21st Century Monetary Policy

Ben Bernanke needs to feel like his life means something—contributed to society in some important way. Making significant contributions to the evolution of new tools of monetary policy lets him leave a mark. There is nothing unusual about this need because it is felt by many people, but perhaps not with the same intensity as Dr. Bernanke.

Monetary policy in the 21^st century covers the important central bankers in the period — Arthur Burns, Paul Volker, and Alan Greenspan — and their approaches to combating problems with the US economy.

Bernanke is clear that those managing the Federal Reserve are getting better at using monetary policy to produce positive outcomes. The new tools of quantitative easing and forward guidance should be part of fixing the economy during downturns. Unfortunately, there is very little evidence that monetary policy makes much difference to the overall prosperity of a country.

Ultra-low interest rates inflated house prices and risk-taking by banks ultimately culminated in the biggest banking blowup since the 1930s in 2008. Bernanke explicitly denies that monetary policy had anything to do with it; he has no idea that debt and risk were building up as interest rates went lower and lower since Volcker slayed inflation in the late 1970s.

There’s no evidence that debt-based growth works. Today, we have much more debt but in different places.

Bernanke lays out the major themes of the book in the beginning with a thesis. New policies have been undertaken by the Federal Reserve because of new economic developments in the 21^st century: “The first of these developments is the ongoing change in the behavior of inflation and, in particular, its relationship to employment’.

The former Fed chairman is referring to the Phillips curve, which proposes a relationship between unemployment and inflation. The simplest form of this relationship is running a regression to show the outcome of lower unemployment is higher inflation. This was the problem in the 1970s, which was much more problematic than most initially thought it would be.

As Bernanke ascended through the banking profession, he no longer believed that inflation and unemployment were strongly linked; instead, he thought employment could be strong without rising inflation.

But in the 1970s, economists did not think that unemployment could rise while inflation continued to remain high and rising. Clearly, the Philips curve is not that reliable. It does not make sense to declare a “new era” that allows ultra-low rates when in the 1970s economists were shocked by the developments.

That’s the first strike against Bernanke.

The second development is “the long-term decline in the normal level of interest rates”. This argument is not substantiated at all. As far as I can tell, Bernanke thinks interest rates will be at zero until humans become extinct. Why will they be low forever? Today, we are close to 6% and Bernanke missed the Covid-19 inflation.

The third part of his thesis is that “final long-term [financial] development is the increased risk of financial instability”. Bernanke believes if the economy has a crisis that the Fed should intervene and can fix problems without any kind of long-term risk. The problem with this idea is that over time, it is like suppressing a large forest fire at the expense of smaller ones or letting a small bridge collapse early with minimal damage. Dr. Bernanke thinks saving the banks saves the economy, but that assumes the banks were not making bad loans to begin with. The loans are still bad.

Jerome Powell borrowed Bernanke’s interventions from the 2008 crisis and ended up with the worst inflation in forty years. The Federal Reserve practically had to be dragged kicking and screaming to raise rates after inflation took off. This terrible mistake has still not been completely fixed.

Bernanke believed that there is no connection between money supply and inflation. Sometimes that might be true, but if I sent every American $20,000 and let them not pay part of their bills for a few years, the odds of inflation would rise. The 2020 monetary policy was a huge failure, which was done partially because of Bernanke’s carelessness about the relationship between money supply and inflation.

After the COVID-19 inflation disaster, experimental monetary policy will undergo much more scrutiny. In the long run, economic growth comes from skilled entrepreneurs using the resources they have in front of them to build something amazing. The cost of capital is only one component. Apple and Microsoft were formed during periods of high cost of capital. We must learn the lessons from the past; we must refuse to trial experimental monetary policy.