Comments on Bernanke Speech
Jude Wanniski
April 18, 2005


From: Ben.S.Bernanke@***.gov
Subject: Re: Comments on Bernanke speech
To: Jude Wanniski < >


From: Ben S. Bernanke, 3:50 pm, 4/18/2005
Thanks.  I understand the main points, which tie back to the issues of monetary policy we have discussed before.  One or two comments:

 By "working to create the conditions" for capital flows to developing countries, I am referring to things like improved corporate governance and property rights, not monetary and fiscal policy.

The cad does increase US investment, because it allows us to draw from the savings of foreigners.  Nobody is suggesting that we restrict capital mobility.  That said, if Americans saved more and thus were able to own a bigger portion of new US capital, that would probably be a good thing all else equal.

Finally, several concepts need to be sharply distinguished:

1) saving = income minus consumption, in the case of a country, GDP - private consumption - government consumption.   A flow concept. Importantly, saving is not the change in total wealth, because the latter includes revaluations or capital gains.

2)  investment = new capital formation (including housing construction) --- not the acquisition of stocks or other financial investments

3)  "inflow of dollars" --- my speech is about the flow of saving, not changes in the money supply.  Current account deficits have no particular implications for the money supply under current arrangements (they would, of course, under a gold standard, in which specie flows would correspond to deficits).

I just note that some of the attached comments do not distinguish the concepts above, which are just definitions, as cleanly as they should.  I think that accounts for a bit of the misunderstanding.  Otherwise, as I say, I understand the general point of view.



From: Jude Wanniski  <
To:   Ben.Bernanke@* * * *.gov         
Subject: Comments on Bernanke speech         
04/18/2005 04:26 PM                                                            
Dear Ben:

This is from our West Coast rep, Wayne Jett, who I think I've sent you before. Again, it is friendly constructive criticism you are not likely to get from other perspectives, and it may help you add to your bag of tools.


Responses to Ben Bernankeís Email:

Wonderful to have this opportunity for dialogue. The short answer is that stability in the dollarís value would answer fully or make irrelevant each and every one of the concerns expressed. Thus, the prompt resolution of these concerns would be to proceed directly towards achieving the dollar stability, rather than going round-about through the maze of issues that arise in attempting to combat price instability with a dollar whose value changes from moment-to-moment. On the various issues/commentaries:

(1) The concerns for a varying supply of gold and choice of the correct equilibrium value for the dollar are adequately addressed through the mechanism for maintaining the dollar's value by using the market as the guide to the number of dollars needed to keep the dollar-denominated price of gold stable. The variations in supply and demand for gold are very minor in relation to the swings in value of the dollar during any interval since 1971, so exchanging the latter for the former would be a great gain in currency stability. Of course, the logic of this statement is dependent upon acceptance of the premise that the price of gold is a measure of the currency value, not a gauge of supply/demand variation. That is the crux of our interpretation of the gold signal.

With this in full view, now is an appropriate time to note that the gold price (as dollar value gauge) has definitely NOT been stable in recent years. At least, the gold price has not been stable in the sense that a currency must be stable. The reason classical economics does not propose pork bellies or corn as the standard for the dollar is because those commodities swing so widely in supply/demand and price that neither would be satisfactory as a currency standard. In the last year, the gold price has varied within the range of $375 to $455, in the past two years the price is up from $330, and in the past five years up from $255. Considering the available alternative (and the benefits) of having the price of gold at $350 or at $380 or $400 throughout that time, this is not praiseworthy performance by the Fed.

(2) When the gold price target is administered through balance sheet management, adding or withdrawing liquidity to achieve the target price, no inflationary pressure occurs. So interest rate management is neither needed nor desirable as a tool of monetary policy. The fact remains that no interest rate, not the fed funds rate or the discount rate, can be shown to be a controlling or even proportional variable in the value of the dollar. The discount rate may be a useful tool in regulating conduct of banking relationships, but the dollar's value should not be changed in any event as an aspect of banking regulation.

(3) Interest rate targets and money quantity targets have been tried by the Fed since 1971, with a few short periods of limited success and repeated highly damaging episodes. Why not try targeting a price of gold for once? Such a trial would be very simple to adopt and simple to implement. The benefits would be substantial and instantaneous. The world, not just the U.S., would benefit greatly and would flock to the dollar. By contrast, interest rate "tools" are more tedious than pushing a string or herding cats. Worse, they simply cannot produce dollar stability. Money quantities are catastrophically worse, because they really do involve the Fed in managing liquidity directly, yet with entirely inadequate methods of measuring the quantities of currency needed as they change from moment-to-moment. Yes, interest rate targets and money quantity targets make the Fed look very busy, but they also make the Fed look very bad, particularly in the eyes of other central banks that view the dollar's volatility at their peril.

Here is the way Governor Bernanke describes the open market operations necessary for targeting the funds rate in his Dayton speech:

The funds rate is a market rate, not an administered rate set by fiat--that is, the funds rate is the rate needed to achieve equality between the demand for and the supply of reserves held at the Fed. As I have already discussed, the demand for reserve balances arises both because banks must hold required reserves and because reserve balances are useful for facilitating transactions. Because of the scale of and volatility in daily payments flows, the demand for reserve balances can vary substantially from one day to the next.

The supply of reserve balances is largely determined by the Federal Reserve--at the operational level, by the specialists at the Federal Reserve's Open Market Desk, located in the Federal Reserve Bank of New York in the New York financial district. For example, to increase the supply of reserves, the Open Market Desk purchases securities (usually government securities) on the open market, crediting the seller with an increase in reserve balances on deposit at the Fed in the amount of the purchase.9 Thus, a purchase of a billion dollars' worth of securities by the Open Market Desk increases the supply of funds available to lend in the fed funds market by the same amount. Similarly, sales of securities from the Fed's financial portfolio result in debits against the accounts of commercial banks with the Fed and thus serve to drain reserve balances from the system.10 Collectively, these transactions are called open-market operations.

Since the Fed is engaging in these operations already, but directing them towards achieving an interest rate target that has shown itself to be unavailing in stabilizing the dollar's value, why not utilize operations of the same nature directed specifically towards achieving the dollar value desired? The current operations are described as if designed entirely with the overnight reserve borrowing of banks in mind. Yet the decisions taken to add or remove liquidity are affecting the dollar's value directly, and thereby affecting economies worldwide, sometimes with dire outcomes.

(4) Under the practices described in Dayton, the FOMC provides additional liquidity by buying Treasury securities from member banks if more funds are needed for overnight bank reserves, regardless of whether the dollar is falling or gaining in value. It is the amount of liquidity provided at the margin, not the interest rate applicable, that determines the unit value of the currency. This illustrates why the dollar's value so frequently moves at variance to the Fed's stated intentions. Simultaneously, we see that interest rates along the yield curve do not move in step with the short-end target. This may well be because liquidity management operations to achieve the short-end target are entirely at odds with the Fed's wishes for the dollar's stability and, thus, for the manner in which those holding it for various terms must value it.

(5)  As the market adjusts the costs of funds along the yield curve, responding to liquidity operations designed to satisfy bank reserve needs at a particular funds rate, the Fed acts against economic activity in counter-productive ways that do nothing to stabilize the dollar's value (or, therefore, prices). Wage increases really do not cause inflation; they are either pure reflections of supply/demand and productivity, or they are responses to inflation occurring as a monetary phenomenon. The harm to the economy is unnecessary and extraneous to the aim of achieving dollar stability. Certainly there are fluctuations day-to-day in demand for dollars, and thus in excess liquidity. But that is why the gold price target mechanism is uniquely and perfectly suited to making the timely adjustments in liquidity necessary for sound and stable currency.

Jude, I'll leave my comments at that and will look forward to whatever response you choose to make. Thanks again for sending the exchange. WJ