Inside Bernanke's Mind; All-In Against Deflation

I'm back from a few days off the grid, and have some thoughts on where we are here in the latter half of 2011, with analysts (and data) seemingly split 50/50 on the likelihood of another global recession. I've been trying to go back to basics and figure out where the primum movens in this crisis really lies. To understand where we are, you have to understand the belief system of those that have their hands on the world's levers.

What keeps Ben Bernanke, Chairman of the US Federal Reserve Bank since 2006, awake at night? Deflation. This is must-read material from his 2002 speech, just after leaving his academic position at Princeton University as chair of the Department of Economics. Since the 2008 crisis he has certainly become one of the most powerful people in the world; in many ways the fate of the globe is tied to his theories on economic policy. NEVER BEFORE has a fiat money system successfully dealt with deflation - Japan has been fighting a losing battle against deflation for 21 years now, with no end in sight and debt to GDP of 225% and rising. Will Bernanke's remedies to defeat deflation work? He certainly thinks so:

Deflation: Making Sure "It" Doesn't Happen Here
Remarks by Governor Ben S. Bernanke
Before the National Economists Club, Washington, D.C.
November 21, 2002

(Some choice quotes in there, like "So, is deflation a threat to the economic health of the United States? [No.] A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year [2001], our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape." Not for long.)

But is his theory true that "... under a paper-money system, a determined government can always generate higher spending and hence positive inflation."?

While it is true that QE did cause inflation, I think there are limits to what "increased nominal spending" can achieve. If zombie banks are propped up but refuse to lend, if corporations hoard cash to bolster their balance sheets by slashing workers and postponing investment, that extra credit is going to end up chasing speculative bubbles like we've seen in the commodities. This has the effect of putting even more pressure on an under-employed population and is a transfer of wealth from those that require the commodities either as basics (food, gas) or input materials to those with an excess of speculative credit. If this sounds familiar, one should not expect a different result with the same conditions.

Eventually, without a broad increase in demand, those prices will no longer be sustainable. It's all a confidence game. Bernanke has all his hoped pinned on staving off deflation until confidence increases and spending, lending and investment pick up.

Keep in mind deflation has already started:

Graph is from this illuminating post discussing the case for unstoppable deflation:

The Automatic Earth Blog: August 27 2011: Et tu, Commodities?

There are only 3 possibilities going forward:

1. Bernanke's dollar debasement theory (described in plain speak in his 2002 speech above) works and staves off deflation long enough for a genuine recovery to take place. The day is saved and we enter another period of growth. Business as usual. Bernanke is supremely confident that the Fed can do whatever it takes to hold off a deflationary spiral (ala Japan).
   
2. Deflation reappears, due to a lack of aggregate demand no matter how much inflation is pumped into the system. Cash is king and debt rollover becomes unsustainable as dollars increase in value, causing increasing bankruptcies and large scale systemic resets.
   
3. Ever larger liquidity injections (QE3 through 99) are required to prop up a failed system. Rather than admit defeat and allow liquidation, the central banks keep running their printing presses, lose control and cause hyper-inflation. Savers are wiped out and commodities are the new bubble as excess liquidity sloshes around.
   

What seems clear is that central bankers know how to handle inflation; they have lots of data to work with, lots of recent examples, and many lived through the last period of rampant US inflation in 79-81. While it was not pleasant, it is something they have seen first hand and studied. Some extreme measures were required (Volcker raised interest rates to 20% in June 1981), but inflation was tamed. There are no economists or bankers alive today that have seen a modern, successful response to a deflationary period to use as a template to recovery.

Bernanke agrees we are in uncharted waters: "One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies."

The bond market is saying "we bet on deflation!" and the gold market is saying "we bet on inflation!" and the stock market rallies say "we bet on muddling through!"

What is clear is that nobody REALLY knows how this is going to play out - but time is running out for the "back to normal" scenario.