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The Ascension of Bernanke Into the Clouds

Tags The FedMonetary Theory

10/27/2005Frank Shostak

On October 24 President Bush nominated Ben S. Bernanke to replace Alan Greenspan as chairman of the Federal Reserve Board. In response, Wall Street became very excited and pushed the Dow Industrial average up by almost 1.7%. The media and the pundit class were overjoyed too.

Most experts regard this successor to Greenspan as one of the greatest monetary economists of our times. So if anyone can step into the big shoes of Alan Greenspan it is Bernanke.

What we are seeing is a repeat of the hosannas that greeted Greenspan when he followed Volcker in that sainted position.

As Rothbard wrote:1

The very existence of the office makes its holder automatically wonderful, revered, deeply essential to the world economy, etc. Anyone in that office, up to and including Lassie, would receive precisely the same hagiographic treatment. And anyone out of office would be equally forgotten; if Greenspan should ever leave the Fed, he will be just as ignored as he was before."

But, we are told, it is Bernanke's great theoretical contributions to economics that accounts for why is so beloved. His understanding of the workings of the central bank is second to none. He is the advocate of the view that the success of central bank policies depends on pursuing policies of price stability. This, he says, can be secured by means of transparent monetary policies, which in turn can be consolidated by means of targeting inflation.

Inflationary targeting

The key in Bernanke's framework of achieving price stability is the setting of an inflationary target. Many people think this is a great idea. They believe that by setting an inflationary target, the Fed will be forced to show leadership as a fighter against inflation.

Furthermore once the public sees that the Fed is meeting the target, this will give the central bank credibility. This in turn will keep interest rates low and investment high and all this in turn will make the economy more prosperous.

In principle, even Greenspan seems to like the idea of targeting inflation. His only objection is that the Fed loses some flexibility if it adopts an inflationary target. For instance, in the case of a sudden shock, which would require the Fed to alter its monetary stance, the inflationary target may prevent such an alteration.

What Bernanke is proposing is not so much different from the current practice of the Fed, which is to stabilize the general price level. The only difference here is that Bernanke wants to assign a particular percentage growth to the price level. Also,Bernanke and most economists are of the view that a stable price level will make changes in relative prices more visible to market players and this will make sure that resources in the economy will be allocated more efficiently.

At the root of price stabilization policies is a view that money is neutral. This means that changes in money only have an effect on the price level while having no effect whatsoever on the real economy. In this way of thinking, changes in the relative prices of goods and services are established without the aid of money.

For instance, if one apple exchanges for two potatoes, then the price of an apple is two potatoes. Now if one apple exchanges for one dollar then it follows that the price of a potato is 50 cents. Note that the introduction of money doesn't alter the fact that the relative price of potatoes versus apples is two-to-one. Thus a seller of an apple will get one dollar for it, which in turn will enable him to purchase two potatoes.

Money therefore appears to be just a mere numeraire. In this way of thinking an increase in the quantity of money leads to a proportionate fall in its purchasing power, i.e. a rise in the price level. A fall in the quantity of money will result in a proportionate increase in the purchasing power of money, i.e. a fall in the price level. All this, however, will not alter the fact that one apple will be exchanged for two potatoes, all other things being equal.

Let us assume that the amount of money has doubled and as a result the purchasing power of money has halved, or the price level has doubled. This means that now one apple can be exchanged for $2 while one potato for $1. Note that despite the doubling in price, a seller of an apple with the obtained $2 will still be able to purchase two potatoes.

In short, there is a total separation between changes in the relative prices of goods and the changes in the price level. So it seems that the only problem with inflation is that it obscures the visibility in the movements of relative prices of goods thereby causing a misallocation of resources. Other than that, this view assumes that inflation is harmless. So if one could somehow make changes in the price level stable and predictable one would be able to neutralize the negative effect of inflation.

The problem with this way of thinking is that it ignores a critical fact: in a developed market economy, the relative prices of goods and services across the time structure of production cannot be established independently of money. Prices of goods are determined by the demand and supply of these goods and by the demand and supply of money. Hence, changes in money supply cannot be neutral as far as the relative prices of goods are concerned.

Now, the effect of changes in the demand and supply of money and the demand and supply of goods on prices of goods is intertwined and there is no way that we can somehow isolate each of these effects.

For example, let us assume that it was observed that over a time span of one year the price of tomatoes increased by 10% while the price of potatoes went up by 2%. This information cannot tell us how much of the increase in prices was due to changes in demand and supply for goods and how much on account of changes in the demand and supply for money.

According to Rothbard,

Even if all the prices in the array had risen we would not know by how much the PPM (purchasing power of money) had fallen, and we would not know how much of the change was due to an increase in the demand for money and how much to changes in stocks.

Obviously, since these influences cannot be separated, it is not possible to isolate and stabilize the so-called purchasing power of money, i.e., the price level. It follows then that since these influences are intertwined any attempt to stabilize the price level would imply tampering with relative prices and thereby disrupting the efficient allocation of resources.

The implementation of a policy of stabilizing prices will lead to an overproduction of some goods and underproduction of some other goods. This is, however, not what the stabilizers like Bernanke are telling us. They believe that the greatest merit of stabilizing changes in the price level is that it allows free and transparent fluctuations in relative prices, which in turn leads to the efficient allocation of scarce resources.

Since it is not possible to isolate the monetary effect on individual prices of goods, obviously the whole idea that one can measure and somehow stabilize the price level is preposterous. If anything such a policy runs the risk of tampering with the free movement of relative prices, which leads to instability and the weakening of the process of wealth generation.

Furthermore, the biggest problem with Bernanke's perspective is that it regards increases in prices rather than the expansion in the money supply as inflation. By focusing on the symptoms rather than causes, there is no way that one can make an economy more healthy and prosperous.

At least on this score, Milton Friedman's framework of stabilization is more credible. At least Friedman says that one should aim at stabilizing the rate of growth of the money supply. Needless to say, Austrians don't subscribe to Friedman's framework either. However, if one is forced to choose between two bad schemes — monetary stabilization or price stabilization — at least Friedman's is more appealing.

What are the other problems with Bernanke's thinking? The man has a pathological fear of deflation, which he defines as fall in the price level. A fall in prices is regarded as dreadful news since it causes consumers to postpone their buying of goods and services. If people hold on to their money during deflation, he believes, its purchasing power will increase and this will enable them to buy more goods some time in the future. It is for this reason, so it is held, that people choose to spend less once prices are falling. Since consumer spending is almost 70% of GDP this means a cut in consumer spending would slow down the economy.

Consequently Bernanke holds that too steep a fall in the rate of growth of the price index could lead to a serious economic slump. This is another justification for having an inflationary target. To avoid falling into a deflationary "black hole" Bernanke believes that the Fed should try to preserve a buffer zone for the inflation rate.

Thus during normal times the Fed should not try to push the rate of inflation to zero. The buffer zone, according to Bernanke, reduces the risk that large unanticipated falls in aggregate demand will drive the economy into a deflationary "black hole." Bernanke believes that if needed in order to counter deflation the Fed should aggressively use monetary pumping.

Following the footsteps of Milton Friedman, Bernanke is also of the view that the Great Depression was caused by the Fed's allowing the money supply to fall sharply. At the Conference to honor Milton Friedman's 90th birthday, Bernanke promised Friedman that the Fed would not make the same mistake again.

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.2

In short, it seems that the Fed is likely to act aggressively on any sign of emerging price deflation.

Despite the almost unanimous agreement that deflation is bad news for an economy's health, this is not at all the case. Deflation comes in response to previous inflation. This amounts to the disappearance of money that was previously generated out "of thin air." This type of money gives rise to various non-productive activities by diverting real funding from productive real wealth generating activities.##

Obviously then, a fall in the money stock on account of the disappearance of money "out of thin air" is great news for all wealth generating activities, since the disappearance of this type of money arrests their bleeding. In short, since a fall in the money stock undermines various nonproductive activities it slows down the decline in the pool of real funding and thereby lays the foundation for an economic revival. Printing more money because prices are falling (on account of a fall in money "out of thin air") only delays the process of rebuilding.


Contrary to the enthusiastic response of Bernanke's nomination as the new Fed Chief we suggest that his framework of thinking could be very negative for the economy's future health. His proposal to target inflation is nothing more than a policy of tampering with the price mechanism, and can only weaken the process of wealth formation. His misguided view on falling prices and what the Fed ought to do in such an event, could produce serious economic trouble down the road.

  • 1. Murray N. Rothbard, Man, Economy, and State, Nash Publishing p 739.
  • 2. Remarks by Governor Ben S. Bernanke on Milton Friedman's Ninetieth Birthday, November 8, 2002.

Contact Frank Shostak

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.