Bernanke Confuses Depression Cure with Disease

An article in yesterday's Wall Street Journal discussed how self-proclaimed "Depression buff" Ben Bernanke claims understanding of how the Fed caused the Great Depression and precisely what he would do to prevent such a calamity from reoccurring under his tenure. Not only are his assertions naïve and egotistical, but flat-out absurd.

Though he claims to have studied The Great Depression in depth, Bernanke is completely clueless as to its actual cause. However, he is partially right about one thing: the Fed did help create the Depression, but for the opposite reasons Bernanke believes. The Fed-induced credit boom of the roaring 1920's laid the foundation for the inevitable bust that ushered in the Great Depression. Bernanke has mistaken the disease for the cure, and his antidote, were it ever administered, would prove to be economically fatal to the U.S. economy.

The mistake made by the Fed during the 1920's was expanding the supply of money and credit too rapidly. However, as increasing productivity prevented consumer prices from rising, the Fed was unconcerned about the inflation it was creating. Instead, the excess money and credit that spilled into financial and real estate markets caused asset prices to rise, which resulted in claims of a "new era" (sound familiar?). The bust of 1929 led to the Great Depression of the 1930's not as a result of Fed tightening, as Bernanke claims, but due to the misguided economic policies of the Hoover and Roosevelt administrations. By preventing market forces from efficiently correcting the imbalances created during the inflationary boom of the 1920's, the Federal Government turned what otherwise would have been a normal, though severe, cyclical recessionary bust, into what became known as The Great Depression.

During the 1920's the British pound, then the dominant world currency, was under pressure. In an effort to prevent British inflation from causing the pound to weaken against the dollar, Federal Reserve Chairman Benjamin Strong decided to increase inflation in the United States as well. By debasing the dollar along with the pound, their relative values could be maintained, thus preserving the illusion of pound stability. Through competitive devaluation, Great Britain exported its inflation to the United States, much the way the U.S. now exports its inflation to China and Japan.

However, the money and credit supplied by the Fed unexpectedly produced the speculative stock market bubble of the roaring 1920's. When Benjamin Strong died in office in 1928, his successor George Harrison (not of Beatle's fame) understood the problems and addressed them by correctly tightening monetary policy, reversing the inflationary expansion that occurred under Strong.

It is to this action which Bernanke objects and for which he blames the ensuing Great Depression. However, the problem was not that stock and real estate prices collapsed, but that they rose so much in the first place. It was not the mistakes of Harrison that caused the bust, but those of Strong that produced the false boom, making the subsequent bust necessary.

Had Harrison allowed the monetary expansion to continue, as Bernanke suggests he should have, the result would have been hyper-inflation, which would have produced even more dire economic consequences than did the bursting of the bubble. The problem is that Bernanke, like Harrison, will soon replace Greenspan, the modern version of Benjamin Strong (though a more accurate comparison may be to Montague Norman, the governor of the Bank of England during the 1920s.). However, unlike Harrison, Bernanke will likely make the wrong policy choice.

Ben Bernrnake believes that credit expansions need never end - that a boom can be prolonged indefinitely simply by printing enough money. The fact that the incoming Fed chairman believes such nonsense is similar to a cold-war president having believed he could win a nuclear war. However, Bernanke's finger will not be on the button, but on the printing press: and he seems itching to crank it up as he is convinced he will win the deflation war.

When asset prices are too high, credit out of line with savings, and consumption out of line with production, serious economic imbalances result. Curing those imbalances is a painful but essential process. In attempting to prevent the adjustments from taking place, Bernanke will do far more harm then good.

As a result of his confusion, Ben Bernanke wants to cure the disease by killing the patient. The best analogy is to a heroin addict continuously shooting-up to avoid the unpleasant reality of withdrawal. He may "succeed" but only by dying. In economic parlance, hyper-inflation is the monetary equivalent of a drug overdose, and Dr. Ben (Kevorkian) Bernake seems dead set on administering it.

December 8, 2005

Peter D. Schiff
President/Chief Global Strategist
Euro Pacific Capital, Inc.
www.europac.net