THE BEAR'S LAIR Bernanke's bad-choice
moment
By Martin Hutchinson
This column has since 2000 been calling for the Federal Reserve to institute a
policy of much tighter money. In a sense, events since August have justified
it; old-fashioned consumer price inflation hasn't reappeared, but the
beginnings of a gigantic global asset price deflation are appearing. At this
point, sudden adoption of the Bear's Lair monetary policy, which would involve
a Federal Funds rate in the 8-10% range, would cause a collapse in confidence
and very likely a repeat of the United States' unhappy
economic performance in 1931-33. So, given that the Fed is now starting from a
place it should never have got to, what is the least painful trajectory from
here?
There are two contrary tendencies to be fought. On the one hand, the housing
market continues to melt down - house prices nationwide dropped 1.5% in the
past month alone. That suggests that lower interest rates are needed to
increase the affordability of housing for the marginal buyers and slow the
decline in prices. On the other hand, the stock markets have continued strong,
and commodity and energy prices have shot up further, producing the specter of
US$100 oil. That suggests that lower interest rates may actually be making the
economic problem worse, transferring all our wealth to unpleasant oil producing
regimes.
The ongoing collapse in the subprime mortgage market indicates that the central
rationale for interest rate policy has changed since August. If house prices
continue to decline as they have in the last year - and there seems currently
no reason whatever that they should not continue doing so - then more and more
borrowers will find themselves with a larger mortgage liability than the value
of their house asset. In itself this does not matter; if employment continues
robust and the non-housing sectors of the economy continue to expand, then most
of those borrowers will be able to continue making their mortgage payments.
Eventually house prices will recover, or their outstanding mortgage balance
will decline, and they will once more find themselves in a net asset position.
This would indicate that easy money was appropriate, but there are three
problems with this. First, the decline in net worth among homeowners is likely
to produce a negative "wealth effect" which will cut consumption and push the
US economy into recession. Second, in reducing short term interest rates, the
Fed may be "pushing on a string" and find itself unable to reduce the mortgage
rates it is attempting to affect. Third, it risks reigniting inflation and it
makes further rises in commodity and energy prices almost certain.
The opposite policy, of raising interest rates, would clearly now be damaging
if carried out to extremes. Liquidity is disappearing from the US money market
as structured investment vehicles are wound down and taken back onto bank
balance sheets. The reduction of $400 billion in asset backed commercial paper
outstanding since August is only one example of this. A sharp rise in interest
rates runs the risk of a deflationary spiral of collapsing money supply such as
occurred in the US in 1931-33, as bank after bank failed.
Fed chairman Ben Bernanke and the Federal Open Market Committee on December 11
seem likely to pursue their recent policy of a mild easing of money, lowering
the Federal Funds rate by 0.25% or so. This will have little effect on house
prices or on the availability of home mortgages. Both need to stabilize at much
lower levels before the market clears. It will not lower rates in money markets
as a whole; the London Interbank Offered Rate is currently trading at a
thumping premium to the Federal Funds rate and will continue to do so.
It will also not lower US fixed rates; the 10-year Treasury bond is currently
trading at a yield around of 4%, close to its historic lows and far below
equilibrium real levels given the Fed's prolonged inability to reduce inflation
below the 3-5%-4% range. It will however inject yet more liquidity into the
world economy, which will force up the price of equities and other non-housing
assets, as well as commodity prices and inflation in general.
This is undoubtedly what Wall Street wants; it is also likely to be largely
satisfactory to Bernanke. Only one Fed chairman has lost his job through
keeping interest rates too low - the unlucky G William Miller in 1979. However,
in Miller's time inflation had already established a firm grip. Bernanke may
reasonably feel that inflation remains sufficiently subdued that the problem
can be ignored at least until after the 2008 election, now only 11 months away.
The dangers of a sharp rise in the Federal Funds rate do not apply to the
modified policy of a mild rise in the rate, maybe to 6% in three steps between
now and March. While this would make little difference to the housing market or
to long term interest rates, it would deflate world stock markets and begin to
mop up the excess liquidity that has distorted the world economy over the last
decade. The private equity market would remain quiescent, hedge funds would
find themselves generally loss-making, and the major US banks that have
excessive exposure to subprime mortgages and other "Level 3" assets would be
forced to come to terms with reality and start cleaning up their balance
sheets.
More important, commodity and energy prices would start to deflate. If asked
which would be most damaging to the US economy: an oil price of $120 combined
with a Federal Funds rate of 3% or an oil price of $60 combined with a Federal
Funds rate of 6%, almost all economists, even those wholly uncommitted to the
Bear's Lair worldview, would confirm that the former combination is likely to
be much more damaging.
The US payments deficit would be exacerbated, increasing the probability of a
catastrophic decline in the dollar, while huge amounts of US consumer wealth
would be diverted into the pockets of oil producing countries. These would
either like Venezuela, Russia and Iran spend it on enhancing their dreams of
world conquest or like Saudi Arabia, most of the Gulf States, Norway and
Canada, save much of the increase, investing it in foreign exchange reserves
and "rainy day funds" in general.
As John Maynard Keynes would have triumphantly pointed out (even a blind pig
finds a truffle occasionally) the compulsive savers are much more damaging to
the world economy than the megalomaniacs, provided the maniacs don't succeed.
History has proven time and again that madmen with dreams of world conquest are
thoroughly stimulative to economic activity, provided they are not permitted to
achieve their goals. On the other hand a further increase in the world's
savings rate, producing an additional "glut" of savings in sovereign wealth
funds while impoverishing US, European and Japanese consumers, is likely to
produce world recession in fairly short order, however stimulating it would be
to asset prices and deal flow in the meantime.
But this choice between cheap money and even higher oil and commodity prices or
moderately expensive money and oil and commodity prices deflated towards their
normal levels is surely what we are faced with. A decline in the Federal Funds
rate from 5.25% to 4.5% has produced a surge in the world oil price from about
$70 in August to over $90. A further decline in the Federal Funds rate would
cause a surge in world liquidity and a weakening of confidence in the dollar,
which together would cause oil prices to soar.
Extrapolating from the trend since August, a 3% Federal Funds rate, perhaps in
spring 2008, would be likely to lead to an oil price around $120 per barrel.
Other commodity prices would likewise surge, gold would soar well over $1,000
and the euro would rise strongly against the dollar to above $1.60. I doubt
very much whether Treasury bond yields would decline significantly, so the
housing market would be largely unaffected and US house prices would continue
to decline, with further consumers forced into mortgage difficulties by the
rise in their costs of gasoline and heating oil.
Such an economy would be even more distorted than the current one. Essentially
Bernanke would have provided yet more inflation for the world economic bubble,
achieving little if any progress towards his goals of US economic recovery and
house price stabilization, but ensuring a most unpleasant long term denouement.
Chinese and US stocks would have risen further, more major companies would have
been sold to sovereign wealth funds and more of America’s wealth would have
been diverted from Main Street to Wall Street and through Wall Street to the
Middle East.
Conversely, a reversal of policy, raising the Federal Funds rate back to 5% on
Tuesday and announcing a goal, absent clear signs of a major downturn, of
raising it further to 6% within the next few months would have the opposite
effect. The monetary tightening would be far too small to affect the ongoing
downturn in housing - in any case long term bond rates would be little
affected. However oil prices would begin subsiding to their long term
equilibrium level, probably now in the $50-$60 range. That would reduce US
consumers' energy bills, giving them additional purchasing power to remain
current on their mortgage payments.
This tighter money policy would strengthen the dollar, reducing the economic
imbalances that a weak dollar has produced and increasing the willingness of
central banks and other foreign investors to hold dollars. It would begin the
messy process of deflation in the US, Chinese and other stock markets, bringing
on the necessary price correction, but limiting the amount of innocent money
that would be lost in a major crash.
It would reduce the resources available to Russia, Venezuela and Iran,
immeasurably improving the world political environment and stabilizing wobbly
"domino" political situations such as Ukraine, Colombia and Iraq. In the long
run, it would produce a smaller and less painful US and global downturn, and
would increase long term US wealth, as well as beginning the necessary
rebalancing of wealth distribution between the overstuffed of Wall Street and
the under-rewarded blue collar class.
The chance of Bernanke pursing this superior alternative? Approximately zero!
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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