Today I’d like you to welcome Dr. Duru from Drduru.com. I’ve known the good Dr. for a while now and spending time on his site has really given me a great perspective on the markets. I contacted him and asked him if I could use his article from a few months ago as it’s very timely. Please enjoy!

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I originally wrote this two months ago, but I believe it is worth repeating in light of the Fed’s historic actions on Tuesday.

“…the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation…If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.” – Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C. on November 21, 2002: “Deflation: Making Sure “It” Doesn’t Happen Here.”

We should find it odd that we are in a deflationary-style panic when our Federal Reserve has a chairman in Ben Bernanke who is absolutely committed to printing as much money as it takes to prevent deflation. Then again, our Treasury has a leader in Hank Paulson who is a former CEO of Goldman Sachs…and that did not prevent the investment banking universe from completely blowing up.

An old high school friend of mine pointed me back to Bernanke’s famous remarks from 2002 (thanks, Mitja!). It made for a fascinating read given the current financial crisis. (I am embarrassed to admit that I always thought Bernanke was the originator of the concept of dropping dollars from a helicopter, but it was actually economist Milton Friedman. Bernanke referred to Friedman’s helicopter in this speech). In this 2002 speech, Bernanke explored several novel academic ideas that he now has a chance to test out in real time. Many of the creative ideas that the Federal Reserve has cooked up to battle our financial crisis seem to have had their genesis in Bernanke’s scholarly endeavors. Bernanke could never have guessed what was in store when he warned his audience that “I should emphasize that my comments on this topic are necessarily speculative, as the modern Federal Reserve has never faced this situation nor has it pre-committed itself formally to any specific course of action should deflation arise.”

Bernanke’s hypothetical exploration was focused on the tools the Federal Reserve might wield when reducing the target for the federal funds rate to 0% failed to arrest a deflationary spiral. I think it is fair to say that the Federal Reserve is currently stretching policy remedies as far as they can go BEFORE being forced to drop interest rates this low. To date, dramatic rate cuts have only served as temporary and fleeting relief with no imminent prospect for solving the fundamental problems of a crisis in confidence. Soon after Bear Stearns failed, I am sure the Fed realized that rate cuts had become largely ineffective. Indeed, over the course of the last three scheduled Fed meetings, rates were held at 2% even as the credit markets continued to deteriorate. Last week’s globally coordinated rate cut signals that the U.S. will not slip down the path to 0% interest rates alone. True to form, this unprecedented move did nothing to relieve the system’s stress. The S&P 500 has so far fallen another 10% since then and credit markets have continued to worsen. At this point, I have to wonder whether the central bank authorities will even bother pushing rates all the way to zero.

What makes the current crisis so particularly difficult for the Fed is that some of the basic requirements of a functioning economy have been wiped away. Back in 2002, Bernanke noted that even after the deflationary shock of the burst tech bubble and 9/11, the fundamentals of the economy remained sound: “A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape. A healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks.” It of course turns out that the regulatory regime was NOT sufficient. Bernanke went on to note that “The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly.” Needless to say, the Federal Reserve is now struggling to keep up with the pace of change in financial conditions. The Fed has had to stretch and creatively interpret its legal powers in a desperate effort to keep up.

The Treasury has also joined the Fed in this mad dash, jumping from one proposal to the next. The latest switch features Paulson coming around to the idea of buying stakes in banks and putting the $700 billion “Troubled Asset Relief Program” on hold. This represents a complete turn-around from Paulson’s earlier comments to the Senate Banking Committee on Sept. 23, 2008: “Some said we should just stick capital in the banks, take preferred stock in the banks. That’s what you do when you have failure. This is about success” (from the New York Times).

So, we face a lethal combination of never having experienced anything quite like the current financial crisis along with agents of governance who have been forced to make up rules and create solutions on the fly as we descend rapidly. Add to this wicked brew an intricate web of volatile global dependencies. We should not be surprised that the crisis of confidence remains so deeply entrenched.

Someday, we will achieve financial stabilization. When we get that relief, we will finally be able to focus on the future, a future in which we reconstruct our financial systems to prevent this kind of disaster from ever happening again. Perhaps we can even think through how to prevent the creative geniuses of financial engineering from dreaming up new pending disasters. In 2002, Bernanke recognized that the best approach to dealing with deflation is not allowing it to happen in the first place: “The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending, in a manner as nearly consistent as possible with full utilization of economic resources and low and stable inflation. In other words, the best way to get out of trouble is not to get into it in the first place.” Today, this statement almost sounds naive given the tsunami of events that have overwhelmed our financial watchdogs. Today’s basic prescription of prevention would have been to stop the growing bubbles in credit and in housing before their inevitable collapse triggered a perilous deflationary spiral.

Unfortunately, Bernanke’s predecessor, Alan Greenspan, absolutely refused to acknowledge definitively that a housing bubble existed. By the time he expressed any concern, the housing bubble had already reached breathtaking levels of madness. Greenspan was also a big fan of complex derivatives and debt securitization because they supposedly were so effective in spreading risk around. Instead, they have been very effective in spreading the contagion of panic and collapse. Greenspan has recently tried to defend his legacy, and I have written critically of his defense. One of Greenspan’s fundamental problems is that he under-appreciated just how extreme the bubble mentality can get. In an interview with the Financial Times, he admits that financial modeling has failed to account for “…the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve.” (This suggests that future generations will learn little from the fall-out of our latest bubbles just as this generation has learned precious little from past bubbles!)

Most importantly, Greenspan has long argued that there is nothing the Fed can or should do even if it could recognize a bubble. He repeated this claim in his interview with the Financial Times: “But if, as I strongly suspect, periods of euphoria are very difficult to suppress as they build, they will not collapse until the speculative fever breaks on its own.” This philosophy may finally be changing. Back in May, the Wall street Journal reported that Bernanke has started research into methods for preventing bubbles. Until some solution is found, the main tool at the Federal Reserve’s disposal will be to print as much currency as it takes to smooth over the pain from the collapse of bubbles…and thus sow the seeds of the next financial calamity.

I am not sure what magic moment will finally pull us out of this financial downward spiral. But I can look ahead to that day when we achieve stabilization in the financial markets and recognize all the massive amounts of liquidity sloshing through the system. Will the planet’s central banks be able to withdraw these supports in time to avert massive inflation? I doubt it. I am skeptical because no one will be sure when the crisis is absolutely over. Caution will rule the day and supports will stay in place far longer than necessary just to make sure no risk remains of falling backward. By then, a lot of clever people will already be far down the path of devising new ways to put excess credit and liquidity to work. So, looking further (into an unknowable timetable), I want to be positioned for a day of surging reflation, and perhaps even rampant inflation. Famed commodity bull Jim Rogers suggested something similar when he made “inflammatory” remarks about future inflation risks on CNBC International on Thursday night (click here to watch). America is committed to printing as much money as it takes to prevent deflation. I am willing to bet that there is enough paper and ink in the world to make it so.

Be careful out there!

By  Dr. Duru
December 18, 2008