Bernanke's False Recovery

Loose monetary policy has weakened, not strengthened, the US economy...

ACCORDING to Ben Bernanke, the Chairman of the Federal Reserve, the pulling back on aggressive policy measures too soon would pose a real risk of damaging a still-fragile recovery, writes Dr Frank Shostak for the Cobden Centre.

The Fed Chief is of the view that for the purposes of financial stability a continuation of the central bank's aggressive stimulus conducted through purchases of Treasury and mortgage securities remains the optimal approach.

In response to the financial crisis and the deep recession of 2007-9, the Fed not only lowered official rates to effectively zero, but also bought more than $2.5 trillion in assets in an effort to keep long-term rates low.

But is it true that a loose monetary stance provides support to economic activity? Furthermore, if this is the case then why after such an aggressive lowering of interest rates and massive expansion of the Fed's balance sheet does the economic recovery remain fragile?

Surely if loose monetary policy could revive economic activity then a very loose policy should produce very strong so called economic growth – so why hasn't it happen this way?

Contrary to popular thinking, loose monetary policy, which leads to a misallocation of resources, weakens the economy's ability to generate final goods and services, i.e. real wealth.

This means that loose monetary policy not only cannot provide support to the economy but on the contrary undermines the foundations for economic growth.

The so-called recovery that Bernanke and most commentators are referring to is nothing more than the revival of various non-productive or bubble activities, which in a true free market environment wouldn't emerge in the first place.

These bubble activities are funded by means of loose monetary policies, which divert real wealth from wealth generating activities thereby weakening the process of wealth generation.

From this we can infer that a still fragile economic recovery, i.e. a fragile revival of bubble activities, despite the very loose Fed monetary stance could mean that the wealth formation process must have been badly hurt. (Note that notwithstanding very loose monetary policies, without the expanding pool of real wealth it is not possible to stage a strong recovery of bubble activities).

If our assessment is valid then obviously the sooner the loose stance is reversed the better it is going to be for the economy.

Needless to say, bubble activities are not going to like this since the diversion of real wealth to them from wealth generators will slow down or cease all together.

A fall in economic activity in this case is in fact the demise of various bubble activities.

Contrary to Bernanke, we can conclude that the continuation of loose monetary policies could only lead to financial instability and prolong the economic crisis.

Some commentators, among them Bernanke himself, blame the fragile economic recovery on banks' reluctance to aggressively lend out the money pumped by the Fed. Without the cooperation of banks, the Fed's aggressive pumping is not translated into a strong expansion in the money supply.

On this the growth momentum of commercial bank lending shows softening. Year-on-year the rate of growth of real estate loans fell to 0.1% in February from 2.3% in the month before.

The yearly rate of growth of business loans eased to 11.3% last month from 13.5% in January.

Also the growth momentum of commercial banks consumer loans has eased last month. The yearly rate of growth softened to 3.8% from 3.9% in January.

The pace of overall commercial bank lending, which includes lending to government, has eased visibly last month. Year-on-year the rate of growth fell to 3.7% from 6.2% in January.

The growth momentum of inflationary lending remains in a visible decline with the yearly rate of growth closing at 6.2% in February from 11.3% in January.

The banks' reluctance to lend is also seen in the strong increase in their holdings of surplus cash. In the week ending March 6 excess cash reserves stood at $1.648 trillion against $1.546 trillion in March last year and $0.8 trillion in January 2009. Also note that in the week ending March 6 the yearly rate of growth of Fed's balance sheet jumped to 7.6% from 4.7% in February.

Once the pool of real wealth comes under pressure, the number of good quality borrowers tends to decline. Obviously this tends to reduce the supply of lending. We suggest that if the pool of real wealth is stagnant or worse declining then regardless of whether banks will start lending or not, no meaningful economic expansion can emerge.

According to the Fed Chairman Ben Bernanke pulling back on aggressive policy measures too soon would pose a threat to economic recovery. Our analysis indicates, however, that the sooner the Fed reverses its loose stance the better it is going to be for the underlying fundamentals of the US economy. A reversal in the current loose stance, whilst good news for wealth generators, is going to undermine various non-productive wealth consuming activities. Meanwhile the growth momentum of US commercial bank lending displays a visible weakening.

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Built on anti-Corn Law radical Richard Cobden's vision that "Peace will come to earth when the people have more to do with each other and governments less," the Cobden Centre promotes sound scholarship on honest money and free trade. Chaired by Toby Baxendale, founder of the Hayek Visiting Teaching Fellowship Program at the London School of Economics, the Cobden Centre brings together economists, businesspeople and finance professionals to better help these ideas influence policy.

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