The Magazine

Putting the Toothpaste Back into the Tube

Federal Reserve chairman Ben Bernanke needs to spell out how he plans to head off hyperinflation.

Apr 27, 2009, Vol. 14, No. 30 • By ANDY KESSLER
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A shadow banking system--Lehman, Bear Stearns, Merrill Lynch--was borrowing short-term in money markets at, say 2 percent, and instead of the classic 10:1 leverage of banks, they were levering up 30:1, sometimes 50:1, creating money out of thin air well beyond the intention of the Federal Reserve. It didn't show up in prices, mainly because of a huge and productive tech sector as well as the waves of cheap Chinese laborers who were providing cheap shoes and toys and furniture to Wal-Mart, "hiding" the over-creation of money. But it did create a shadow economy of home builders, linoleum layers, decorators, Home Depot Expo salesfolks, and on and on.

And that was shadow wealth. The only real wealth is wealth that is productively created. The rest is just paper. After the collapse of the banking system, sunny and shadow, hoarding became the order of the day. The world rushed into U.S. Treasuries. Short-term rates as a result are almost zero. The dollar has been a safe harbor, jumping versus the euro and the yen. No one wants to spend money, on houses, on cars, or even, gasp, on big screen TVs. So the velocity of money has shrunk. To what? Well, no one really knows.

So to make up for lower velocity, to keep the economy from shrinking like a raisin, the Fed has been increasing the monetary base to increase the amount of money in circulation. But it's hard. Even with TARP funds, banks don't want to lend, so their 10:1 increase of Fed money isn't happening, let alone 50:1 Bear Stearns-style money creation. Bernanke has therefore been buying U.S. Treasuries, with cash, to increase the money supply. Which is pretty funny since he is also selling U.S. Treasuries out the back door to fund the $787 billion stimulus package and the $1.3 trillion Obama budget deficit.

The Fed can put all the cash it wants or thinks it needs into the economy, but someday, maybe soon, maybe in a year or two, the economy will start growing again. People will stop hoarding dollars. Their 2004 Taurus will be looking a little old. Baby needs a new pair of shoes. Banks will start lending again to businesses and maybe even to home buyers. As money starts getting spent, all that money's velocity starts increasing. Oops, there goes the price level. With so much money floating around, chasing too few goods, inflation is a-comin'. The Fed will have to start pulling all that extra money off the street and back into its vaults. And in just the right amount.

But how? Doing the opposite of what it is doing now. By raising interest rates. By sopping up dollars by not only selling Treasuries, but also selling all those mortgage-backed securities and other toxic stuff bought from Bear Stearns, AIG, Fannie and Freddie, and everyone else. By removing all the backstops it put in for the commercial paper and other markets to keep them functioning. But won't that have the effect of slowing the economy? Sure will. This is a tightrope act. Getting all that toothpaste back into the tube will require the skills of a surgeon and the moxie of a middle linebacker, and someone deaf, dumb, and blind to congressional meddling. And worse, this is something that has never been done before.

My suggestion: Lay out a blueprint for pulling the money back in. Tell Wall Street and Main Street exactly what you are going to do, and when and how your plan will be triggered. When economic activity rises by 2 percent, you are going to increase interest rates by 1 percent and "retire" another $500 billion. That will stop second guessing and congressional quibbling. And I'd get it out quickly, this summer. It's hard to keep a good economy down, especially with 50 billion extra Andrew Jacksons sloshing around the bucket.

Andy Kessler is a former hedge fund manager turned author who writes on technology and markets. His most recent book is
The End of Medicine (Collins).