Bernanke's Unintended Consequences

The Federal Open Market Committee has "displayed exactly the required unconventionality in solving many seemingly intractable problems over the past three years," -- Narayana Kocherlakota, president of Federal Reserve Bank of Minneapolis, on Aug. 17

NEW YORK (TheStreet) -- In the 11th century, King Canute the Viking's courtiers claimed he was "so great, he could command the tides to go back." Sensing an opportunity to make a point, Canute had his throne carried to the seashore and commanded the waves to stop. When they didn't, he had made his point that the deeds of "great men" were nothing in the face of nature's power.

U.S. economic policymakers should learn the same lesson.

Federal Reserve Chairman Ben Bernanke appears quite confident that he has the right "policy tools" to predictably "fix" our $14 trillion economy. The Fed views the economy as an orderly machine -- as long as policymakers pull the right levers and push the right buttons, they will produce a predictable result. We wonder if the economy is subject to such precise control, or if these efforts are as arrogant as ordering the tide to stop. Instead of a machine to be manipulated, we see the economy as a living, unpredictable organism, fraught with unintended consequences.

Last spring, Fed governors confidently began to "pull levers and push buttons," taking actions intended to "fix" our economy by creating inflation. They sought to increase the money supply, injecting trillions of dollars into the banking system to create a new cycle of increasing credit. At first, the economy and stock market recovered, but by the spring of 2010, this initial "sugar high" began wearing off. The barometers of the economy's health began to deteriorate this summer, implying that maybe we need more than just easy access to cheap credit.

Unintended Consequences: The Fed has underestimated the "deleveraging" our economy is undergoing. Although flush with cheap sources of capital, lending has declined. Banks can't find creditworthy borrowers. Instead of making risky loans, they are re-depositing excess reserves back with the Fed, or purchasing Treasuries. Loan demand has deteriorated because consumers already feel over-indebted and are instead paying down debt. Credit and the money supply have been contracting, while the savings rate has been increasing.

Perhaps the Fed chairman should have taken a lesson from Japan. In 1990, Japan reached the end of a credit bubble and began to experience similar deflationary conditions. Japanese policymakers thought they had the right set of "tools" to manipulate their economy, but after 20 years of "stimulus" projects, and trillions of yen in monetary injections, Japan has suffered persistent deflation. The Japanese tried the same policies, but learned the hard lesson that deleveraging is like the tide -- a force of nature that cannot be redirected. We might have learned that policy-tinkering did nothing to stop the correction, but simply prolonged it.