Why Ben Bernanke Loves Ron Paul

 

Right now I’m reading one of the best books on economics I’ve come across: Currency Wars: The Making Of The Next Global Crisis, by investment banker and risk manager, James Rickards. Since we’ve bandied around on this blog with Ron Paul, Keynesianism, and other assorted economic truffles, I thought I’d weigh in with something provocative from Mr. Rickards’ book. Rickards contends that critics of the Fed like Ron Paul are actually a part of the U.S. central bank’s plan. As amusing as those Youtube clips are of Ron Paul laying into the central bank grand wizard, Ben Bernanke, according to Rickards, they’re exactly what Bernanke and his central bank minions want.

Before I defend this, I’ll provide some background reading to help this make sense.

We first have to understand the economic theory of monetarism. Monetarism is the theory, made popular by Milton Friedman, that changes in the money supply are the most important changes a country can make in GDP. One of the things that Friedman became famous for was his contention that GDP changes can be broken down into a ‘real’ component, with actual gains, and an ‘inflationary’ component, with illusory gains.

The theory is encapsulated in the following equation:

MV = Py.

Money supply (M) times velocity (V) equals nominal GDP, which can be broken down into its components of price changes (P) and growth (y).

The money supply is controlled by the Fed. But, not everything is directly under the Fed’s control (you could even dispute that ‘M’ is under the Fed’s control, but that’s for another post). The problem is that velocity is all psychological – the proverbial wildcard in the deck. As Rickards says:

It all depends on how in individual feels about her economic prospects or about how all consumers in the aggregate feel. Velocity cannot be controlled by the Fed’s printing press or advancements in productivity. It is a behavioural problem, and a powerful one.

In the mind of the Fed, the economy is screeching to a painful stop. Uncle Milton’s equation is breaking down. The Fed has exhausted their ability to change the money supply, so the solution is to attempt to change velocity. And this will mean manipulating the hopes and fears of enough U.S. citizens to get the economy humming along again.

There are two ways to do this. The Fed can instill in the public either euphoria from newly created ‘wealth’ or the fear of inflation. Rickards points out that there was a stock market rally from 2009-2011, but it wasn’t strong enough to move consumer spending and investment in any significant way. So, Rickards thinks that the government has turned to creating fears of inflation.

The way for the Fed to do this was to manipulate three things at once: nominal rates, real rates, and inflation expectations. You keep the nominal rates and inflation expectations high and create negative real rates (the difference between nominal rates and the expected rate of inflation). Rickards uses the example of having inflation expectations at 4%, nominal rates at 2%, with leaves you with a real rate of -2%. According to this way of thinking, if real rates are negative, borrowing becomes more attractive, which will fuel investment and spending. “Negative interest rates create a situation in which dollars can be borrowed and paid back in cheaper dollars due to inflation.”

Now, this all makes sense theoretically, but is there any evidence that Ben Bernanke agrees with this line of thinking? There is.

Bernanke and Krugman studied Japan’s economic plight in the late 1990s at Princeton University. A summary of their work was written by a colleague of Krugman and Bernanke, Lars Svensson, in 2003. First, Svensson talks about everything that we’re seeing play out in the world economy right now: a depreciating US currency in order to boost exports and create inflation.

Even if the … interest rate is zero, a depreciation of the currency provides a powerful way to stimulate the economy … A currency depreciation will stimulate an economy directly by giving a boost to export … sectors. More importantly … a currency depreciation and a peg of the currency rate at a depreciated rate serves as a conspicuous commitment to a higher price level in the future.

Here’s the money quote from Svensson:

If the central bank could manipulate private-sector beliefs, it would make the private sector believe in future inflation, the real interest rate would fall, and the economy would soon emerge from recession … The problem is that private-sector beliefs are not easy to affect.

In Svensson’s writings, we see what according to James Rickards, is Bernanke’s playbook: interest rates are kept close to zero, the dollar is devalued by quantitative easing, and public opinion is manipulated to create the fear of inflation.

It would seem that Ron Paul is accomplishing what Ben Bernanke wishes he could do himself – stoke the fears of inflation at home.

Rickards concludes in a poignant, though somewhat overblown conclusion:

This was central banking with the mask off. It was not the cool, rational, scientific pursuit of disinterested economists sitting in the Fed’s marble temple in Washington. Instead it was an exercise in deception and hoping for the best. When prices of oil, silver, gold and other commodities began to rise steeply in 2011, Bernanke was publicly unperturbed and made it clear that actual interest rates would remain low. In fact, increasing inflation anxiety reported from around the world combined with continued low rates was exactly what the theories of Bernanke, Krugman and Svensson advocated. America had become a nation of guinea pigs in a grand monetary experiment, cooked up in the petri dish of the Princeton economics department.