“With conventional monetary policy having reached its limit, any further policy stimulus requires a different set of tools.” ~ Ben Bernanke, April 3.

I have this mental image of Bernanke and a dozen other Ph.D.-holding economists laboring over a car. Its hood is up. It is stalled at the side of the road. It is about an hour from Yuma, Arizona, the fan belt capital of the world. Bernanke has a tool kit next to him. It is filled with brand-new metric tools. He is working on a used Plymouth.

The problem is, the car they are working on is not their car. It’s ours.

In the good old days, the FED’s tool kit was simple: expand the monetary base, lower the federal funds rate at which banks lend to each other overnight, and issue a press release about the mandate for economic recovery.

It’s not working any more.

THE ULTIMATE TRAP

The FED has increased the monetary base to such an extent that there is now way to turn back without risking not merely a recession, which we are in, but a depression, which the FED has inflated to avoid.

This is clear to anyone who understands the Austrian theory of the business cycle. The FED has moved into panic mode. Yet it has been unsuccessful so far in stemming the tide of recession.

The Federal deficit is now out of control. When Congress consents to a $1.8 trillion deficit, it no longer exercises the power of the purse.

The FED will have to fund whatever the private markets will not fund, which now appears to be whatever foreign investors refuse to fund. They sold a quarter of a trillion dollars in Treasury debt in February and March. These debt certificates constituted an increase in supply on the capital markets. These unexpected sales would have raised Treasury interest rates had the FED not intervened to buy more Treasury debt.

The question of questions now is this. When banks at last decide that this economy is safe enough to lend into, the excess reserves that they hold at the FED will flow into the economy. This will put the FED’s balance sheet into play. The fractional reserve banking process will take over. M1 will increase by 100%. It will not be offset by a decline in the M1 money multiplier.

The fun will begin.

Bernanke understands this. He knows what will happen to the money supply unless the FED increases reserve requirements to offset the increase in the monetary base. The FED can do this, of course. But then it is back to square 1: the recession that its increased spending will have overcome will return.

He is in a lobster trap. He says he can get out.

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Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2009 Gary North