This column went on record before President George W. Bush’s selection of Ben Bernanke as Fed Chairman and said that of all the likely candidates, he would be the worst. In the next decade, that judgement was miserably justified. Now President Trump has avoided the funny-money favorite Rick Rieder of BlackRock and instead appointed Kevin Warsh, the most monetarily conservative candidate, with a long and impeccable record of monetary policy probity. Yet Trump has not changed his views; he is even more a fan of “funny-money” Keynesian policies of negative real interest rates than were Presidents Bush and Obama. So, can Warsh’s new justification for lower rates, used to make him attractive to Trump, possibly work, or will he be dragged into the Bernankeist pit that Trump favors?

Ben Bernanke (Fed Chairman, 2006-14) put three policies in place that have bedeviled U.S. monetary policy ever since. First, he began the policy of quantitative easing “QE”, that exploded the Fed’s balance sheet to a peak of $9 trillion from around $800 billion in 2007-08. After years of tepid efforts at “quantitative tightening” those policies have left it at $6.6 trillion, and expanding rather than contracting as Fed Chairman Jerome Powell has reinstituted a QE program.

Second, Bernanke in 2008 dropped short-term interest rates to zero, where they had never stood before, and kept them there or thereabouts throughout his term of office, as did his successor Janet Yellen (2014-18). In consequence, since the U.S. inflation rate remained positive throughout, real interest rates were negative throughout the 2010s, long after the worst of the recession was past.

Third, in 2012, Bernanke instituted a Fed inflation target of 2%, claiming on the evidence of 1930-33 but ignoring that of 1873-96, that deflation was uniquely economically damaging. He had some precedents for doing this – New Zealand’s Fiscal Responsibility Act of 1994 was the first to set such a target, although it mandated the Reserve Bank Governor receive pay rises of 2% minus inflation, which effectively set the inflation target at 1%, since the Governor did not want to become steadily poorer! In any case, as this column has remarked, Bernanke’s 2% target for U.S. inflation was directly contrary to the Humphrey-Hawkins Act of 1978 governing the Fed, which mandated that the Fed pursue price stability, which by definition means a zero inflation target over the long run. Whether or not the Fed hits that long-term average, it must pursue it.

Bernanke’s policies have proved enormously damaging to the U.S. economy in three ways, and that damage is mostly still continuing. His zero interest rates policy, making real rates negative, made unproductive real estate investment irresistibly attractive and produced such excrescences as New York’s “pencil towers,” residential structures of huge height, ultra-thin footprint and shoddy construction, that you could not pay me to live in – it has also by diverting capital to such rubbish suppressed productive investment. As Austrian economic theory sternly mandates, this superfluous “malinvestment” must be demolished before the economy can regain full health. The only saving grace is that since the inflation spurt of 2022, the Fed has kept interest rates above the inflation rate, so this damaging Bernanke policy is not currently wreaking further havoc, although if Trump gets his wish of 1% interest rates without a reduction in inflation, it will start laying waste to the economy again.

Bernanke’s policy of buying Treasuries and housing agency bonds in large quantities through QE has left the Fed with large running losses and $240 billion in negative capital, as the bond investments were made at the foolish artificially low interest rates of 2010-21. While the recent declines in interest rates have brought the running loss close to break-even, there is no plan to eliminate the accrued deficit.

More important, this policy has subsidized government budget deficits since 2010, resulting in the Federal deficit rising to around $2 trillion per annum. It also appears to have suppressed productivity growth in the economy as a whole, as unproductive (government) or fairly unproductive (mortgage debts) assets are given special treatment. Finally, it has allowed the banks to make around $2.9 trillion of interest-bearing Fed deposits (to fund the Fed’s portfolio) which yield them a wholly unearned profit and block their balance sheets from lending to small business, their proper economic function. The current “QE” policy must be reversed forthwith, the “quantitative tightening” policy of selling bonds and shrinking the Fed’s balance sheet resumed and the rate paid to banks on deposits with the Fed reduced to no more than 1%, thereby stimulating the banks to do something more useful with the money and allowing the Fed to make a modest profit and pay down its capital deficit.

It is however Bernanke’s third policy, the 2% inflation target, that has done most damage of all his policies, yet this policy would be easiest for Warsh to reverse. With an inflation target of 2%, which experience has shown is frequently missed, nominal interest rates must be around 5% for a neutral Fed policy, making real estate and long-term asset financing very expensive in cash-flow terms as well as increasing the cost of government debt. If Warsh were to reduce the inflation target to zero immediately, and put his credibility behind that move, interest rates would move within a period of 18-24 months to the level consistent with zero inflation, in other words in today’s market below 3% for long-term government bonds (long-term TIPS with inflation protection currently pay 2.6%). That policy will make yields decline, so creating a bull market of rising prices in long-term bonds, making it easier for Warsh to run down the Fed’s bond holdings rapidly, because the rising bond prices will attract buyers. President Trump will then be happy, the U.S. economy will be far healthier and more balanced, and ordinary people will be able to save for retirement in the secure knowledge that inflation will not erode their savings.

Apart from moving the inflation target to zero, which he can do easily, we know that Warsh has been very critical of the QE programs. Indeed his resignation as a Fed Governor in 2011 was partly caused by disagreement on this policy. He will therefore want to reduce the Fed’s balance sheet, through a program of QT. The problem with this is that the Federal Budget deficit is still so bloated that QT might cause a crisis in the markets (or might be engineered by the big banks to do so, a repeat of the same trick the Bank of England used against Liz Truss in 2022).

It all comes down, therefore, to productivity growth. If Warsh is right in seeing a sustained period ahead of 4-5% per annum productivity growth, then his problems solve themselves. The productivity growth produces output growth without inflation, extra revenue pours into the Treasury, and the Budget deficit shrinks as if by magic (provided Trump and Congress restrain themselves – no new programs or random giveaways, however tempting they may be)!

There is certainly a productivity boost coming; indeed it is already here in 2nd quarter and 3rd quarter figures – 4.9% in the 3rd quarter. You would expect that. Trump has already removed many of the Biden administration’s stupidest regulations, while returning to producing coal, oil and gas rather than windmills will increase productivity growth further, as well as relieving everybody’s electricity bills. The question is how long the productivity boost will last, and whether productivity growth will remain close to its current level of nearly 5%. AI may help in the long run, but it would be foolish to rely on that. Warsh at least needs a plan for policy if the productivity growth boost is not quite enough to solve all problems.

Since Warsh has promised Trump to avoid higher rates, and he knows the inflationary problems of reducing rates without a productivity “miracle,” his only solution will be for Congress and the Trump administration to get their act together and make substantial real cuts in the budget deficit. Tariffs help substantially (provided the Supreme Court is not so idiotic as to invalidate them) but the yield from tariffs cannot be more than about $400 billion a year. To get the Budget deficit down to $1 trillion, from which increased economic growth can reduce it to zero, another $600 billion in annual savings must be found. Trump may find this boring, and the Congressional Republicans may have got used to making no significant effort to cut spending, but the effort must be made. Warsh must exhort them and keep exhorting them. If they want ideas on how to proceed, they should ask Newt Gingrich. He made the necessary cuts, in 1995-99, before the sloppy leftist globalists of the George W. Bush administration combined with the pork-loving Speakership of Dennis Hastert to reverse Gingrich’s achievement.

Fiscal as well as monetary probity are needed. If Warsh can provide the latter and encourage Trump and Congress to make a better attempt than they have been making so far on the former, the United States’ problems will be solved, and Warsh will go down in history as a great Fed Chairman, worthy to rank with Paul Volcker and Bank of England Governor Montagu Norman.

But he must start with making zero the inflation target. On that all else depends!

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)