The Bernanke Depression

When the history of the next economic crisis is written it will probably be blamed on Ben Bernanke (right), who has spent his life fighting the last war and is left wholly unprepared for the next one.

Bernanke is the new head of the Federal Reserve. He is also a student of the Great Depression. More specifically he's a student of economist Milton Friedman, who argues that the Fed caused the Great Depression by restricting the money supply.

Friedman is right. The trouble is that Bernanke learned the wrong lesson. It's the same lesson he says he learned from the Bank of Japan's failure to stop the 1987 panic there from turning into a decade-long (nearly two-decade long, actually) recession.

What he learned was when growth stalled print money. Take out the excess, "reform" the surviving banks, then reflate.  Aim for low, but real inflation.

The trouble is, that doesn't answer for what is happening. We don't have a shortage of liquidity. We have too much.

At the same time inflation is rising (due to higher energy prices) asset levels are falling (because the housing bubble is being pricked, and Americans are totally dependent on housing as a store of savings). The "virtuous cycle" of exporting our deficits in the form of dollars, then importing the bonds, can also become a "vicious circle" as asset values fall (as they must in a real estate bust).

Everything Bernanke has learned will tell him to maintain liquidity in the face of inflation. He won't raise interest rates to maintain asset values. He will see the housing crash as deflation, and in time lower rates. The result will be a collapse of the dollar.

The proper course of action would have been to warn people of the coming calamity, to talk down real estate prices, and to demand action on the deficits. In the face of the collapse, it's to do precisely what was done in 1930, because the cause is the opposite of what happened then.

Just as devotion to the 1815 Balance of Power resulted in World War I, so Bernanke's solution to the problems of 1929 will make the problems of 2007 worse.

Bernanke has already missed his chance to be useful. It will be up to the next Fed chairman, and the next generation of American political leaders, to rescue the dollar and rebuild the economy.

It will be a long, hard slog.