The Great Gamble

Laurel Magri explains her 'other' profession, click to hear.

Yesterday, at Sunday Brunch, the topic of this blog came up, specifically my contention about the coming onslaught of inflation.

Close friends question my 'alarmist claims' that the central banks of so many nations are actually 'printing money' in an effort to deal with the financial crisis.

Fortuitously Fed Chairman Ben Bernanke provided an unprecedented media interview on Sunday night with the CBS newsmagazine '60 Minutes'.

From the interview...

• "In the crisis, Bernanke had freedom to act immediately - he doesn't need permission from Congress or the president. While they debated on Capitol Hill, Bernanke cut interest rates nearly to zero; then he used Depression-era emergency powers to launch a dozen rescue programs of his own. There was support for money market funds, mortgages, short term lending to small business, and support for auto loans, student loans and small business loans - commitments of a trillion dollars, doubling the size of the Fed's balance sheet.
  
  Asked if it's tax money the Fed is spending, Bernanke said, 'It's not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed. It's much more akin to printing money than it is to borrowing.'
  
  'You've been printing money?' Pelley asked.
  
  'Well, effectively,' Bernanke said. 'And we need to do that, because our economy is very weak and inflation is very low. When the economy begins to recover, that will be the time that we need to unwind those programs, raise interest rates, reduce the money supply, and make sure that we have a recovery that does not involve inflation.'
  
  He's not kidding about printing money: the Fed issues U.S. currency, which is why it says 'Federal Reserve Note' on all the bills in your wallet. The Treasury Department's Bureau of Engraving and Printing is just a few blocks from Bernanke's office. It prints the money at the Fed's request.
  
  The Fed's mandate from Congress is to put enough money in the system for maximum employment, but not so much that it sets off inflation."
  

The reason Bernanke has embarked on this course is clear. As he told 60 Minutes, we were close to a second Depression and addressing it required emergency measures.

In a sense, Bernanke has been preparing for this emergency his whole professional life. He got a PhD in economics from MIT. He chaired the economics department at Princeton, where his specialty was the Great Depression.

He's among many economists who now believe it was the Federal Reserve itself that helped turn the recession in 1929 into a global calamity.

• "They made two mistakes, basically. One was they let the money supply contract very sharply. Prices fell. Deflation. So monetary policy was, in fact, very contractionary. Very tight during that period. And then the second mistake they made was they let the banks fail. They didn't make any strong effort to prevent the failure of thousands of banks. And that failure had terrible effects on credit and on the ability of the economy to right itself," Bernanke explained.
  

So there you have it, right from the horses mouth. The Fed's intention is to print more and more money knowing that it will trigger inflation and stave off the deflationary cycle we were plunging headlong into.

So is Bernanke worried about unleashing the inflation genie?

No. As Bernanke says in the interview, he believes he can control it. When the economy begins to recover, the Fed will wrestle inflation to the ground by unwinding those programs, raising interest rates, and reducing the money supply.

It's a huge gamble because despite Bernanke's confidence, the inflation genie is an economic Pandora's box.

According to greek myth, Pandora had been given a large jar and instruction by Zeus to keep it closed. But Pandora ultimately opened it. When she opened it, all of the evils, ills, diseases, and burdensome labor that mankind had not known previously, escaped from the jar, but it is said, that at the very bottom of her box, there lay hope.

In their desperation to find that hope, the central banks of the United States, Canada, Britain, Japan, China and Switzerland have opened that box.

We have been down this road before. In the late 1970s the inflation genie was unleashed and it ravaged the economy by inflating consumer prices at an annual rate of 13.5%.

While the circumstances and causes were different from today, the fact is that when when the Fed finally took decisive action... interest rates rose dramatically.

The US Federal Reserve Chairman of the day, Paul Volcker, is widely credited with ending that inflation crisis of by employing the proposed measures Bernake is now talking about - particularly by raising the federal funds rate.

The federal funds rate shot up to an average 11.2% in 1979, was raised by Volcker to a peak of 20% in June 1981. That year the prime rate for banks shot to 21.5%.

Paul Volcker is now Chair of the President's Economic Recovery Advisory Board.

It doesn't take a rocket scientist to see what advice Bernanke is receiving on this crisis. Bernanke believes he can quickly shut off the tap and reign it in before it becomes a problem.

Beware the law of unintended consequences.

Even in a perfect world, when inflation takes off, you will see a dramatic hike in the interest rate in an attempt to immediately wrestle it to the ground.

And if the genie doesn't go back into the bottle right away, that rate could well shoot up higher than it did in 1981.

That's what is scaring the pants off of savvy investors right now.

Oh btw... if you were to renew your $650,000 mortgage at an inflation period rate of 22%... your monthly payment would be $11,412.24.

Like the Real Estate Industry says, "It's a great time to buy", isn't it?

They best pray Bernanke doesn't burn all of us as he plays with fire.

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Email: village_whisperer@live.ca