In a
speech to the Economics Club in Washington,
Federal Reserve Bank chairman Ben Bernanke warned
Americans to save more and spend less to preserve
their standard of living for the long term. The
core of his message that Americans must improve
fiscal discipline and the quality of their
education is not new; his advice will be
applicable as long as the US has politicians and
schools. The speech is more striking for what was
not mentioned - namely the Fed's role in this
process.
We know that the retirement of
baby-boomers poses enormous
challenges. Bernanke
expressed the urgency of fiscal-policy reform
to pave the way for either greater government
revenues or lower expenses. It seems everybody
likes to talk about the need for greater savings,
but no politician wants to have it take place
while he is in office. The reason is simple: in
the short run, greater savings tend to come with
less spending - increased savings could signal a
recession.
Bernanke is not a lawmaker. As
Fed chairman, and in conjunction with the Federal
Reserve Board, he oversees US monetary policy.
Monetary policy should be primarily concerned with
preserving purchasing power by setting interest
rates and money-supply targets. And while not
mentioned in Bernanke's speech, the Fed has an
enormous influence over the spending and savings
habits of both consumers and government.
Overly accommodating monetary policy
pushed consumers into debt after the technology
bubble burst. Shortsighted fiscal policy has also
contributed to the poor state of the American
consumer ("lower taxes get more money into
consumers' pockets"), but the Fed has plenty of
its own housecleaning to do before scolding
politicians because they behave, well, like
politicians.
The right medicine to foster
savings and investments would be for the Fed to
tighten money supply through higher interest
rates, by imposing stricter lending standards and
directly reducing money supply through market
intervention. The Fed is best positioned to
encourage savings and investments and to put a
damper on consumption. Small cuts in consumption
now could prevent much more painful cuts in the
future.
Why doesn't the Fed prescribe this
medicine rather than passing the buck to Congress?
Because the US economy is too leveraged, too
interest-rate-sensitive. As US consumers nowadays
buy just about everything on credit and have loads
of debt, higher interest rates today hit them
harder than they would have 20 years ago. Indeed,
the current interest-rate environment has already
started to deflate the US housing market and has
put in motion an economy that may slide into
recession. Increasing interest rates sufficiently
to force a cut in consumption risks inducing
deflation and a depression.
While much
tighter monetary policy may be the right medicine
to prepare for the demographic challenges ahead,
it is not one the Fed under Ben Bernanke's
leadership is likely to prescribe. In his research
about the Great Depression, Bernanke identified
the strong US dollar as one of the culprits that
made the Depression more severe. He has also
praised the Japanese ultra-loose monetary policy
to fight deflation.
Aside from preserving
the standard of living in the long run, the dollar
should benefit from what would amount to a radical
shift in Fed policy. Right now, the United States
is dependent on more than US$2 billion in inflows
from overseas investors every single day, just to
keep the dollar from falling versus a basket of
currencies; the inflows are required to finance
the current-account deficit. If Americans were to
save more, they would be less dependent on
foreigners to keep the dollar afloat.
However, in the absence of a clear
commitment by the Fed to transform the US into a
nation of savers and investors, a weaker economy
is likely to be accompanied by a weaker dollar: as
the economy weakens, foreigners may be less
inclined to invest in the US and thus exert
downward pressure on the dollar.
It comes
as no surprise that Bernanke would tell Congress
to jump over its own shadow and pass entitlement
reform rather than to impose reform through
monetary policy. But as Bernanke said, "the
imperative to undertake reform earlier rather than
later is great". Ironically, in the absence of an
agreement on entitlement reform, the politically
most convenient solution is a devaluation of the
dollar. In such a scenario, nominal promises can
be kept, but the purchasing power of benefits
erode. While this is a likely scenario, it is a
risky one as side-effects may include significant
inflation: we cannot always count on globalization
to bail us out by keeping consumer prices low.
The recent volatility in the price of gold
indicates that the US may actually be heading
toward a deflationary recession. While that is
possible, it is more likely that the US will have
lower short-term interest rates a year from now as
the Fed will loosen monetary policy to give
support to an ailing economy. In the months to
come, it may become increasingly apparent that the
dollar and its purchasing power are less important
to the Fed than the pain that would be suffered by
a significant portion of the population if
monetary policy were too tight.
Axel
Merk is the portfolio manager of theMerk Hard Currency
Fund, a no-load mutual fund that
invests in a basket of hard currencies from
countries with strong monetary policies assembled
to protect against the depreciation of the US
dollar relative to other currencies.
