In quest for jobs, Fed chair Bernanke's money spigot hurts economy in long run

The Bureau of Labor Statistics reported today that the US unemployment rate fell to 7.8 percent, but job growth remains sluggish. (The economy only added 114,000 new jobs last month.) The Federal Reserve has been trying to remedy this slow growth, but its policies may be doing more harm than good in the long-run.

“We want to see more jobs.” With that statement last month, Federal Reserve Chairman Ben Bernanke launched yet another round of “quantitative easing” (QE3) – a program of pumping new money into the financial system with the aim of driving down interest rates and incentivizing businesses to grow and hire.

The move is not surprising. In his extensive writing on the failures of the Fed during the Great Depression, Mr. Bernanke criticizes it for increasing interest rates in the mid-1930s – triggering a recession just as the economy was beginning to recover. If we were in the same pickle today, one could defend the Fed’s efforts to keep rates artificially low. However, the current financial crisis is quite different.

High interest rates played a significant role in laying the groundwork for the Great Depression. As such, efforts to lower them may have mitigated the hit our economy took in the ‘30s. When our recent crisis hit, however, interest rates were already artificially low. Further lowering them only exacerbates the risk of triggering capital flight.

Capital flight occurs when investors en masse pull their assets out of a country due to diminished confidence in its financial system. Historically, the phenomenon was mostly limited to emerging economies, as witnessed in Asia and Latin America during their financial crises over the past decades. The past several years, though, have seen massive capital flight from developed economies – including Southern European countries such as Spain and Greece – in the wake of speculation on devaluation of their currency.

As a result of quantitative easing, the value of US currency is at risk, and we, too, are no longer immune to capital flight. We haven’t hit the financial state of the euro zone, but the magnitude of our economic crisis is already unlike anything America has ever experienced. 

Some analysts estimate the central bank could print as much as $2 trillion to pay for this open-ended plan – more than doubling the amount of US currency currently in circulation. Such a flood of new money will likely drive down the value of the dollar relative to other currencies and assets.

The dollar has already weakened significantly against other currencies. During an earlier round of quantitative easing (QE2), when the Fed purchased $600 billion in bonds, the value of the dollar fell 18 percent compared to a market basket of currencies. In the months leading up to QE3, the dollar fell 6 percent. And with the Fed now set to pour $40 billion into our banking system every month for the foreseeable future, we can expect even greater devaluation.

The greatest risk to US financial markets stems from other countries’ willingness (or lack thereof) to continue to hold dollar reserves as the value depreciates. If those nations suspect that the US cannot maintain the strength of our currency, they will begin to drain assets from American banks – seeking safer havens for their wealth. That could entail trading US treasury bonds for perceived “safer” currencies such as those of New Zealand or Canada or even switching to an entirely different asset class such as gold or silver.

While there may not be any significant signs of capital flight yet, just look east. The Chinese are the largest, external holder of US debt. And they’re already heading down this path – dropping the share of their portfolio comprised of US dollar assets from 74 to 54 percent in the last five years. It may very well be a harbinger of what’s to come. 

Attempting to counter fears fanned by trends like this, Bernanke talks of a “soft landing” – a scenario in which the Fed is able to restrict the money supply and increase interest rates before its policy’s pressures lead to chronic or hyper-inflation. However, that outcome is not likely given the sharp increase in the price of gold and other commodities. One strategist predicts a 36 percent increase in the price of gold to $2,400 an ounce by the end of 2014. Credit markets are also signaling a difficult outcome for QE3. Just this month, Eagan-Jones downgraded US debt from AA to AA-, citing the Fed policies to stimulate the economy.

The Fed’s essential argument for these policies is that “cheaper money” (aka lower rates) will encourage businesses to take out loans and then use that capital to hire more workers and invest in new projects. It’s an attempt to jumpstart the economy.

With these policies in place though, the long run prospects for the US economy are not promising. The outcome is likely to be a 1970s-style economy in which a rapid expansion of the money supply is accompanied by high inflation and unemployment, and slower economic growth.

These are some of the factors at play in the Fraser Institute’s recent revelation that America’s global standing in terms of economic freedom has fallen from 2nd to 18th in the last decade. “When governments finance their expenditures by creating money, in effect, they are expropriating the property and violating the economic freedom of their citizens,” according to the study’s authors.

As Milton Friedman explained, “inflation is caused by too much money chasing after too few goods.” And as the Fed continues its monetary easing, that chase will also drive off capital as well as the employment it could create. The Fed should revert to the single mission envisioned with its conception in 1913: long run price-stability. It can achieve this by implementing less, not more interventionist policy.

If Mr. Bernanke truly wants to see more jobs, he needs to ease up on the easing.

Barry W. Poulson is professor emeritus of economics at the University of Colorado, Boulder. He is also past president of the North American Economics and Finance Association, an adjunct scholar of the Heritage Foundation, and a senior fellow of the Independence Institute.