Death by dichotomy
In Wall Street Journal last week, Alan Metzer claimed that Milton Friedman never would have supported quantitative easing. Yesterday Sarah Palin slammed Bernanke as well.
This type of criticism is convenient for those who would like to paint our current debate as a fight between those on the left who believe that only government can get us out of our current slump and those of the right who have faith in capitalism and the free market.
This dichotomy is pernicious and destructive to our economic future. Card-carrying free marketers have endorsed quantitative easing by the Fed, not because they don’t believe in capitalism but because they do. Our current economic malaise may have begun on Wall Street, but it is not a sign that capitalism in and of itself is rotten. It’s a demon that we have faced many times throughout history – the old-fashioned bank run.
This time around, the run wasn’t on the traditional banking system of checking and savings deposits. Instead it was a run on short-term lending markets. Sometimes called the shadow banking system, this was a group of investment banks and other financial intermediaries that took out specially engineered short-term loans and invested the proceeds in, among other things, subprime mortgages. When the subprime market went bust, so did the shadow banking system. Investors rushed to get their money out before the banks went under, in the process speeding up the collapse of those very banks that were in trouble. This was a classic run.
We understand the effect that bank runs have on the economy. They shrink the money supply. They destroy the value of real assets such as stocks and homes. They cause a rapid rise in unemployment and if left unchecked lead to a spiral of disinflation and economic stagnation. These were the effects that those of us who saw the run predicted, and they have largely come true.
If you didn’t realize that there was a shadow banking system or you didn’t know that it suffered a run, then it might seem like the Fed’s money printing came out of nowhere. How could they expect to print this much money and not get hyper-inflation of a crash in the dollar? The Fed could do this and indeed needed to do this because the financial markets had been using those specially engineered short-term loans as a form of money. When that lending dried up, the money supply effectively shrank.
We can have a healthy debate about what went wrong in the shadow banking market and why government regulators did not step in to prevent the market from growing so large – up to an estimated $12 trillion at one point.
However, the money creation by the Fed over the past few years hasn’t been an attempt to impose a secret tax through inflation or to debase the dollar. It has been an effort to offset the money destruction that occurred in the financial panic.
This is why inflation is falling not rising.
The Fed must continue its efforts if it does not want to see inflation falling further, employment continuing to hover around 10 percent and the U.S. economy risking a decade long stagnation.
Karl Smith is an assistant professor of economics and government at the University of North Carolina and a blogger at ModeledBehavior.com.
| November 9, 2010; 10:14 AM ET
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