Most hard money advocates understand that the artificial increase of money and credit is inflationary.  So when Ben Bernanke increased the money supply by over a trillion dollars and the government increased the budget deficit from a half trillion to over 4 times that figure in one year, most fiscal conservatives and fed watchers yelled "inflation".  I was one of them. 

Last week in testimony before Congress Bernanke was questioned on this very point by Congressman Ron Paul.  The exchange was instructive.  Ron Paul cited these massive increases of spending and money and credit creation. He questioned if interest rates went up substantially, whether the fed would have the will to contract the money supply and allow the economy to fall into recession.

Bernanke's response was, in effect, that if it came to a choice between defending the currency and preventing a recession, the currency was their number one priority.  He delineated the tools the fed had at their disposal to accomplish this.  And he reiterated his position that the moves were both necessary to prevent structural damage to the nations monetary system --and temporary.

I do not believe that Bernanke is an evil man.  Nor do I believe he is stupid.  I think he knows everything we know about the threat of inflation and agrees with this very real potential threat that Ron Paul was pointing out.  I also believe he has thought through how he intends to combat progressive inflation.  His strategy, I believe, is to re-inflate enough to preserve the monetary system and prevent deflation from taking hold, but not enough to cause an institutionalized inflationary problem.

There is a difference between inflation and progressive inflation.  Inflation, which is the artificial increase of money and credit, dilutes all other dollar claims outstanding.  It is a tax.  It applies whether prices are rising or falling.  (See "The Penalty" under "other articles by Paul Nathan" on this page).  The initial increase affects prices, interest rates, production, and investment decisions, throughout the economy, and distorts the market process along the way.

But, once the new money has worked its way through the economy the market adjusts to the new set of conditions and the affects stop there.  A tax has been levied, distortions occurred, but as long as this is a one time only injection, the economy tends to adjust and return to normal.   The effects run their course and prices become stable again.

Progressive increases in the supply of money and credit is a very different story.  Progressive increases, which means going from 2% rates to 5% rates to 7% rates, ad infinitum,  create vast distortion leading to mal-investment, over-consumption, and the mis-allocation of resources.  If allowed to go on unchecked this leads to progressive increases in prices and interest rates.  At the end of this processes the monetary system explodes as it becomes impossible for the market to adjust.  (See my article on the "Crack-Up Boom" again, under "other articles").

At some point Ben Bernanke is going to be confronted with this choice.  If we take him at his word, he will allow interest rates to rise, if and when, the economy recovers.  He will allow the economy to turn down and perhaps go into another recession.  If I read him right, he will take whatever actions necessary to prevent systemic damage but that does not include preventing recession, nor does it included progressive inflation by the fed.  His focus is on the health of the financial system.  If and when the system stabilizes, then the chips can fall where they may.

Two problems arise with this strategy:  Will the administration allow him to do this?  Bernanke's term is up at the end of the year and he can be replaced.  The agenda of Barak Obama is not the agenda of Ben Bernanke.  The Obama Administrations 3.6 trillion dollar budget is intended to stimulate the economy, reduce unemployment, and change social priorities.  The trillion dollars supplied by the fed, attempts to replace the money lost to the banks and finance companies.  It is an attempt to prevent deflation and an implosion of the entire banking system.  Bernanke can not control Obama's fiscal policy, but he doesn't have to finance it.  Will Bernanke be allowed to "take away the punch bowl" as he said he would in testimony to Ron Paul?

And second, if prices rise will the fed attempt to withdraw the money it injected into the economy in order to return the inflation rate to a lower level as Ron Paul and many hard money advocates want?   Bernanke has said as much in testimony.  This, I believe could be a huge mistake.  There is an example of this in history that provides a valuable lesson.

During the first world war, England was on the Gold Standard.  It suspended gold convertibility and pursued policies of inflationary finance to finance the war.  After the war it tried to return to the Gold Standard by reducing the money supply and force the price level of the country back down to pre war levels.  It tried to fix the Pound in terms of gold at the previous price. The experiment failed miserably.  The Gold Standard got the blame as the nation was thrown into depression.  This mistake was responsible for England abandoning the Gold Standard which it had adhered to, more or less, since the 14th century.  In many things monetary, you can not go back.  I believe this is the case now.

I suggest that we reflect a little harder and keep an open mind as this experiment to re-inflate the economy unfolds.  Assumptions that an inflationary mess is inevitable may be premature.  A couple of clues that are usually reliable in foretelling future inflation are the price of gold and the value of the dollar.  The dollar and gold correctly forecast the disinflation and stability of the years 1980 through 2006.  Both were stable during this period, then moved violently at the end of 2006 signaling the commodity boom and the financial trouble of 2007 and 2008.  For the last year gold and the dollar have been stable again, telling us that neither deflation nor inflation was on the horizon.  And indeed it was not -- prices have ranged either side of zero since they stabilized.

The price of gold shot up 60 dollars on the day that Bernanke announced the fed would monetize the debt by buying long term bonds, but gold then re-evaluated the inflationary threat.  Since that day gold has leveled off again and the dollar has traded in a narrow range.  And interest rates have risen in the face of the feds announcement.

Just as the gold market has re-evaluated the inflationary threat, I think so should we.  Most hard money advocates are convinced that inflation, if not hyper-inflation, is inevitable.  I think this fear may be overstated.  If Bernanke makes this a one time injection of new money and credit; if he allows interest rates - eventually - to rise and fight inflation even at the cost of a double dip recession; then I think we can avoid a nasty bout of inflation.  And if he does not contract the money supply, but reduces the increase to normal levels; and if he allows the markets to adjust to it, then, I think we can avoid another more sever recession.

The best course of action, (and perhaps the only rational one we have) I believe, is to pay the penalties we must, and allow the economy to adjust.  Pay the inflation tax which might only be a one time 4 or 5% penalty; pay the interest rate penalty, which may mean having to endure 5 to 7% long term interest rates for a time; pay the higher tax bill which is coming on the local, state, and eventually the federal level; and pay the penalty of further recession if and when necessary.  And most importantly, endeavor to resume reasonable monetary growth as soon as possible and we should eventually return to a stable price level.  Economic activity will remain sub-normal, but that's just another penalty for our multi-trillion dollar expenditure.

In the months ahead we will test the will and wisdom of Mr. Bernanke to fight inflation and we will also test the political fortitude of President Obama to tolerate this fight in the face of rising interest rates.  It should be interesting.

Paul Nathan