In Ben we trust to balance money supply, demand

August 15th, 2009 at 04:38pm Annette LaCross

The central bank of the U.S. is walking a real tightrope these days. And some folks already are betting against it.

The specter of inflation, or worse, hovers ominously on the horizon, and if the Federal Reserve can’t rein it in judiciously, it stands to significantly impede any progress we make toward an economic recovery.

Since global finance fell apart last September, the Fed has pumped literally billions of crisp new dollar bills into circulation. Sort of.

They’ve printed these new bills, certainly. But many of them aren’t technically “in circulation” at the moment because the financial institutions to which they were given aren’t spending them.

Then there are the billions more paying for the Obama administration’s stimulus projects, all of it designed to force the economy to right itself. And when it does, those dollars will start trickling into general circulation.

Therein lies the tightrope on which the Fed must delicately balance: When do they start decreasing the money supply, which is much, much greater than market demand?

Used correctly, inflation and increased government spending are useful tools in a recession. Increase the money supply and lower interest rates and, bingo, lending goes up and the economy gets a jolt. Use the government’s money to put people to work and, bingo, spending goes up, the economy gets a jolt.

The downside, of course, is the resultant decline in the value of a dollar.

And the amount of money available is enough to trigger hyperinflation, which, as you can probably guess, is just like inflation except worse.

As I said, a few have established hedge funds betting on hyperinflation, which seems a little too pessimistic, even for me. Still, the Fed didn’t have much of a choice. The alternative, to let the markets figure it out themselves, would have almost certainly led to a depression to rival the first. In fact, the lack of government intervention is one of the primary reasons the Great Depression came about in the first place.

Fed chief Ben Bernanke, a student of the Great Depression, knew that if the government didn’t start a massive infusion of cash into the marketplace, the entire system would fall apart.

But now comes the tricky part: pulling that cash back into Fed coffers before it gets loose and sends the system careening out of control again, this time in the other direction.

But history — in fact, pre-Depression history — has left Bernanke another road map to follow, even if it’s a good example of what not to do.

After World War I, when Germany was saddled with debt it couldn’t pay, its central bank started printing money.

Within a matter of months, goods shot to stratospheric levels. In the time it took to enjoy a cup of coffee, the price of the cup doubled. Restaurant waiters had to reset prices on menus several times a day. Workers were given a half-hour after they were paid — in thousands upon thousands in currency notes, which they carted around in wheelbarrows — so they could spend the money before it became worthless.

As Liaquat Ahamed wrote in his excellent book “Lords of Finance,” it was “the single greatest destruction of monetary value in human history.”

Bernanke believes he can wind up that money before it does too much damage. And for the time being, I’m keeping my money on him.

Contact Business Editor Annette LaCross at alacross@rrstar.com or 815-987-1295.

Entry Filed under: Federal Reserve, inflation, recession