As part of its plan to combat the general economic malaise that followed the collapse on Wall Street, central bank planners at the United States Federal Reserve adopted a strategy to inflate the monetary supply. Federal Reserve chairman Ben Bernanke has said time and again that he certainly prefers inflation to deflation – once going so far as to say he would drop money from a helicopter if it meant he could stave off a deflating dollar.

Unfortunately, adopting a position where inflation is preferred is not a perfect solution. Inflation can be just as much a hazard as deflation, and the perils of allowing either to run out of control are roughly equivalent. In the 1930s rapid and unchecked monetary deflation led to the Great Depression in the United States, and helped bury the economy under its own weight for nearly a decade. However, in the 1920s rapid and unchecked monetary inflation did roughly the exact same thing to the Weimar Republic. The result of both was an economic catastrophe, which would eventually shape geopolitical events around the entire world.

The United States isn’t exactly on the precipice of becoming the famine state it was 80 years ago, nor is it close to becoming the wasteland that Germany was 90 years ago. But it is in a position where one false step could completely erase all of the gains made in the past two years as we fought back this recession.

According to BusinessWeek, a growing number of America’s most influential central bankers are growing restless with the Fed’s inflation targets. They want to rein in the money supply before it becomes a problem unto itself.

Kevin M. Warsh, a member of the Federal Reserve Board of Governors, alluded to a scene in a horror film where a subject barricades himself from a a threat outside (deflation) only to turn and find the real threat (inflation) locked in with them. Thomas Hoenig, president of the Kansas City Fed, dissented at meetings in January and March where chairman Bernanke opted to keep lending rates at their historic lows.

Low interest rates should help the economy recover – by making money cheaper for banks and thus cheaper for bank customers – but it has yet to take any noticeable effect. Perhaps low lending rates kept the U.S. out of a depression. Perhaps the U.S. stayed out of depression in spite of low rates.

There is no real way of knowing whether or not our low rates kept the U.S. safe from the storm, but there is some evidence to suggest that the low rates and easy money helped set up the financial maelstrom in the first place.

Throughout the Bush-era bubble economy Fed lending rates continued to get lower and lower. Rates were already at historic lows when the financial system ground to a halt and banks began collapsing left and right. Chairman Bernanke, along with the rest of the Bush and Obama economic teams, believed that the best way to fight the collapse was to continue cheap lending. Now that the economy has begun to stabilize conventional wisdom indicates that rates should gradually come up.

The United States used cheap money and an inflated monetary supply to build up its financial largesse over the past decade. It then used the same practice to fight against the collapse of that very system. Now, it is continuing the old practice in order to bring the economy back, despite the obvious fact that a pro-inflation policy could simply put us back to where we were in December 2007.

This is not just an American problem. Most western economies are attempting to deal with the same inflationary processes in their own economies. The difference between the U.S. and its counterparts around the world is our lack of back up economic fundamentals.

Europe, Japan, etc. can carry inflation without much worry because they have productive and balanced economies. They are not overly reliant on the success of financial institutions for their prosperity. In the U.S. this is not the case. Nearly all of the economic growth in the past decade has been a direct result of financial growth; when the financial sector collapsed the rest of the economy had nothing to fall back on.

In a perfect situation the U.S. approach to monetary policy would be fine, but given our circumstances a more responsible and conservative approach may be necessary.

Print PDF