How Will Bernanke Deal With Inflation?

Inflation and monetary policy under the new fed chief

A few weeks ago the Senate confirmed a man who will have extraordinary power over the everyday lives of Americans. No, I am not talking about new Supreme Court Justice Samuel Alito. I am talking about someone with much more sway: new Federal Reserve Board Chairman Ben Bernanke.

During his swearing-in ceremony, Bernanke asserted, “Our mission [at the Fed], as set forth by the Congress, is a critical one-to preserve price stability, to foster maximum sustainable growth and output and employment, and to promote a stable and efficient financial system that serves all Americans well and fairly.”

Let’s examine, then, the Fed’s performance in managing the dollar and the economy. Since 1913, when the Fed was established, the dollar has lost approximately 95 percent of its value. A dollar just doesn’t buy what it used to. By contrast, when the country was on a real gold standard, there was no long-term increase in price levels, as we have experienced for the past 65 years or so. In fact, price levels in 1929 were about the same as those in 1800.

In addition, while the consumer price index, a major measure of inflation, increased a fairly modest 3.4 percent last year, pay and benefits increased only 3.1 percent—the lowest since 1996-meaning that people are not even keeping up with inflation.

An even better gauge of inflation is the increase in the money supply. Rapid increases in the money supply have been going on for some time, but have been particularly sharp since the mid-1990s. In just the last nine years, the supply of M3-the broadest measure of money supply—has more than doubled. Note that when an individual tries to print his own money, it is illegal; when the government does it, it is monetary policy.

What is the effect of pumping all this money into the economy?

By flooding the economy with money, the government, acting through the Fed, is effectively reducing the value of all the existing dollars out there. There is a general rise in prices as the increased amount of money in circulation makes people feel richer (though this is an illusion). Banks reduce interest rates and extend more credit. Since credit is cheaper, people take on more debt. In recent years, many people saw housing prices rise and used their home equity to finance greater spending. Businesses borrow to invest in projects, particularly long-term projects such as new equipment and plant expansion.

The trouble is the economic “boom” has arisen not through increased savings, but rather through the expansion of credit. Sooner or later, the bills will have to be paid and individuals and businesses will realize that their borrowing and spending are unsustainable. The longer the credit expansion caused by increasing money supply, the greater the distortion in savings (not enough) and business investment and consumer spending (too much), the greater the malinvestment in the economy, and the more severe the “bust” will be when the economy inevitably corrects.

Last year, the personal savings rate turned negative for the first time since 1933, when the nation was mired in the Great Depression. The savings rate averaged 7.6 percent from 1929 to 2005, although it has been below that average now for 13 consecutive years. Household debt continues to rise. The divide between savings and consumption rates is growing. Add to this the emerging weaknesses in numerous housing markets. What will overextended families do if the housing bubble pops?

The question now before us is: How will new Fed Chairman Bernanke behave? Is he more likely to keep inflation in check by reining in money supply growth or to continue much the same way that Alan Greenspan did and just turn the printing presses loose? Sadly, the latter is the much more likely scenario.

In a 2002 speech, Bernanke provided a not-so-subtle hint of his monetary policy leanings when he implied that deflation could be combated by dropping money from helicopters in order to “stimulate” the economy (the resulting harmful distortions in the economy notwithstanding). This remark earned him the nickname “Helicopter Ben.”

Boom-and-bust economic cycles are not mere happenstance; they are caused by inflationary monetary policies. Inflation reduces the value of money and thus erodes wealth. This is why it is often referred to as a “hidden tax.” Easy money policies may make us feel richer in the short run (that is why they are so popular with politicians and Federal Reserve Board members), but they necessitate painful corrections in the longer run. Unfortunately, Chairman Bernanke does not seem likely to reverse the current easy money orgy anytime soon. In the meantime, get ready to fire up those helicopters.

Adam B. Summers is a policy analyst at the Reason Foundation.