Larry Kudlow

About 30 years ago, Paul Volcker launched a monumental monetary effort to bring down inflation. As Fed chairman, he sold bonds, removed cash from the economy and cared not one wit about rising interest rates. And it worked. Gold plunged, King Dollar soared, and the drop-off in bank reserves and money extinguished high inflation -- and actually launched a multi-decade period of very low inflation.

This week, current Fed chairman Ben Bernanke embarked on an absolute reversal of Volcker's policy. He is launching a monumental effort to buy bonds and inject new money into the economy in order to reignite economic growth and job creation. It's like history is repeating itself, but in reverse. Gold is soaring, the dollar is falling. Something's wrong with this picture.

Bernanke's QE3 is an unlimited Fed effort to buy mortgage bonds with new cash. The plan -- which starts immediately -- envisions $40 billion of bond purchases and money-creation per month, coming to $480 billion over the next year. And there are no limits to these purchases. These operations are open-ended. This could last for years -- maybe in perpetuity -- until job creation shoots way up and unemployment comes way down.

Nothing like this has ever been used by our nation's central bank. The Fed's balance sheet, which has ballooned from around $800 billion to $2.5 trillion under Bernanke, will go to $3 trillion, or $4 trillion, or who knows how high.

But here's the rub: More money doesn't necessarily mean more growth. More Fed money won't increase after-tax rewards for risk, entrepreneurship, business hiring and hard work. Keeping more of what you earn after-tax is the true spark of economic growth. Not the Fed.

In the supply-side model, the combination of lower marginal tax rates, lighter regulation and a downsized government in relation to the economy is the growth-igniter. Money, on the other hand, determines the value of the dollar exchange rate and subsequently the overall inflation rate. A falling dollar (1970s) generates higher inflation; a rising dollar (1980s and beyond) generates lower inflation.

This is the supply-side model as advanced by Nobelist Robert Mundell and his colleague Arthur Laffer. In summary, easier taxes and tighter money are the optimal growth solution. But what we have now are higher taxes and easier money. A bad combination.

The Fed has created all this money in the last couple of years. But it hasn't worked: $1.6 trillion of excess bank reserves are still sitting idle at the Fed. No use. No risk. Virtually no loans. And the Fed is enabling massive deficit spending by the White House and Treasury.


Larry Kudlow

Lawrence Kudlow is host of CNBC’s “The Kudlow Report,” which airs nightly from 7 p.m. to 8 p.m.