstanding credit supply.

Contrary to popular belief, neither the government nor the Fed would wish such a thing to happen. The U.S. government does not want its bonds to attain (official) junk status, because its borrowing power is one of the only two powers over money that it has, the first being taxation. The Fed would commit suicide if it were to hyperinflate, because Federal government bonds are the reserves of the Fed. That's why it is called "the Federal Reserve System." U.S. bonds are the source of its power. As long as the process of credit expansion is done slowly, as it has been since 1933, people can adjust their thinking to accommodate the expansion without panicking. But by flooding the market with FRNs, the Fed would cause a panic among bond-holders, and their selling would depress the value of the Fed's own reserves. The ivory-tower theory of unlimited cash creation to combat a credit implosion would meet cold, harsh reality, and reality would win; deflation would win. Von Mises was exactly right: "There is no means of avoiding the final collapse of a boom brought about by credit expansion." Observe that he said "no means." He did not say, "No means other than helicopters."

Bernanke's plan, according to articles, is to aim for a 2% annual inflation rate. "Bernanke has called that the Goldilocks idea: not too hot, not too cold. The just-right spot…."1 He is convinced that such a policy is all the economy needs to keep it steady. Clearly, Bernanke is a firm believer in the idea that the economy is a machine, whose carburetor simply needs fine-tuning to get it to run smoothly. Economists, deep believers in the potency of social directors, are convinced that "monetary policy… moves the entire economy."2 There is no room for "animal spirits" as far as this idea is concerned. Because of this proposed targeting plan, Bernanke is expected to act "More openly. More methodically. More predictably."3 Well, Ben might aim to do those things, but society, the economy, the credit supply and the stock market do not behave in such a manner. When you think you have them under your thumb, they have you.

Like most economists, Bernanke doesn't accept the idea of the causal power of waves of social mood. He therefore believes, for example, that the Fed engineered the boom of the 1980s and 1990s. He also thinks, as do most economists, that the Fed's freshman errors in the early 1930s caused the Great Depression. At the Conference to honor Milton Friedman's 90th birthday on November 8, 2002, Bernanke promised the Friedmans that the Fed now understands how to keep the machine in tune. He said, "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."4 That's quite a promise, and it might have some validity if the underlying premise of the Fed's power were correct. But social mood will "do it again," and there is nothing that Bernanke can do about it. He reiterated this guarantee in his acceptance remarks at a press conference on October 24, saying, "I will do everything in my power to ensure the prosperity and stability of the U.S. economy."5 "Everything in my power" equates to nothing when it comes to reversing social trends.

Like the entrenched belief in continued inflation, there is a widespread expectation of smooth sailing under Bernanke. Summing up the prevailing view, an economist says, "Bernanke is universally admired and respected by people who have seen him on the inside of that institution. The bottom line is that this is excellent news for the Fed and for the economy."6 A nationally known economist adds, "We need a Fed chairman who is steady, solid and sticks to basics. Ben Bernanke is the right person at the right time."7 This general conviction will set up the vast majority to be fooled and ruined. There is a vocal minority who views him as a potential disaster, but the only danger they see under his leadership is excessive inflation. With virtually everyone prepared for either good times or severe inflation, bad times and deflation will catch them all off guard.

It is not the case that Fed chairmen are either fools or geniuses, as their records appear to imply. They do, however, preside over eras that make them appear to be one or the other. I am firmly of the opinion that Ben Bernanke, well educated by Harvard and MIT though he is, and fine fellow though he may be, is doomed to suffer a historically bad image as chairman of the Federal Reserve. If for some reason he leaves the post prematurely, his immediate successor(s) will suffer that fate. The trend in social mood will continue to determine the chairmen's degrees of success, not the other way around.

As to Bernanke's qualifications, I must demur from the accepted view that he understands the economy and markets at some genius level. On August 31, 2005, Reuters issued this statement:

Bernanke said the bond market's reaction to the hurricane, pushing market-set interest rates lower, showed more concern about the potential hit to growth than to the risk of a broad inflation surge due to soaring energy prices. "I think that is a vote of confidence in the Federal Reserve," the former Fed governor said. People are confident that inflation will be low despite these shocks to gasoline and oil prices. Looking forward...reconstruction is going to add jobs and growth to the economy," he added.

In four short sentences, Bernanke, in my humble opinion, expresses six erroneous ideas:

  1. The bond market did not react to the hurricane. There is no evidence that any market reacts to natural disasters. This idea is a myth that derives from the natural human tendency to default to mechanical models of social causality.
  2. Markets have never translated natural disasters into "concern about the potential hit to growth." You cannot pick out hurricanes, tornadoes, floods, city fires or blackouts on a chart of stocks, bonds, oil or anything else.
  3. The idea that any two-point move in the bond market is "a vote of confidence in the Federal Reserve" is ludicrous. One would then have to believe that every two-point setback during the year is a vote of non-confidence in the central bank.
  4. People are not "confident that inflation will be low." They are buying homes at a record pace, certain of price gains. Investors are bullish on oil, gold, silver, commodities and REITs. The public is convinced that gasoline prices will stay up.
  5. "Shocks to gasoline and oil prices" do not make inflation rise. Price rises due to shortages have nothing to do with inflation, much less do they have a causal inflationary role in general as Bernanke implies by the word "despite." Inflation is due to the expansion of money and/or credit, period.
  6. The destruction of any useful item, even a screwdriver, much less the mass destruction of infrastructure, does not "add jobs and growth to the economy." It detracts from the economy. The French economist Frederic Bastiat exposed this erroneous idea over a century and a half ago. (To learn more, just type "Bastiat, broken window fallacy" into Google search.)

Bernanke will surely reign in a bear market, when almost every decision he makes will be seen as dumb. But as this example shows, he also seems to hold some erroneous ideas.


1 Kanell, Michael. (2005, October 25). "Bernanke Likely to Set Target for Inflation, Work to Hit It." Atlanta Journal-Constitution, p. A10.

2 Ibid.

3 Ibid., p. A1.

4 As quoted in Shostak, Frank, "What Should We Expect from Bernanke Now That He Is the Fed's Chairman?" www.brookesnews. com/053110bernanke.html, 10/31/05.

5 Shell, Adam. (2005, October 25). "Markets Applaud Bernanke's Nomination." USA Today.

6 Kanell, Michael. (2005, October 25). "Bernanke Likely to Set Target for Inflation, Work to Hit It." Atlanta Journal-Constitution, p. A10.

7 Laffer, Arthur. (2005, October 26, 2005). "Ben Bernanke is the Right Person at the Right Time," The Wall Street Journal.