Why Not Let Prices and Wages Fall?

Bernanke's sophisticated surgical tools keep making the patient worse


Here's a sign that you may not have to worry about inflation for a while: The Los Angeles Times business page is warning that higher prices "have seeped from the gas pump into the broader U.S. economy in May, adding new hurdles for the sluggish recovery." 

This is from the lede of an article that actually presents plenty of evidence that inflation is still a minor worry—at least relative to all the major worries in the American economy. The Federal Reserve Bank of Philadelphia reports that regional manufacturing is continuing a months-long slide. Unemployment is back up to 9.1 percent. Retail sales [pdf] are down. Traditionally, when nobody is hiring and nobody is buying, you can expect inflation to be anemic. 

In fact, we should probably expect a new round of mainstream news stories warning about the "risk of deflation" and "deflationary shocks" and other fanciful terms describing the agony of being able to buy stuff cheaper. 

Who's right? 

For reasons I have described at length, I advise skepticism of any inflation claims that are based on the "core" consumer price index (CPI). I also marvel that the Federal Reserve's massive creation of new dollars has resulted in a deep and lengthy economic crisis during which we've seen only one fiscal quarter of price deflation and a 17-month period of sharp wage inflation. The latter—wages and unemployment paradoxically going up at the same time—is another lamentable feature the early part of the current crisis shares with the early part of the 1930s depression. 

The greater question is why deflation is considered such a toxic occurrence. We are not talking about a price rollercoaster here. The real estate market peaked in June 2006, which means we have had five years to adjust to reality. We have seen household net worth drop by $5 to $8 trillion dollars. American workers are competing with radically lower-paid counterparts in other nations. 

So why hasn't the price of anything come down? More to the point, why is the concept of falling prices and wages considered so heterodox that our very language is biased against deflation? The term of art is "inflation adjustment," but never "deflation adjustment." 

Inflation hawks would say deflation hasn't happened because the Fed created more than $2.9 trillion during two rounds of quantitative easing, the second of which is ending this month. But those folks may not be fully aware of the implications of the Fed's interest-on-reserves program (IOR).

Interest on reserves, which as its name implies has the Fed paying banks interest on money they keep in their vaults, was a monetary tool that the Fed had been seeking for many years prior to the real estate correction. It was supposed to go into effect this year, but in a panicked response to a perceived threat to politically connected Wall Street institutions, the Democratic Congress and the Bush Administration accelerated the program as part of the Emergency Economic Stabilization Act of 2008. 

Although IOR has been connected to the late Milton Friedman, Friedman only advocated paying interest on reserves that banks are legally required to keep. Federal Reserve Bank Chairman Ben Bernanke has gone far beyond this proposal to pay banks interest on their excess reserves as well. Right now banks are sitting on $1.6 trillion in excess reserves, the largest reserve level in American history. 

Why is Bernanke plying this tool as the American economy continues to dissolve? More important, why does the Fed claim simultaneously that the IOR program is not depressing bank lending while also claiming it is an effective brake on inflation? As I wrote in November

The Fed wants us to believe mutually exclusive stories: Paying interest on reserves is an important deflationary tool that allows the creation of trillions of new dollars; and paying interest on reserves has nothing to do with the fact that banks are not lending out a historic excess of reserves.

The second explanation may be less incredible than it sounds. The U.S. economy continues to work its way back through at least 10 years of asset, credit, and wage inflation. It's possible that this long-overdue deflation could eat up an additional $600 billion, that the rate of IOR could remain nominal through another few years of frost in the climate for lending, spending, and hiring.

Bernanke's monetary strategy, which in the end owes less to Friedman than to the old lady who swallowed the fly, ensures that we will find out. By issuing this enormous pile of funny money, the Fed more or less guarantees it will at some point have to use IOR as an inflation rein. Bernanke might have gotten the same result—and a lot less heartache—if he'd just stopped paying the interest in the first place.

San Jose State University economist Jeffrey Rogers Hummel has a theory that goes a long way toward explaining both Bernanke's behavior and his academic writings. Bernanke famously signaled his agreement with Friedman and Anna Schwartz's view that excessive monetary tightening spun the 1929 stock market correction into what is now called the "Great" Depression. But there is a subtle distinction: Friedman believed the problem was that not enough money was on hand. Bernanke, despite his popular moniker "Helicopter Ben," thinks the problem was that the banking system—a portion of the economy he believes is important enough to merit special treatment—needed to be supported. Thus Bernanke isn't interested in monetary easing so much as a perverse strategy of targeted bailouts. 

"The old view was to control the money supply and therefore the supply of credit, and allow the market to allocate it where market participants think it should go," Hummel said in an interview. "Bernanke believes it's now important for central banks to allocate the credit." 

Hummel lays out this thesis in a fascinating article [pdf] for the Spring 2011 Independent Review. The Fed, he argues, has effectively become not just the master of the money supply but an active central planner for the whole economy. The implications of that are, at best, worrisome. If the last three years are a taste of how things work under the newly empowered Fed, we're all in heaps of trouble. But Hummel points to Bernanke's recent performance as evidence. 

"Look at his policies before September 2008," Hummel said. "The crisis emerged in summer 2007. Bernanke was so concerned about inflation taking off that he was injecting money into Bear Stearns and banks through the term auction facility, but he was also pulling money out of the economy by selling off the Treasury portfolio. That's called sterilization." 

Supposing that one of the Fed's claims—that IOR is an effective inflation brake—is correct, and supposing that Hummel's view of Bernanke's logic is accurate, some things begin to make more sense. The last three years have been by almost any yardstick disastrous for the American economy. "In my opinion," University of Georgia economist George Selgin wrote in an email interview, "the first round of quantitative easing failed because it didn't contribute to a needed increase in needed increase in M [money stock] and MV [money stock times velocity of money] (total spending)*, the latter having shrunk dramatically at the time. The failure was partly due to the Fed's own policies, which contributed to a very large increase in banks' already high demand for excess reserves. The failure was in this respect somewhat like that of '37-8." 

Selgin believes IOR was not only questionable as an idea but implemented at the wrong time. "Whatever elaborate reasons may be given in defense of the general concept as a means for perfecting or achieving reliable monetary control, implementing it in October 2008, a time when the money multiplier was contracting rapidly, was just plain irresponsible," Selgin writes. "Once again: shades of '37-8." 

But there is a possibility that even now Bernanke has a plan. Not to put too fine a point on it, but the Fed is not paying interest on reserves to you or me. (In fact, my own bank is paying effective negative interest on my savings.) It's not paying interest on reserves to Mark Zuckerberg, or Texas Instruments, or NetFlix, or the family of first-generation Americans who run your nearest convenience store. Does this mean Bernanke is knowingly doing this just to grease his bankster buddies? Not necessarily. 

I have written extensively about the fear of declining real estate prices that characterized both the Bush and Obama administrations. It is no wild claim to say that the institutions of economic control have spent half a decade now doing anything they can to reinflate the real estate market. Does Bernanke see the buildup of excess reserves as one stage in a long-term effort to restore the real estate market? Eventually those reserves will go somewhere, and what better place to start than in the portion of the economy that has actually deflated: the brisk business of refis, HELOCs, first-time home mortgages, and other debt-fueled support for the real estate industry? Bernanke seems to believe he can micromanage that outcome. 

Bernanke has spun such filigrees of airy nothingness around his interventionist tools that it may be a disservice to John Maynard Keynes to call this stuff "Keynesian" anymore. But Fed policy is remarkable in its commitment to control over freedom or even general public contentment. Sometimes prices just want to fall. It's no crime to let them do that. 

* An earlier version of this article misstated part of Selgin's statement. 

Tim Cavanaugh is a senior editor at Reason magazine.