Ben Bernanke's Wild Ride (and Ours)

I begin with a video. It is the most persuasive low-cost, home-brew video that I can remember. If you do nothing else today, watch this video. I wish I had produced it. Conceptually, it is a stroke of genius. It sets forth the current banking crisis admirably. The remainder of my report rests on this video.

If you watched it, you now know the nature of the problem, as well as its magnitude.

To say that we are in uncharted waters does not begin to get across the idea of the magnitude of our current situation. America is in a canoe, floating down a river that has never been explored. Most of the passengers are trying to listen to the tour guide. But there is a noise that interferes. It is the sound of a waterfall ahead. The noise is getting louder.

The tour guide is new. It is a new career for him. His first day on the job: January 20. He is a good talker, although it’s clear that he is improvising.

The guys with the paddles are also new on the job. This is their first trip down this particular river.

You and I are along for the ride. We were assured that this would be a scenic trip, back when the excursion company, Ben Bernanke’s Slow Boat to China, sold us tickets.

So far, we have gone through two sets of rapids: the first in August 2007, which seemed to end by September, and the other beginning a year later, in August 2008. Since then, the rapids have gotten wilder, and the canoe more obviously not under control by the first crew with the paddles, who left on January 20 and handed the paddles over to the new crew.

The canoe seems out of control. Each set of rapids is worse than the last. We get through one set. The other crew kept telling us that everything was under control after the first set. Then we hit the second set. They abandoned ship, assuming you would call this canoe a ship.

The crew has handed out life jackets, but has told us that we don’t have to put them on yet. But they have put on theirs.

The excursion company’s owner, Dr. Bernanke, has said almost nothing since August 2007. His assistant, Hank “Bailout” Paulson, has bailed out. His replacement, Tim “Turbo” Geithner, has just been handed a paddle. Because he was paid $398,000 last year as captain of a cruise ship, the S.S. FOIA-Proof, no one is sure why he signed up for this low-paying assignment.


Turbo Bill will have to decide which branch of the river to follow. He has a map. It lists three branches. Two of them mention the possibility of falls. There is some hope that the third route will avoid the falls.

The first set of falls is marked Inflationary Falls. The second set is marked Deflationary Falls.

There is a hoped-for third branch of this river: Conventional Creek. Dr. Bernanke has bet his future — and ours — on this one. Sadly for us, the map is torn at this point. It is a matter of guesswork as to where this creek connects with the main branch of the river.

The video presents the graphic reality of Dr. Bernanke’s strategy to negotiate the rapids. The increase in the Federal Reserve System’s lending to American (and some foreign) banks in 2008, as of November, was a staggering $700 billion.

This increase in lending to banks was accomplished by an increase in the Federal Reserve’s adjusted monetary base from $850 billion (2007) to $1.8 trillion. See the graph here.

Here is our problem — as well as Dr. Bernanke’s. This increase in the monetary base was produced by fiat money: the money spent by the FED to purchase assets. The money was spent into circulation, as all increases in the FED’s balance sheet are.

This money has entered the banking system. There are two things the banks can do with this money: (1) keep some or all of it on deposit with the FED, where the public cannot get its hands on it; (2) purchase investment assets from the public, which means that the fractional reserve banking process will take over and turn the monetary base into spendable money. If the banks do the second, the money supply will more than double. Prices will then more than double. We will go over Inflation Falls.

If the banks keep the money on deposit at the FED, because the FED started paying interest on deposits last October — three years earlier than previous legislation had authorized — then the increase in excess reserves will have the same effect as would the doubling of the legal reserve requirement by the FED. It will offset the increase in the monetary base. Dr. Bernanke is betting his future and ours that this will get us onto Conventional Creek.

The intricate route through the rapids to Conventional Creek — assuming Conventional Creek actually exists — involves trusting commercial bankers not to do what bankers have always done: lend every dime the banks can get their hands on. Banks make money by making loans. There is no other way for banks to make a profit. Always before — except possibly in 1929—33 — banks have lent every dime that was deposited. To sit on unused reserves is to avoid getting paid. Bankers enjoy getting paid. They fear not getting paid.

So, Dr. Bernanke seems to be betting the canoe on bankers’ doing what bankers never do: sit on reserves. He is luring bankers to lend to the Federal Reserve, which does not face the wrath of shareholders or the FDIC. It does not have to make a profit. It gets to decide each year how much money to return to the Treasury as its donation. It keeps enough to pay its bills.

To lure bank deposits into the FED’s digital vault, the FED started paying interest last October. But interest was low: 1.5% until the second week of October, and 1% thereafter. This is the federal funds rate, the rate at which banks lend overnight to each other to meet reserve requirements.

This fall in the FedFunds rate has now created a problem for Dr. Bernanke’s journey to Conventional Creek. The FED has announced a target rate for FedFunds of 0%. In recent weeks, the rate has fallen to about one-tenth of 1%. I post this on my site in the department, “Federal Reserve Charts.”

The link is “Free Market Federal Funds Rate.” Here was the FedFunds rate as of the week of January 19 — inauguration week.

You can see that it was close to one-tenth of 1%. Basically, this was no interest payment at all.

Here is the situation facing banks. They can keep their money on deposit at the FED for free. Or they can buy 90-day Treasury bills, also for one-tenth of 1%. This is how they avoid all risk of default. But they cannot make a profit. They cannot avoid losses.

Meanwhile, anyone who receives digital money who decides to keep digital money has his money in a bank. Banks must pay interest on most accounts. For as long as depositors demand a rate of interest above 90-day T-bills, banks have a major cash flow problem. More money is going out the door in interest than is coming in from T-bills and reserves at the FED. “What’s a banker to do?”

He can pay less to depositors. That means depositors’ hopes of ever retiring and living off of capital are doomed, unless they find a way to beat the stock market or the commodities market. They must become entrepreneurs. They do not want to do this.

It was not that they had any legitimate hope before. They were paid (maybe) 3%. Price inflation was at 3%. They were taxed at ordinary rates on the interest payments. They were going into the hole. But the illusion of hope was still there. If they are paid nothing on their deposits, they know they are doomed to working until age 85, unless prices fall by 3% a year — which would be a great thing. It has not happened since 1932.

Banks are paying depositors well above 0% these days. To find out how much, visit this site for the best rates nationally.

So, for every dollar that a bank keeps at the FED or in T-bills, it is losing money.

What is the incentive for banks to lose money? Only this: the terror of losing even more money.


Ever since September 2008, M-1 has taken off like a skyrocket: Inflationary Falls. In contrast, the M-1 money multiplier has fallen like a stone: Deflationary Falls. I post links to these charts in my department, “Federal Reserve Charts.” You can see both charts on one page here.

My explanation for the M-1 money multiplier’s reversion to an M-1 money divisor is that the FED began paying interest on bank reserves. This has kept most of the increase in the adjusted monetary base from creating an inflationary disaster.

The bankers have now run out of profitable options. They must accept one of these painful alternatives. First, they accept the slow draining away of profits that will come as a result of the freeze on the interest rate income on their excess reserves — money they could legally lend. Second, they accept the risk (technically, uncertainty) of lending to corporations in the middle of the longest recession since the end of World War II. These corporations may go bankrupt. Third, they can lend to the U.S. Treasury to buy long T-bonds, which pay above 3%. Their principal is then at risk. Rising long rates, due to monetary inflation and then price inflation, could raise yields, thereby lowering the market value of the T-bonds.

If bankers keep their banks’ money at the FED, this means that their terror is extreme. They would rather suffer the slow losses of money paid to depositors. A sure loss is better than the potential losses of lending to corporations or the U.S. Treasury. This means that they think the canoe is going to go over Deflationary Falls.

If bankers are this pessimistic about the economy, then we really are in uncharted waters. The people who Americans paid to manage their money misinvested hundreds of billions and — it may turn out — close to $4 trillion during Greenspan’s bubble and the carry-over under Bernanke’s attempted slowing of the monetary base, 2006—2007. These people were lured into a trap by Greenspan’s monetary and interest rate policies. Those Austrian School economists and forecasters who warned that this would happen were ignored then and are ignored now. “Crackpots. Lucky guessers.”

Now these same people, in shell shock because of what the market has done to their investments, are paralyzed in fear.

We are now being told by the so-called experts who told us not to sell our stocks, let alone sell short (I recommended both in November 2007), that the stock market is close to the bottom. Yet they cannot tell us when this economy will recover. Then how do they know the stock market is at the bottom?

We are told, “The market has discounted all the bad news to come.” Did the market forecast this in October 2007? No. So, why are the ex-genius stock fund managers any better informed now than then?

If the banks will not shift those excess reserves to T-bonds or corporate bonds or corporate loans, then there is not going to be a recovery for years. Banks are still failing. Corporations are still failing. The FED is still pumping in fiat money to re-capitalize banks. Before long, it will be doing the same with T-bonds, for the Federal government’s expected deficit is $1.2 trillion. If bankers think, “This economy is too risky to lend any money,” then this economy will continue to decline.

Will we get mass deflation? No. Mass deflation is a theory suggested by Keynesians. They call this a zero-bound economy. This is what Bernanke has worried about all along. In his now infamous “helicopter” speech in 2002, he said this.

However, a deflationary recession may differ in one respect from “normal” recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero. Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the “zero bound.”

We are now at this point. The consumer price index actually fell in December. The Median CPI was flat.

Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy. First, when the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be. . . .

Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value.

This is bad for consumers, he said. What can be done about this? In short, “What’s a central banker to do?” This:

Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern — the limitation that it places on conventional monetary policy. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate — the overnight federal funds rate in the United States — and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.

We are now at that place that Bernanke feared was theoretically possible. It has happened on his watch. Some people still believe that the central bank, in his words then, has “run out of ammunition.” He assured us that a central bank never runs out of ammunition.

However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.

What the video on FED lending showed is Bernanke’s desperate attempt not to run out of ammunition. Unless this ammunition is nothing but blanks, he will hit his target: the economy.

It is best to avoid a zero-bound condition, he said. As with all Keynesians, all Chicago School monetarists, and all supply-side economists, Bernanke hates the thought of price deflation.

As I have already emphasized, deflation is generally the result of low and falling aggregate demand. The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending, in a manner as nearly consistent as possible with full utilization of economic resources and low and stable inflation. In other words, the best way to get out of trouble is not to get into it in the first place.

Tough luck, Ben. We are there.

Within the hard-money camp, most of us think mass inflation will be the result if present policies are followed by the FED. The banks will eventually have to buy T-bonds and other interest-paying assets. If they don’t, the red ink of payments to depositors will bankrupt them. They are like wounded men on a battlefield. They will bleed to death. The FDIC will intervene, or the FED will, before this happens.

American banking is now nationalized. Congress is in a position to force banks to lend. “No loans, no more bailout money.” Before we go over Deflation Falls, Congress will do just that.

There are deflationists in the hard-money camp. They are in fact the true hard-money people. They think the dollar is true hard money. They think prices will fall. They trust the dollar, not gold. The ones who trust gold and the dollar are not deflationists. They are confused.

They think we will go over Deflation Falls. I don’t mean that they predict a Japan-like economy. Japan had a few years in the 1990’s in which price deflation of 1% occurred. A rate of deflation that low is subject to statistical error. No one really knows what “prices in general” — there are no known prices in general, only statistical indexes — did or did not do, when we are talking about a change of 1%.

I am talking about someone who thinks the 1930’s are coming back. Bernanke described this scenario: “massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America’s worst encounter with deflation, in the years 1930-33 — a period in which (as I mentioned) the U.S. price level fell about 10 percent per year.”

I make the following prediction: this is not going to happen.


What about muddling through? What about a reversal of the zero-bound economy, but without mass price deflation? What about a reversal of FED policy, once the economy reverses?

First, why should it reverse?

Second, how soon?

Third, what can the FED do to reverse its policy? Can it unload the toxic waste assets it swapped for Treasury debt? On whom? At what discounted price? Forget about it. The FED is stuck forever with this junk.

Can the FED stop buying T-bonds and T-bills? With a $1.2 trillion deficit forecast this year? President Obama has said this will not be the last such year. If the FED stops buying, rates will climb. If rates climb, the recession reappears. No exit there. More monetary base increases.

Fourth, the FED can hike the reserve requirement for banks. Convert today’s excess reserves into legal reserves. This is exactly what it should do: move toward 100% reserve banking. But then the banks will bleed again: more payments to depositors than income from lending. They cannot lend because the reserve rate is at 20%, or whatever the FED decides. The FDIC then gets stuck with more busted banks. It is below $25 billion in reserves now, and that is in Treasury debt. It must sell Treasury debt in order to raise cash to cover deposits.

No exit.


I am all for muddling through. But, at this point, I don’t see Conventional Creek on my copy of the map. The monetary base has been doubled. The only thing keeping banks from lending to the limit of their legal reserves is fear. If bankers are so afraid to lend, despite returns of one-tenth of 1%, we are not heading toward Conventional Creek. We are headed for the falls. Inflation Falls.

Dollar falls.

Gold rises.

January 28, 2009

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.

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