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     Nov 10, 2010

The great monetary battle of 2011
By Martin Hutchinson

It now looks as if 2011 will see a definitive showdown in which the Ben Bernanke Federal Reserve and its allies in sloppy monetary policy worldwide are finally forced to face up to the damage caused by their depredations.

The new US$600 billion round of "quantitative easing" by the Fed and the almost simultaneous Republican capture of the House of Representatives make it likely that matters will come to a head sooner rather later. As a spectator sport it will be enjoyable; unfortunately we are all also participants.

With a little tact and recognition of the problems his policies have caused, Bernanke could have avoided a showdown. He has


pushed two new reliable soft-money Fed governors through the arduous process of senate confirmation and his third nominee, Peter Diamond, will be very difficult for the Senate to block in this month's lame-duck session following his Nobel Prize. (While the Nobel peace and literature prizes have been politicized, the economics prize is only moderately so, and in any case Diamond's prize appears not only well-deserved but relevant, since the labor market, his specialty, is arguably the No1 US problem right now.)

Leave interest rates at super-low levels, by all means, maintain the Fed's bloated balance sheet at current levels, by all means: these policies will be economically damaging but not so much so in the short term as to get congress's attention. However, by resorting to yet further Weimar-style money creation the day after mid-term elections have massively repudiated the unsound financial policies of the last two years, Bernanke was asking for trouble.

Politically, major political difficulties are now likely for the Bernanke Fed. The chairman himself was only confirmed for re-nomination in January with 30 negative votes, the highest for any Fed chairman in history, at a time when the opposition Republicans had only 40 senators. Both in the Senate and the House there are Republican lawmakers (the Paul family, father and son, for example) who believe the Fed should not exist.

There are also a substantial number who believe either that the US should move to a gold- or commodity-based standard or that the Fed statutes should be tightened up to "Volckerize" it and prevent continuation of the massive money creation of the last 15 years. Even beyond these there are many further Republicans who simply believe, as do regional Federal Reserve Bank presidents Thomas Hoenig, Charles Plosser and Jeffrey Lacker, that interest rates are currently too low and should be raised above the inflation rate.

Since a high proportion of Republican voters share these concerns, a campaign by congress to end Bernanke's perpetual easy-money policy would draw considerable popular support.

You also have to examine the alternative activities available to the new House majority. It cannot pass legislation that is of any interest to its supporters, other than as a symbolic gesture, because it probably won't pass the senate and if it did, President Barack Obama would veto it.

It can cut some of the bloat out of Federal spending, and probably get it past Obama's veto (because vetoing appropriations bills on the ground that they are not bloated enough won't be a real winner - this isn't 1995). Indeed just having a Republican Speaker and appropriations committee with a desire to cut spending should save the US public at least $25 billion a year, the average difference between the president's initial budget and that finally passed by the House in fiscal years 1996-99. (After Newt Gingrich's replacement by the porcine Dennis Hastert, the equation went the other way - from fiscal year 2000 onwards, under Democrat and Republican presidents, the bloat added by congress above the President's original budget was at least $25 billion and in many years more.)

Nevertheless, cutting spending in a continuing recession will cause considerable squawking from those affected and mass hysteria from the likes of Nobel economics laureate and New York Times columnist Paul Krugman, and will thus be possible only in moderation.

Thus on the economic front the most enjoyable and productive thing a new congress can do is to harass Bernanke until he changes his policy. Bernanke's term of office does not end until January 2014, but he is forced to report to both houses of congress twice a year and in addition he can be and is frequently subpoenaed. Unlike the Supreme Court, which in the famous aphorism "follows the election returns", Bernanke ignored them in his announcement on Wednesday; this will prove to have been a mistake.

The $600 billion of Treasuries Bernanke expects to buy before the end of next June, at $75 billion per month, will represent 72% of the Treasury deficit during that eight-month period, based on the 2009-10 funding pattern. In a period in which the US economy is slowly recovering, interest rates are far below the rate of inflation, and consumption is rising at a healthy rate (since nobody sensible saves when interest rates are at their Bernanke-caused lows), this is a highly risky policy.

The Fed's theory behind its quantitative easing is that forcing long-term interest rates down will cause banks to look for riskier assets with higher yields, and thus start financing small business, the principal source of new jobs. However, there are in reality far too many other places for the banks' cash to go. For example, it can go into junk bonds, whose issuance is running at record levels - these do not finance small business but big leveraged buyouts, which on balance destroy jobs rather than create them. Then bank money can finance hedge funds, which can buy commodities, driving their prices up to astronomical levels.

Alternatively, the displaced bank cash can go into emerging markets, causing speculative bubbles in those markets and driving up their rates of inflation. While most such markets have currencies that float against the dollar, speculative inflows into those markets, unless "sterilized" by the central bank, increase the domestic money supply and worsen domestic inflation problems. Petrobras CEO Jose Sergio Gabrielli remarked on CNBC following the announcement that "more liquidity is good for Petrobras" - for one thing it increases oil prices. But that's hardly the purpose of the exercise. Since the Brazilian economy is already overheated because of its government's grossly excessive spending, the Brazilian people will not thank Bernanke for his bounty.

The day following Bernanke's action, the gold price rose $53, closing at a new record. More ominous for the US consumer, oil prices also rose more than $2 to a new post-2008 high. Bernanke's new injection of money may well provide the last surge in liquidity that causes global commodity markets to run altogether out of control. In that case Bernanke's theological disquisitions on whether his target inflation rate should be 2% or 4% will quickly become irrelevant.

While energetic statistical fudging by the Bureau of Labor Statistics may hide the truth for several months, at some point within the first half of 2011 it's likely that US inflation rates will explode upwards, not gently as they did in the early 1970s, but heading rapidly toward double digits.

Bernanke and his supporters on Wall Street will try to deny the reality of these rises for as long as they can - you can expect to hear talk of a new "sub-core" inflation index that includes no items whose price is actually rising but only a few tech gadgets whose prices are falling - but with a watchful Tea Party contingent in congress looking for something useful to do that won't work for long. You can expect aggressive congressional hearings to begin in the second quarter and intensify thereafter.

The second half of 2011 is thus likely to see a massive political struggle to force Bernanke either to resign or to reverse his policies altogether, pushing short-term interest rates above the inflation rate. Within the Fed, the struggle will initially have little support, because most governors, who have a majority of the rate-setting Federal Open Market Committee votes, as well as the president of the New York Fed, Bill Dudley, were carefully chosen for their soft-money views.

You can expect to hear much lofty discussion about the inadvisability of allowing the "politicization" of the Fed. However, the arguments against Fed politicization relate to the possibility of short-termist and expansionist politicians suborning a soundly run Fed (as for example president Lyndon Johnson did to Fed chairman William McChesney Martin in 1965-68 and president Richard Nixon did to Fed chairman Arthur Burns in 1970-73). They do not apply to the opposite possibility, where a thoughtful and concerned congress tries to rein in a Fed whose policies derive straight from the least satisfactory years of the Weimar Republic.

Congress will not however be alone in trying to rein in the Fed. Internationally, the destabilization caused by the flood of Fed liquidity will bring protectionist moves like the capital inflow taxes of Brazil and Thailand. The rise in commodity prices will cause immense hardship in poor countries, bringing increased pressure on the Obama administration. And the fall in the dollar against other currencies will cause economic loss to Europe's big exporters and massive losses to the largest dollar holders such as the People's Bank of China and the Bank of Japan. Group of Eight and Group of 20 meetings will thus become very unpleasant experiences for the US participants.

Finally, there will be pressure from the markets themselves. With or without the Fed's energetic purchases, at some point holders of long-term Treasuries will decide that they are a truly lousy investment (for one thing, what will happen in July 2011, when the Fed suddenly stops buying?) Monthly inflation announcements will become moments of hara-kiri for bond traders, as figures higher than officially projected by bank economic departments will produce losses of 2%, 5% or more on the principal value of their entire Treasury portfolios. At that point, Wall Street will itself begin to put pressure on the Fed.

The inoffensive Fed chairman G William Miller did not survive pressure from the bond markets in 1979. Much more richly deserved will be the markets' defenestration of Ben Bernanke.

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 2005-10 David W Tice & Associates.)

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