Alack and Alas, We Are Undone for Bernanke Has Twist (and QE1, QE2, QE3, and QE Forever)

Recently by William L. Anderson: Bailouts and the Wonderland Economy

In Beatrix Potter's classic The Tailor of Gloucester the poor tailor laments the loss of the "twist" of silk needed for the waistcoat he is creating, declaring, "Alack and alas, I am undone, for I have no twist." When Potter wrote the story in 1902, the notion that a central bank (the U.S. Federal Reserve System did not exist then) would come up with "clever" means to hide the fact that its operations were bankrupt was not quite in the realm of politically-acceptable actions.

Such financial shenanigans would come a decade later, when Europe burst into warfare and governments hopelessly inflated their currencies to pay for the carnage, leading to what has been a permanent "twist" in policy. Continuing in that vein of deception, Ben Bernanke and the Fed have come up with schemes such as "Operation Twist" and Quantitative Easing to hide the fact that it is bankrupting the economy.

Aptly named "Operation Screw" by financial analyst Peter Schiff, Bernanke's "Operation Twist" scheme has been an attempt to have the Fed purchase long-term federal treasuries and sell some of its portfolio of short-term paper in order to bring long-term and short-term interest rates closer, bringing down long-term rates in the process. I say "scheme" because that is exactly what it is: an attempt by the Fed to use monetary trickery in an attempt to fool the markets.

The standard line from Bernanke and his admirers (and even some of his critics, such as Paul Krugman, for whom the Fed never can inflate enough) is that the U.S. economy is in the doldrums because "aggregate demand" is lacking following the financial crisis of 2008. Thus, any action by the Fed to lower interest rates and to improve liquidity is bound to result in increased "aggregate demand," which means that Americans will buy things and lead to an economic rebound that will put people back to work.

As Krugman writes:

…Obama is in a much better position than the conventional wisdom would suggest; the economy isn't booming, but it's growing, and the labor market is moving sideways rather than down. It's not Reagan's morning in America (which reflects the different and much more intractable nature of the 2008 crisis and aftermath), but it's not the political disaster you might imagine.

Krugman probably is right in that a semi-stagnant economy that does not seem to be in crisis plus a decidedly-weak Republican presidential candidate, Mitt Romney, probably does spell victory for Barack Obama in November. So be it. I cannot imagine a President Romney actually doing what is necessary to bring the economy to a real recovery and to let people know what actually is happening.

In the arena of political economy, the Keynesian theory wins hands down over anything the Austrians can produce for the simple reason that under Keynesianism, there is no such thing as malinvestment. All capital theoretically is interchangeable, and no matter where government funnels new money, be it in road construction or paying for new solar energy panels, the economic effect pretty much is the same: increased "aggregate demand."

If Bernanke purchases $40 billion a month of housing securities, as the Fed has announced it will do, all the better, as it will drive down mortgage interest rates and give households more money to spend. Bernanke's only mistake, at least according to the critics on the Left, is that it is still too little, and that the only thing that really will light a fire under the economy is hardcore inflation.

On the other hand, Austrians are derided as "liquidationists." Just let the economy fail, have people put out of work, and the Austrians are in full-blown celebration. Contrary to the Keynesians, however, Austrians do not believe the entire economy somehow must be liquidated. For that matter, unlike the Keynesians, Austrians do not believe that liquidation of the malivested portions of the economy would mean that everything else had to fall apart, too. Writes Schiff:

Prior injections of quantitative easing have done little to revive our economy or set us on a path for real recovery. We are now in more debt, have more people out of work, and have deeper fiscal problems than we had before the Fed began down this path. All the supporters can say is things would have been worse absent the stimulus. While counterfactual arguments are hard to prove, I do not doubt that things would have been worse in the short-term if we had simply allowed the imbalances of the old economy to work themselves out. But in exchange for that pain, I believe that we would be on the road to a real recovery. Instead, we have artificially sustained a borrow-and-spend model that puts us farther away from solid ground. (Emphasis mine)

To put it another way, Schiff is agreeing that had the Fed and Congress not bailed out the banks and financial houses in the aftermath of the Lehman Brothers failure four years ago, the initial downturn would have been worse than what happened. Being that the crisis came in the middle of a presidential campaign, it is not surprising that Congress and the Fed acted as they did.

As a short-run strategy, the bailouts and the Obama "stimulus" that followed the president's inauguration provided what seemed to be a "softer landing" than what a hard-nosed policy of allowing the malinvestments to liquidate might have been. However, the "soft landing" was not landing at all, but rather a fall into an economic version of quicksand. True, another round of "quantitative easing" or yet another financial trick by the Fed will have some effect, but on the margin, each "pull-another-rabbit-out-of-the-hat" scheme will be less effective than the previous action.

At some point, the economy stops growing and all there is left is the inflation, and this result is inevitable no matter what the Keynesians might claim. The problem is that Keynesians believe that an economy is nothing more than a homogeneous mass of factors of production and final products into which one stirs money. If things slow down, just add more money.

Austrians hold to the tenets of what is known as Say's Law, which is nothing more than an acknowledgement that consumption requires production, and that the source of increasing standards of living come from the ability of an economy to produce goods that help consumers fulfill their different needs. (No, Say never wrote that everything that is produced will be consumed, contrary to Keynesian claims. Say just was arguing that the real source of purchasing power within an economy comes from those things that are produced. Furthermore, Keynes did not "discredit" Say's Law; instead, he created a straw man and then demolished the false argument.)

From this vantage point, it is easy to see what is happening as the Fed floods the world with more dollars, be it through Operation Twist, or the endless QEs. If, as Austrians believe, that a price system helps to determine the value relationships between the different factors of production, including labor, then anything that distorts a price system ultimately will distort those factor relationship. The longer the distortions continue, the harder it becomes for the economy to have a meaningful recovery.

By the time the housing bubble collapsed, the distortions within the economy were obvious. Had the economy been allowed to correct itself, as Austrians were recommending, then the U.S. economy would have been on the road to a real recovery by now. Instead, Congress, the president, and the Fed pursued policies that not only stymied the needed correction, but actually tried to undo it.

One must understand that without a meaningful correction, there is no recovery. What Twist and the QEs are doing is to block the correction by forcing even more distortions upon the economy, which means that not only must the economy work through the damage caused by the original housing bubble (and the Tech Bubble before it), but it now must deal with the distortions that Bernanke and others have imposed.

Contrary to what Washington is telling us, Bernanke is not "fighting" a recession; he is creating a depression. By insisting that inflation will cure our economic ills, Bernanke and others are only making the economy worse. Be prepared for depressed conditions for years to come.