Bernanke's Monetarism Is a Logical Impossibility

About former Federal Reserve chairman Arthur Burns, Rice University historian Allen Matusow once wrote that "he had no fixed monetary principle of his own, except a determined eclecticism that translated into unsteadiness of purpose." It would be fair to describe our present Fed Chairman in the same way.

Indeed, in an opinion piece for the Wall Street Journal on Tuesday, Ben Bernanke set out to explain the central bank's plan for managing economic growth and inflation in a way that could only be described as a hybrid of Phillips Curve and monetarist thinking. But to be fair, they're not dissimilar.

Phillips Curve advocates argue that there's a point at which economies grow too much such that inflation is the result. Monetarists believe that growth in the money supply beyond a set limit causes inflation. Neither is valid.

In his Journal piece, Bernanke re-affirmed his Phillips Curve bona fides with his suggestion that once "recovery takes hold", there could be "an inflation problem down the road." To restrain future inflation, the Bernanke Fed "will need to tighten monetary policy". The problem here is that not only does economic growth not cause inflation, but the Fed can't control the supply of money in the way Bernanke suggests.

First up, growth doesn't cause inflation because if the supply of labor or capacity in these fifty states ever runs low, companies of all stripes can and will do as they've always done, and that involves accessing the abundant supply of labor and capacity around the world. No matter the Fed's static views of the U.S. economy, we are but one part of an increasingly integrated world economy.

Sports giant Nike is based in Oregon, but it has never manufactured any of its products in the United States. Airplane manufacturer Boeing is now based in Chicago, but the 787 Dreamliner is being built in six different countries. If it's acknowledged that labor and capacity aren't finite, then it should also be said that neither is our capacity to innovate. The fact that most of us never deal with a live human being when we buy movie or airplane tickets, or when we deposit money at the bank is proof positive that markets maneuver around all manner of labor shortages.

So while the Fed can surely retard economic growth through its rate machinations, it can't control the monetary phenomenon that is inflation by targeting the economy. It can't precisely because it cannot control labor and capacity inputs outside the United States. In that sense the Fed's use of its rate target to manage inflation will never work in the way Bernanke would like it to.

Regarding the supply of money, it should first be said that the M1 (demand deposits in banks) and M2 (M1 + savings accounts) measures of "supply" that he cited in his Journal piece are notoriously misleading. The late 1970s revealed this very clearly in that rising inflation (as evidenced by a skyrocketing gold price) made many eager to shift out of money bank deposits into hard, commoditized assets precisely because dollars were losing value. To the monetarists this was evidence of tight money, but in fact the falling Ms were signaling that money was too cheap and couldn't be held in traditional accounts.

Looking at what Bernanke terms an "exit strategy", specifically a drawdown of the trillion dollars the Fed added to the banks under the absurd notion that money creation equals economic growth, this won't work either. And if Bernanke doesn't know why it won't, his ignorance as to why serves as another reason for his Fed Chairmanship not to be renewed.

Put simply, the dollar is the world's currency. For evidence we need only remind ourselves that 2/3rds of all dollars are overseas. If and when dollar shortages reveal themselves stateside, the shortfall is made up with inflows of dollars from foreign locales.

So when Bernanke says he can contract U.S. bank reserves and lending through interest payments on dollars returned to the Fed, he is not writing truthfully. Just the same, if the Fed increases reserve requirements on banks in order to reduce lending and the money supply, there will similarly be no decrease in dollars lent in the U.S. despite Bernanke's protests otherwise.

That is so because there exists a large reserve of dollars that the Fed does not control. Specifically, our largest money center banks have outposts around the world. Most notably through the Eurodollar markets, major U.S. banks can easily work around any supposed tightening by the Federal Reserve by accessing dollars from banks the Fed does not regulate. Smaller regional banks can borrow from the larger ones.

Much as Middle Eastern countries can't dictate the final destination of the oil they bring out of the ground (rendering the notion of "embargo" meaningless), the Fed can't dictate where the dollars it issues end up. For Bernanke to say the Fed can control the supply of dollars in the U.S. is the equivalent of Iranian president Mahmoud Ahmadinejad telling us he won't allow Iranian oil to reach our shores. Neither can be made to happen.

Rather than worrying ourselves over the supply of money, we need to remember what the late Jude Wanniski repeated over and over again: it's not the quantity of money that matters, but the quality of money. By quality Wanniski meant the value of money, and this is something the Treasury and Fed can control by simply making the dollar as good as gold.

Indeed, if our monetary authorities would communicate to the markets a dollar price rule whereby the dollar could be exchanged for gold, demand for our suddenly credible currency would skyrocket and the trillion dollars the Fed pushed into banks would suddenly not be enough. Monetarists, including perhaps Bernanke, would squeal about the inflationary implications of money growth, but with the dollar stable in value, there would be no inflation to speak of.

In a 2003 interview with the Financial Times, the late Milton Friedman, who was the modern father of monetarism acknowledged that, "The use of quantity of money as a target has not been a success," and "I'm not sure I would as of today push it as hard as I once did." Just as economic growth or lack thereof can't be used as an inflation measure, neither can money quantity.  Bernanke should know this.