Keep Your Eyes on Bernanke's Shoes

The humor scenes of Robin Williams’ movie, Patch Adams, were quite good. Two of them remind me of Bernanke’s present assignment. One was Adams’ attempt to cheer up a morose dying patient. His strategy was to dress as an angel and come up with phrases synonymous with death. The dying man finally enters into the spirit of the challenge. Basically, it was “go out with a smile.” (Doesn’t sound funny? I guess you had to be there.)

Second was the scene in a ward full of pre-teen cancer patients. Williams grabs some available implements and turns them into a clown’s wardrobe. He cuts a red rubber syringe and sticks it onto his nose. He grabs a pair of bedpans and uses them as shoes.

Every time I think of Ben Bernanke, I think of a guy with a bright red nose and bedpan shoes. But I merge the two scenes. He is trying to get us to laugh by coming up with clever euphemisms for financial death. To this image, I add a beard.


Think of a combined circus act: a tightrope walker who is a clown. He dons a pair of bedpan shoes and steps out onto the rope.

He uses a safety net. But he uses it in a peculiar way. It isn’t under him; it’s over his shoulder.

This is Bernanke’s assignment. He is the man in charge of the economy’s safety net. It isn’t much of a net. It is the legal authority to create money. This money is then used to buy mostly U.S. Treasury debt. To this has been added collateral held by commercial banks.

This may not seem like much of a net. Basically, it’s a license to print money. How does that provide safety for the tightrope walker himself?

Bernanke is a very special performer. He must provide a sense of command. He must persuade the rest of us that he is the preserver of the safety net. That net is supposed to protect all the rest of us in our death-defying walks across the high wire. But it’s not attached to anything except the equivalent of a printing press. Bernanke holds that device in his hands.

The device has two long bars, each extending out from one side. It’s a kind of balance pole. At the end of each bar is a sign. One says “deflationary depression.” The other says “inflationary crack-up boom.”

At the center of the two bars is the mini-printing press. It’s voice-activated. A whisper gets it going. It then spews out money toward the “crack-up boom” side of the bar whenever it looks as though the economy is tilting toward deflationary depression. Then, when the bar tilts too far toward “crack-up boom,” he whispers to stop printing money. He then leans toward the deflationary depression side.

All the while, he keeps up a line of patter. When it looks as though he and the economy will topple off the tightrope toward recession or even depression, he starts talking up liquidity. He’s got it down pat.

The Federal Reserve also took a number of supplemental actions, such as cutting the fee charged for lending Treasury securities. The purpose of the discount window actions was to assure depositories of the ready availability of a backstop source of liquidity. Even if banks find that borrowing from the discount window is not immediately necessary, the knowledge that liquidity is available should help alleviate concerns about funding that might otherwise constrain depositories from extending credit or making markets. The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets. (Aug. 31, 2007)

At the height of the recent financial turmoil, the Federal Reserve took a number of steps to help markets return to more orderly functioning. The Fed increased liquidity in short-term money markets in early August through larger-than-normal open market operations. And on August 17, the Federal Reserve Board cut the discount rate — the rate at which it lends directly to banks — 50 basis points, or 1/2 percentage point, and subsequently took several additional measures. These efforts to provide liquidity appear to have been helpful on the whole, but the functioning of a number of important markets remained impaired. (Nov. 8, 2007)

Then, when it looks as though the economy might be facing rising prices and the instability associated with rising prices, he starts his famous anti-inflation patter.

More fundamentally, experience suggests that high and persistent inflation undermines public confidence in the economy and in the management of economic policy generally, with potentially adverse effects on risk-taking, investment, and other productive activities that are sensitive to the public’s assessments of the prospects for future economic stability. In the long term, low inflation promotes growth, efficiency, and stability — which, all else being equal, support maximum sustainable employment, the other leg of the mandate given to the Federal Reserve by the Congress. (July 10, 2007)

Moreover, if inflation were to move higher for an extended period and that increase became embedded in longer-term inflation expectations, the re-establishment of price stability would become more difficult and costly to achieve. With the level of resource utilization relatively high and with a sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern. (July 18, 2007)

The thing that catches my attention is the dating of these routines. The first two, designed to take our minds off the threat of depression, were both given after mid-August, 2007, that is, after the subprime mortgage crisis first raised its ugly head. The second two, designed to take our minds off the threat of rising prices, were delivered prior to August.

If chronology means anything, the balance bar was leaning toward anti-inflation before August. Then, in late July, he shifted the balance bar’s weight by leaning toward anti-depression. He turned on the money machine in a rather loud whisper.

But then he whispered it back off in mid-August through mid-September. Then back on. Then off. On-off, on-off: it’s a sight to behold!

There he is, high above the ground, with a bright red nose, a beard, and a pair of shiny bedpan shoes. He is out there in front of us. We dutifully listen to his words of encouragement. We watch him lean left, then lean right, all the time insisting that the net will save us, probably, all things considered, but not to trust in moral hazard, where the net saves any group’s investments. It will save all our investments, more or less, give or take 20% — 30% at the worst.

But he’s carrying the net. It’s supposed to be down there under us, isn’t it? But it isn’t. It’s over his shoulder.

I keep looking at his shoes. Just one slip. . . .


Because of the vast increase in the size of the leveraged futures markets called derivatives, now in the range of $11 trillion in contracted liabilities and $500 trillion in dollar amounts or their currency equivalent traded annually, the world’s central banks’ task has become highly complex. The size of the derivatives market is vastly beyond the assets of any central bank. The Federal Reserve, which is the largest central bank, has about $1.2 trillion in its portfolio, mostly in the form of U.S. Treasury debt.

Then there are all the other debt liabilities, worldwide, especially real estate debt. The participants — creditors and borrowers — have trustingly operated on the assumption that over a hundred legally independent central banks somehow manage the upkeep of a single safety net for the interdependent world economy.

The public assumes that committees of salaried bureaucrats can handle the unforeseen outworkings of hundreds of millions of private transactions in regulated and unregulated capital markets. These committees can do this while walking the other tightrope, which links central banks’ assertion of independence from government control and incumbent politicians who don’t want an economic downturn on their watch, but above all in election years.

If we wanted to make this analogy accurate, a central banker has one foot on the depression/crack-up boom tightrope and the other foot on the independence/incumbent politicians tightrope. The ropes don’t always swing together.

The complexity of modern capital markets grows greater every day, yet the central banks’ tools of evaluation, let alone control, remain basically stagnant. Franklin Sanders has summarized these tools: “inflation and blarney.” Sometimes the blarney is incoherent: Greenspan’s Fedspeak. Sometimes it is footnoted: Bernanke’s speeches. But it remains blarney. It is patter from a very high wire without an independent safety net.

We need a safety net. We used to have one. It was called the international gold standard. It was a gold coin standard. It controlled central banks and their governments. How? By putting commercial banks at the mercy of holders of IOUs to gold coins. The same system governed the issue of government IOUs: bonds. Some of these IOU holders were other central banks. Most were little people who held legally redeemable paper money rather than gold coins.

All this ended in the late summer of 1914, when commercial banks ceased redeeming IOUs for gold coins, central banks confiscated the gold in commercial banks’ accounts, and governments passed laws legalizing both steps. The justification for this confiscation was World War I. With respect to the confiscation of gold in the United States in 1933, it was the Great Depression. It was upheld by the Supreme Court by a vote of 5 to 4.

That series of events placed the world’s central bankers on their individual yet interconnected tightropes.

They all have bedpan shoes.


The financial tightrope has begun to swing back and forth more violently. The winds of financial change are blowing more wildly. The ability of central bankers to walk the line has been reduced.

Beginning in August, the subprime mortgage crisis revealed itself in America’s capital markets. Millions of borrowers — home owners — had signed loan agreements that allowed creditors to hike their interest rates. The creditors were in fact borrowers. The initial issuers of mortgages were no longer long-term holders of the mortgages. They sold the contracts to pools of investors within days of the signing of the papers.

So, to keep the process going full blast, the creditors decided to become borrowers. They borrowed money short-term in order to issue more mortgages. The mortgages were of two varieties: long term and short term. Long-term mortgages were issued to reliable borrowers who were expected to remain in their homes and making monthly payments for decades. Short-term mortgages were issued to home buyers who did not have credit ratings to obtain long-term mortgages. The lenders assumed these people would remain in their homes even after rates climbed to match rates in short-term credit markets. This assumption blew up in August.

At that point, the money for leverage — short-term loans to long-term lenders — dried up. The mortgage lenders had been going out of business since December, 2006. Now the bankruptcy rate increased, as large lenders went belly-up.

This leaves the local mortgage markets without large pools of short-term loans disguised as long-term loans. This reduces liquidity locally. Home sellers cannot find buyers at pre-August prices. But they refuse to admit that this lack of liquidity will force them to lower their asking prices. The inventory of unsold homes rises. Sellers are holding on when they can.

Sometime in 2008, millions of them will no longer be able to hold out any longer. A recession will force their hands. They will have to move, either leaving homes vacant or forcing them to rent their homes to strangers. At that point, the decline in housing prices will accelerate.

This means that everyone’s home equity will shrink. For recent buyers (2005 or later), it may disappear. It may even go negative: more money owed than the homes are worth after commissions and discounts.

If people own their homes free and clear, this does not affect them immediately unless it’s time to sell. If they move out — to a retirement facility, for example — they can rent their homes to strangers if they want to retain ownership. The same applies to people who have been building equity for a decade. But equity builds rapidly only after about half the mortgage period is over. Most Americans move every five years. So, equity as a percentage of home prices is usually reduced because sellers buy larger, more expensive homes. Then they borrow against this equity.

This is another way of saying “increased leverage.” This is the nightmare of central banking. The more leverage there is, the more wildly the tightrope swings in the wind.

The whole world has imitated central banking: increased leverage. There is no industry more wealthy with less equity than central banking. The equity is in the form of a government-granted monopoly: the legal right to say how fast commercial bankers can create fiat money.


The central bankers can inflate. They usually limit this inflation to the purchase of very short-term assets: promises to repay. This, plus blarney, is all they have to keep the economy from toppling into either recession or inflation.

When you think “central banker,” think “bedpan shoes.”

The more equity you have, the stronger your safety net. The Federal Reserve can buy equity by issuing more fiat money. When it does, the nominal equity of the economy increases. The actual equity shrinks. Equity is more and more defined as IOUs: promises to pay.

Don’t bet your future on promises to pay.

December22, 2007

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2007