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The government has a printing press to produce U.S. dollars at essentially no cost

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior). Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

-Ben Bernanke, National Economists Club, Washington, D.C. November 21, 2002

What was Bernanke saying here during this now famous speech? First of all, I reckon Bernanke wishes he had never delivered this speech because of how explicit it is about injecting money and depreciating the value of the dollar – and the degree to which today’s monetary policy can be gauged by this speech. This is what is being dubbed "the helicopter speech." This is the one speech Bernanke has given which makes inflation hawks fear quantitative easing. As to the content of the 2002 speech, it is clear that Bernanke was saying that quantitative easing is essentially money printing – i.e. the Fed can "produce as many U.S. dollars as it wishes at essentially no cost". So let’s get that out of the way first, shall we. You have the Pragmatic Capitalist pointing to Bernanke’s performance last night on 60 Minutes as some sort of proof that QE is not money printing. Yet this is in direct contradiction to Bernanke’s remarks from 2002. What gives? Well, let’s break down the 2002 speech.

Here is the beginning of the part before the section I excerpted above.

under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

What Bernanke is saying here is that there are no hard deflationary constraints in a fiat currency system like a tether to gold to prevent a central bank from creating electronic dollar credits (what I will call more cowbell from here on) to purchase existing financial assets. If the Fed applies much, much more cowbell, say $8-10 trillion worth, it has to eventually have an inflationary impact. Bernanke’s conclusion, therefore, is that the only real constraints to preventing deflation are self-imposed and, thus, political.

The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

Here the Chairman makes explicit what he is saying by giving an analogy. The gold analogy is apt because one cannot create more gold. There is a fixed supply – and only a limited amount more can be mined cost-effectively over time. Fiat money does not have these constraints. If the Fed’s got a fever, the Fed can prescribe as much cowbell as it so chooses. And so we get to the crucial passage.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

This is definitely about expectations. What Bernanke is saying is this, "we could create an infinite supply of reserves if we wanted. You must know this. If backed into a corner, we could simply threaten to create this infinite supply. And in so threatening, we would alter inflation expectations dramatically. People would become worried about the value of their money. This would change consumer behaviour and spur immediate consumption in order to prevent loss from currency depreciation."

Bernanke is quite explicit here regarding the potential for currency depreciation that elevated inflation expectations should produce when he says "reduce the value of a dollar".

Bernanke then backs away a bit.

Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).

Chairman Bernanke knows the Fed would never risk hyperinflation (nor would politicians allow this). According to this last statement, he does believe the Fed has the tools to create enough inflationary expectations to get more consumption – if the political desire to do so is there. You might ask why the Fed wants inflation when most people (including me) think inflation is bad. That’s a good question I answered in my post Why is deflation bad?

Here’s the kicker now.

Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities.

What Bernanke is saying is this, "we essentially do QE every week during open market operations. We don’t call it QE because it is in the course of controlling the Fed Funds rate, but that’s what it is – QE for short-term money, an asset swap of T-bills for reserves. When we hit zero Fed Funds rates, we don’t need to do short-term QE because rates are at zero percent. Yes, I know we could drive rates below zero in theory, but I’m not going to mention that here. Let Eric Tymoigne write on this one. Instead, what we need to do is consider zero a lower bound and look for other ways to stimulate aggregate demand like effectively giving banks free money or abdicating our independence as a monetary authority in order to take on a quasi-fiscal role by working in concert with the fiscal authorities. They will deficit spend and we will tacitly agree to have the Fed buy the debt on the secondary market via quantitative easing."

These last two points are significant because you can see this is exactly what the Fed has done during this crisis – and these are the points that are most controversial as well. As I see it, Ben Bernanke has been implementing his 2002 speech as Fed Chairman.

Here’s the last bit of this section.

Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

This is mostly boilerplate to end his thinking on the matter. He is saying that these activities are untested so the Fed will need to act judiciously in doing this the right way. Bernanke is by no means saying they will abstain from "nonstandard means of injecting money" into the economy. Notice that Bernanke uses the phrase ‘injecting money’ what I am euphemistically calling ‘more cowbell.’ Bernanke goes on to say the Fed should do this before deflation takes hold.

Translation: it is always preferable to a central bank to print money or create some reasonable facsimile of printing to prevent deflation before its onset than to try and deal with deflation once it has set in.

Quantitative easing: printing money like mad to ward off deflation, 30 Nov 2008

I believe that’s where we are now – right on the verge of debt deflation taking hold via a housing double dip and negative equity. Commodity prices may be rising and passing through in a regressive way into food, energy and clothing. Healthcare and education costs are rising too. But core inflation as measured by the government is declining due to a lack of pricing power. Companies have combated this by trying to prevent cost pressures from feeding through by keeping headcount down. This has effectively meant that lower income households get the bad side of both commodity price inflation and debt/income deflation.

Judging from Bernanke’s previous writing, he seems to think a combination of fiscal and monetary stimulus are what are needed to prevent debt deflation from becoming entrenched in a way that turns cyclical unemployment into structural unemployment. Based on Bernanke’s commentary on 60 Minutes last night, I believe he will continue to prescribe more cowbell, "nonstandard means of injecting money", unless political forces or internal dissent stop him.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

8 Comments

  1. Tom Hickey says:

    It is entirely possible that Dr. Bernanke does not know what QE actually does and how it works. If it did, he would know that to influence the yield curve, the Fed should announce its targeted rate (price) and stand ready to deliver whatever amount (quantity) would be necessary to achieve it. Instead, the Fed announced a quantity that it would purchase (600B) and left price ambiguous. Under these circumstances, QE is a sort of magic wand that the Fed chairman can claim accomplished its “goal.” Since no goal was stated, who’s to know. It’s BS, not monetary policy.

    Printing money implies in most people’s minds increasing currency in circulation. Tsys are in effect a government liability, while that pays some interest, while reserves are a government liability that generally either pays no interest or lower interest. By driving up the price of a bond to effect a sale that might not have occurred otherwise, the Fed increase reserves . This increases reserves accounts of banks that are bond sellers and deposit account of seller that are not banks. These funds are simply converted to savings in another form.

    QE also transfers interest paying bonds to the Fed’s balance sheet, so that the government is paid the interest instead of nongovernment. This withdrawal of interest from nongovernment is a decrease in net financial assets entering the economy, potentially decreasing currency in circulation.

    Moreover, an increase in reserves has no direct affect on inflation as QE 1 shows. The Fed increased the monetary base exponentially and many people seeing the quantity curve were sure that the US was going into hyperinflation. So they naturally shorted tsys. Surprise, tsys rose in price as yields drops in response to persistent disinflation. Now the Fed is engaged in QE2 and alluding to QE3 if needed. But yields are not budging and disinflation is threatening to turn into deflation.

    There is no money multiplier. QE does not lead to increased consumption, and it does not lead to an increase in credit extension. The reserves it creates in exchange for tsys simply sit or are saved in another asset form, either in the US or abroad, perhaps driving those assets higher than they would have been otherwise.

    QE has no evidential effect on the real economy and is a non-event for Main Street. Much ado about nothing. All it shows is the inability to the Fed to do anything of significance to extricate itself from a liquidity trap.

    • It’s not just possible but probable that he doesn’t know as I have said here before. But one can’t quote him as if he does when he is saying something very different today then he did in 02. And remember this is someone who missed the housing bubble entirely.

  2. Jo says:

    Sadly, deflation isn’t preventable – under any monetary system.

  3. fresnodan says:

    Nice post as usual.
    In looking at these theories, I can only evaluate them by seeing how I and people I know react. Other than my job, my only source of CASH is interest on saving. I have substantial saving, enough that it used to supply me with about 5K of income above my salary. That to me was pure expenditure – vacations, house projects, etcetera. Now, it is essentially 0. I will soone be retiring. All low interest rates has done is kept me from spending that CASH. Perversely, it has made me DECREASE spending and INCREASE savings, despite the lack of paid interest. Low interest loans – for what? (and don’t get me going about the cost of money for banks and the cost of money for me) – I have to worry about sufficient income. My car is 10 years old, and if I had interest income I would buy a new one. But I don’t, so I won’t.
    I read a lot of financial blogs – and it seems amazing to me that the issue is not recognized – it is not lack of demand, it is lack of money.

    • Quite so, but demand without money is invisible to markets. What astonishes me is that all the folks out there kvetching about government infringement on our freedoms don’t see that allowing unemployment and underemployment in a market based civilization is the single greatest impingement of freedom the government can systematically make short of mass incarceration. This Keynes quote that’s been circulating gets to the point:

      “The Conservative belief that there is some law of nature which prevents men from being employed, that it is ‘rash’ to employ men, and that it is financially ‘sound’ to maintain a tenth of the population in idleness is crazily improbable – the sort of thing which no man could believe who had not had his head fuddled with nonsense for years and years.”

    • Very good point, Dan. I reckon Bernanke is much more sanguine about the prospects of QE in private. If he was ‘wikleaked’ I could see him showing more uncertainty. Public officials often feel that showing certainty in the face of adversity is appealing and helps keep things calm. But, the fundamentals do need to be addressed; that’s the lack of money you’re talking about – and QE is not helpful in this regard.

  4. Icarus says:

    Please see my parody of Bernanke’s comments from his 60 minutes interviews of 2009 and 2010.
    http://www.youtube.com/watch?v=6hnG_iWAauY

  5. SMIA says:

    Discussing QE without mentioning IOR (the Fed’s practice of paying interest on reserves, which dates only from 10/6/08) shows a complete lack of understanding of what is going on with respect to “money”. Right now, the Fed is paying 0.25% interest on what amounts to a 1-day T-bill. This is *far* above the Treasury yield curve. Accordingly, no matter how much new money the Fed creates via QE, it will just sit in bank reserves and have no impact on demand.

    • Another good point. I believe Last year, Sweden had set up a mechanism to penalize banks for holding excess reserves, so the Fed knows how it could alter this. Fed officials know this conflict exists.

      See here:

      http://www.creditwritedowns.com/2009/07/sweden-negative-interest-rates-and-quantitative-easing.html

      Would this make a difference? Perhaps, but you have to remember that we want banks to lend prudently. Coercing lending will have unintended negative consequences regarding loan quality.

      • Edward, in my mind the other thing about penalizing excess reserves is one of mindset. If I’m a bank and you’re only going to penalize me 0.50% for leaving my excess reserves with the central bank, that’s a pittance to pay if the expected loss on my portfolio is higher than that. Because then it’s a very simple choice.

        Also, if you factor in the ability – or the inability – of banks to either raise capital in the markets or generate enough net income from actual lending (not just buying bonds) in this environment, then you can see how expensive acquiring new capital is. So from that perspective, it’s a bunker-like mentality that a bank will take on.

        So what I’m trying to say is, if you were going to penalize them the way Sweden did with its banks, you’re going to have to ratchet up that penal rate a lot higher.

      • IOR has absolutely no effect on bank lending. Banks don’t use RBs to make loans. RBs have no capital charge. IOR raises bank profits and adds to capital Every bank loan has to be preferable to the risk-free rate with or without IOR, since even without IOR banks always have the option of investing in Tbills. Anyone who thinks IOR reduces lending doesn’t understand how banking actually works.

  6. traffic says:

    To say that Ben Bernanke doesn’t understand how QE works strikes me as false. “Our earlier use of this policy approach had little effect on the amount of currency in circulation”. This from his Nov 4 WaPo op-ed.
    He has said more than once that he understands that QE in the current climate doesn’t expand the money supply in any appreciable way. He also understands that paying interest on reserves is encouraging banks to hold reserves and not lend them. So why is he pursuing these policies? I can think of a few reasons but doing it out of ignorance of how reserves transmit through the economy is not one of them.

    • As rates are now rising and you say you can think of a few reasons why Bernanke is doing QE, I’d like to hear them.

      • traffic says:

        The most disconcerting one to me is that he has become our chief monetary psychologist. Deflation hurts because people expect it and then act accordingly. Sometimes I think he is playing poker and he is simply going “all in” to manage inflatin/deflation expectations. I think you had it right with “This is definately about expectations”. We will get “more cowbell” until we start dancing to his tune. If we don’t start dancing, we are in trouble (or maybe just become Japan).

        • I wasn’t happy with Bernanke’s performance at all. He looked defensive. He sounded defensive. The bit about not printing money was poorly done as the Jon Stewart clip shows.

          http://www.creditwritedowns.com/2010/12/jon-stewart-the-big-bank-theory.html

          What Bernanke needed to do was defend himself in terms he used before – in the 2009 ’60 Minutes’ piece and in his helicopter piece. In general, I would say it was simply a bad idea to do it at all. And note, there was nothing wrong with the substance of what he said. I don’t support but he is probably right that it’s not going to increase M2 or M3 very much if at all. This is, in fact, why I can’t support QE – it’s ineffective policy and controversial at the same time. It makes no sense to lose credibility over it then. And clearly, the Fed has lost credibility.

          See what David Greenlaw of MS says about QE here:

          http://www.creditwritedowns.com/2010/12/the-fed-and-money-printing.html

          I think he does a bang-up job.

          • traffic says:

            The MS link gets it exactly right. And Bernanke would probably agree with every bit of it. And yet QE continues. So what is he looking to do? Influence rates? Failed, plus not alot of bang for the credibility risk. Build up bank balance sheets? Maybe he sees some tail risk for banks due to mortgages, Europe, or whatever that most people don’t. I just can’t see a good reason for QE relative to the costs so I arrive at “managing expectations” by default. And as for the printing money debate goes, I think of it like the tree falling in the forrest, if reserves are credited but no one is there to borrow it, is it really money?

          • I have one quibble with Greenlaw’s view – he makes it seem like normally reserves create lending rather than the other way around. My understanding about the reason the multiplier is dropping has nothing to do with reserves at all. Really, this is about credit growth and the reserve issue is irrelevant.

  7. traffic says:

    In his textbook case,an increase in reserves is necessary create lending. In that case, lending is reserve constrained. But in our “zero bound” world, where you can borrow in the fed funds market for almost nothing, it is demand for loans that that is the constraint on the growth of credit money. You are right about credit growth in our current climate, and I think he agrees with you.

    • Actually, even fed economists have recently released a paper which shows empirically reserve creation has no relationship to lending. This isn’t only about the zero bound. It’s about the fact that demand for loans is the critical factor in all circumstances. If I find a link to the paper I will post it. It was widely circulated just a few weeks ago.

  8. Nicholas says:

    The only inflation that Ben cares about is the one concerning home prices. I do not think he likes the rest, although he is willing to accept the cost if home prices start rising.

    It is not clear whether QE will affect home prices. It all comes down to demand and supply. Look at the price of natural gas where the marginal buyers are domestic; compare that to demand of raw material prices whose demand comes mainly from abroad.

    A better plan would have been for the Fed to sart buying houses instead.

  9. greg says:

    This is where Bernanke is wrong

    “What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply.”

    This is SOOO wrong I cant believe a Fed chairman could even say it. Scarcity does not transmit to value. Plenty of ubiquitous things are valuable. Things that are needed are valuable and money is needed by everyone in todays world.

    WE give value to the US dollar by producing things in its name, so to speak. We also need dollars to settle tax liabilities, another source of value.

  10. Anonymous says:

    I think quoting, especially a central banker, from 8 years ago is a tad on the ‘quote mining’ side of things. No disrespect intend

  11. Anonymous says:

    I think quoting, especially a central banker, from 8 years ago is a tad on the ‘quote mining’ side of things. No disrespect intend

  12. IOR has absolutely no effect on bank lending. Banks don’t use RBs to make loans. RBs have no capital charge. IOR raises bank profits and adds to capital Every bank loan has to be preferable to the risk-free rate with or without IOR, since even without IOR banks always have the option of investing in Tbills. Anyone who thinks IOR reduces lending doesn’t understand how banking actually works.

  13. What a ER tax actually does is encourage banks to manipulate liabilities so that they can be counted as RR. For instance, they would completely cease sweep accounts and as much as possible reduce the attractiveness of deposits relative to non-reservable liaiblities. I dealt with ER tax in two long posts at the KC blog in July 2009.

    • Right. I see this now as the response to my question to about a tax on excess reserves. Do you have a link?

    • In Sweden there is no reserve requirement so there are no excess reserves over a reserve ratio. Since the negative IOR there has been increased lending to uncreditworthy borrowers and a rise in house prices. Additionally the Riksbank offered term loans for 12 months at a fixed rate when it implemented the negative IOR. I am not sure how this applies to the case you made since there is no reserve requirement. But since July 2009 it doesn’t appear that Swedish banks have manipulated liabilities but rather have increased loans to uncreditworthy borrowers.

    • In Sweden there is no reserve requirement so there are no excess reserves over a reserve ratio. Since the negative IOR there has been increased lending to uncreditworthy borrowers and a rise in house prices. Additionally the Riksbank offered term loans for 12 months at a fixed rate when it implemented the negative IOR. I am not sure how this applies to the case you made since there is no reserve requirement. But since July 2009 it doesn’t appear that Swedish banks have manipulated liabilities but rather have increased loans to uncreditworthy borrowers.

  14. What a ER tax actually does is encourage banks to manipulate liabilities so that they can be counted as RR. For instance, they would completely cease sweep accounts and as much as possible reduce the attractiveness of deposits relative to non-reservable liaiblities. I dealt with ER tax in two long posts at the KC blog in July 2009.

    • Right. I see this now as the response to my question to about a tax on excess reserves. Do you have a link?

    • In Sweden there is no reserve requirement so there are no excess reserves over a reserve ratio. Since the negative IOR there has been increased lending to uncreditworthy borrowers and a rise in house prices. Additionally the Riksbank offered term loans for 12 months at a fixed rate when it implemented the negative IOR. I am not sure how this applies to the case you made since there is no reserve requirement. But since July 2009 it doesn’t appear that Swedish banks have manipulated liabilities but rather have increased loans to uncreditworthy borrowers.