As I tell students in my Foundations of Economics class, our evaluation of the efficacy of various economic policies will only be as good as the economic theory we use to do the evaluation. If our theory is bad, that will lead to bad policy analysis.
This fact was also strikingly revealed in Ben Bernanke's remarks to the annual Economic Symposium in Jackson Hole, Wyoming I discussed yesterday. When discussing what the economy needs to achieve sustainable recovery and what the Fed can do to help the process along, Bernanke affirmed that the Fed would inflate as necessary to ward off falling prices. I have written many times about the negative economic consequences of such inflationary monetary policy.
As my students will often ask, if it is true that monetary inflation provides no social benefit, but actually stimulates capital consumption because of malinvestment undertaken during an inflationary boom, why would smart people like Ben Bernanke advocate such policy? Such policy advocacy is partly explained by the different economic framework used by Bernanke and his comrades in inflation.
In his speech to the Economic Symposium he revealed that he operates within a Keynesian/Monetarist world view. Now given the potted history of 20th Century economic thought, most people would say it is impossible to possess a world-view that is both Keynesian and Monetarist. After all were not Paul Samuelson and Milton Friedman always at odds with one another? Many times, perhaps, but not always.
As Jesus Huerta de Soto points out in his magisterial treatise Money, Bank Credit, and Economic Cycles, there are enough fundamental similarities between Keynesians and Monetarists to place them both in a single category he simply calls "Macroeconomists." These modern macroeconomists tend to ignore the influence of time in production, see the economy as a circular flow of goods rather than a complex structure of production, and focus on macroeconomic aggregates which prevents analysis of underlying microeconomic factors such as malinvestment. In this modern macro framework, economic downturns are understood as being due to insufficient aggregate demand resulting from exogenous causes such as pessimistic animal spirits, technological glitches, or monetary policy mistakes.
Keynes' plan A for maintaining full employment was to fully socialize credit markets, so that all saving and investment would be controlled by the state. Recognizing the political unpalatablilty of that plan, he recommended monetary inflation as his plan B. Inflation would lower interest rates and stimulate investment in production. Milton Friedman's views on the efficacy of inflation during recessions were similar. He said the Great Depression was due to the Fed's not being activist enough to restore liquidity and recommended inflation for Japan's 20-year "lost decade." Friedman's position was that the central bank had to maintain liquidity (i.e. inflate the money supply enough) to provide economic stability.
This is the mindset revealed by the remarks of Bernanke. Discussing the economic outlook Bernanke said "For a sustained expansion to take hold, growth in private final demand--notably, consumer spending and business fixed investment--must ultimately take the lead." He later adds net exports as a third source of aggregate demand.
The notion that aggregate demand drives the economy is one of the most troublesome popular economic fallacies. It tends to mistake money income with wealth as if money is what we eat, wear, and live in. In fact, more money might raise monetary incomes, but it will not necessarily make us more wealthy because more money does not equal more land, labor, or capital goods. Therefore more money does not generate more consumer goods. More money generates prices that are higher than they would be otherwise.
What is required for real recovery is a rebuilding of the capital stock, which requires saving and investment, and a reallocation of convertible capital out of unsound investments and into projects producing what people really want. Bernanke's policy of inflation will not accomplish this. The reason he persists with that policy, however, is because of his faulty economic framework. As the title of Richard Weaver's most famous book says, ideas have consequences.