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Death by dichotomy

By Karl Smith

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

By Karl Smith  | November 9, 2010; 10:14 AM ET
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Thanks, very well said. The problem remains that the Fed probably isn't up to the job, because it can't create the consumer demand that businesses need to justify expansion and hiring. The Fed action is part of doing enough to keep things from getting worse--a story that is getting old. Perhaps that's the best we can do for now.

Posted by: pjro | November 9, 2010 10:34 AM | Report abuse

"This is why inflation is falling not rising."

Karl, unfortunately you're completely wrong, although well written. Only "core inflation" has been falling. This mystifyingly bad statistic that leaves out food and energy prices is completely incorrect for the overall economy. Oil today hit a two year high, and other agricultural products such as wheat, corn and soybeans are also at multi-year highs. (I personally have made about 43% this year on rising commodity prices. Guess I should give it all back and tell the kids "no Christmas I was wrong!")

Several companies in their most recent quarter of reporting have cited higher food and energy prices in their revised estimates for the coming year.

Using only core inflation allows the Fed to continue to bury the dollar while pretending that inflation isn't happening.

When very soon you go to fill up your gas tank with $3.00 a gallon gas, please tell the attendant that the price can't be correct because inflation is falling!

Posted by: 54465446 | November 9, 2010 11:08 AM | Report abuse

One of the more reasonable concerns I have seen relates to the money going to the "wrong" place.

The loan and junk bond markets are back to 2007 - high yield has done extremely well (the Blackrock Corporate High Yield Fund has returned 41% since 7/31/07 and 52% since 8/29/08), and covenant-lite loans have returned. Per The Economist, junk bond issuance through October makes 2010 the record year for issuance. Gold is up to $1,420, from ~$650 during the summer of 2007 and $725 back in October 2008. Oil is pushing $90 a barrel. Some things are inflating, but they might just be new bubbles.

In addition to ignoring a lot of the asset price action, another problem with core inflation is that a huge component is owner's equivalent rent, a made up number which is a price no one sees nor pays.

OER has fallen about 0.1% over the past year, which has surely dragged down both the CPI and Core CPI by several tenths of a percentage point over the past year.

Posted by: justin84 | November 9, 2010 11:40 AM | Report abuse


You are the best "numbers guy" that I have ever seen posting on a thread.

Posted by: 54465446 | November 9, 2010 12:06 PM | Report abuse

Great article...superb reasoning...and just what could Sarah Palin criticize someone like Bernanke..I seriously doubt if she has ever read anything about him or his work at the Fed.

Posted by: fairness3 | November 9, 2010 12:53 PM | Report abuse


Since world leaders have been nearly unanimous in their criticism of the Fed's action, why couldn't Palin? You try to make it sound like she is too stupid to have a voice.

It is really a question of perspective, and has little to do with unemployment. The Fed is committed to causing inflation to break the huge deficit, but they can't come out and say that. Their duel mandates give them cover to do this cloaked in helping the economy.

The Fed is really tremendously worried about the value of the assets they took from Wall Street during TARP (you know, the one that has been "repaid" LOL).

Their Maiden Lane subsidiary has already taken the unprecedented action of trying to force a "take back" on some of these securities. They would never have done so if there was not a huge level of concern about the viability of these assets.

The Fed counted that most commentators on non-business oriented sites would either not undertand what happened or not see it as significant. They were right on all counts!

Posted by: 54465446 | November 9, 2010 1:46 PM | Report abuse

Thanks 54465446.

Just trying to add color where I can.

To be fair to Karl, I think his overall point is right - there are plenty of pro-free market types who consider monetary policy tools as useful in driving a recovery to blunt calls for government efforts on the fiscal side. All else being equal, monetary stimulus is probably better than fiscal stimulus, especially when controlled by conservative central bankers.

That said, focusing on the core CPI runs the risk of letting bubbles form in commodities and assets as money tends to flow there first. By the time core CPI YoY growth rate had broken back above 2%, it was already late 2004, and the housing bubble had been ongoing for several years.

Posted by: justin84 | November 9, 2010 6:04 PM | Report abuse


Do you agree with my opinion that unemployment is the perfect cover for devaluation? I mean it's not exactly a unique theory or anything. The Chinese this week basically said the same exact thing when commenting on QE2.

Posted by: 54465446 | November 9, 2010 7:51 PM | Report abuse

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