A lack of Confidence
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Imagine the following scenario. Unemployment remains stubbornly high as the Chairman of the Federal Reserve enters the Oval Office. The President urges the Chairman to pump more money into the economy to stimulate economic growth before his reelection bid. The Chairman responds: “In my view, the monetary authority has laid the foundation for recovery. What is holding back the economy now is not any shortage of money, but a shortage of confidence. If we flooded the banks even more than we have, I think you could have awful problems in XXXX and beyond.”

Is the above scenario fact or fiction?

Multiple choice question:

XXXX refers to which year? a) 1931 b) 1972 c) 2012 d) none of the above; this conversation never occurred as the Fed is an independent agency operating without presidential interference.

The scenario is fact, and the correct answer is b). The quote comes from a secretly taped verbatim conversation between then Chair of the Fed, Arthur Burns, and President Richard Nixon. Burns eventually caved in to Nixon’s pressuring and was proven quite correct in predicting “awful problems in 1972 and beyond.” The decade of the 1970’s turned out to be our most inflationary decade of the past one-hundred years. It took three recessions and an unemployment rate exceeding 10 percent for nearly a year to beat back inflation.

But 2012 would have been a good guess. In fact, the Bernanke-Obama response to recession has much in common with the Burns-Nixon response with two notable differences. Bernanke has been much more aggressive in flooding the banks, and the banks have been much more determined in refusing to lend the money out. Burns flooded the banks with $5 billion in new reserves from the beginning of 1969 through 1972; Bernanke flooded the banks with over $750 billion in new reserves from the beginning of 2009 through 2012. Even after adjusting for differences in the size of the economy and price levels in these two periods, Bernanke outdoes Burns in flooding the banks by a factor of ten-to-one! The Fed did not stop there, however. It continues to flood the banks, increasing bank reserves by approximately $500 billion since December 1, 2012, under its program of quantitative easing.

So are we to suffer even more awful problems than resulted from the Burns-Nixon flood? The answer depends on the Fed and how it handles things when banks regain their confidence and start unloading the nearly $2 trillion in excess reserves they now hold. If the Fed fails to “back-peddle” successfully, inflation appears all-but-inevitable. What seems to be holding back the economy now, as in Nixon’s time, is not any shortage of money but a shortage of confidence. Stay tuned.