THE BEAR'S
LAIR An
exit strategy from Bernanke By
Martin Hutchinson
Mitt Romney has now said
he would not reappoint Ben Bernanke as chairman of
the Fed. What a relief! (Or maybe not; I still
reckon Obama has a 50-50 chance of winning in
November, and he will now presumably get
Bernanke's help, including a dose of QEIII at
either the September or October Fed meetings,
whenever Bernanke thinks it will do the most
"good".) Still, even if Romney wins and persuades
Bernanke (whose term ends in January 2014) to
forego a year of lame-duckery, there's still the
question of how we exit from Bernankeism. Four,
six or 17 years of loose money, however you count
it, have left a huge number of vulnerabilities in
the economy, so exit has the potential to be both
painful and destructive.
When you include
fiscal policy, there are three separate exits to
be considered. There's
the rise in interest rates needed to get
short-term and long-term rates safely above the
rate of inflation, thus bursting the pervasive
global asset and commodity bubbles and restoring
positive real returns to savers. There's the
reversal in "quantitative easing" by which the Fed
must sell its portfolio of more than US$2 trillion
of Treasury bonds and Federal Agency securities,
thus removing risk from its balance sheet and
ceasing to fund the federal deficit. And there's
the fiscal recovery, eliminating the annual $1
trillion deficits, part of which might conceivably
be achieved by faster economic growth, but most of
which must be achieved by higher taxes and lower
spending.
Then, on top of managing these
three processes, the exit has to be integrated
with the needs of the global economy, avoiding
crashing the market in Japanese government debt,
now at a highly unstable level of 220% of GDP,
while allowing a reasonable exit for the weaker
sisters of the eurozone. The US does not have
direct responsibility for these problems, but at
least needs to tailor its policy so as to avoid
making them intolerably worse.
Various
policy reversal strategies would be
counterproductive. To take the most extreme
example, it would be foolish to attempt to reverse
"QE" without doing anything about the deficit.
That would double up on the strains to the
financial market from financing the deficit,
making the annual net cash flow drain on the
market perhaps $2 trillion rather than $1
trillion. Almost certainly, this would cause a
liquidity crunch, producing an economic lurch
downward that would both worsen the deficit and
bring even more misery to the American working
class.
The British strategy under Prime
Minister David Cameron, of making modest
back-loaded spending cuts, allowing spending to
increase in real terms in the short term, while
raising taxes immediately, is also
counterproductive. In Britain's case, the
authorities have staved off severe problems by
massive doses of quantitative easing, financing a
high percentage of the budget deficit through the
Bank of England. Needless to say this has resulted
in more misery for Britain's unfortunate savers
and a further economic lurch downward, albeit a
mild one. It does not offer an attractive path
forward.
It thus follows that reversing QE
must come late in the Bernanke reversal process;
that lowering the deficit must take a top priority
and that spending cuts should precede or at least
coincide with tax cuts. Passing legislation takes
time, so monetary steps should logically precede
fiscal ones.
The first step to take is
thus to raise interest rates. Given this logic, it
would be madness to allow Bernanke to subsist in
office until January 2014, surrounded by
soft-money Fed governors appointed by President
Obama, doing further long-term damage to the US
economy for an entire year before he can be
removed. A newly elected President Romney should
demand his resignation on his first day in office,
backed if necessary by a resolution of the US
Senate (if the Republicans are lucky enough to
control that body). A replacement should be
nominated immediately, preferably someone of
unassailable scholarly achievement but massive
determination, able to win quick Senate approval,
yet tough enough to overcome resistance from Obama
appointees within the Federal Open Market
Committee. Fortunately, he will have at least a
few allies among the regional Fed presidents, some
of whom have been calling for a tighter, more
disciplined policy for several years now. Of the
2013 FOMC members James Bullard of St Louis is
sound, but alas the indomitable Thomas Hoenig has
now been replaced in Kansas City. (Hoenig himself
would be an admirable choice as Bernanke's
successor.)
The first day a new Fed
chairman is in control, by special FOMC meeting if
a regular one is several weeks away, he should
increase the Federal Funds target rate to 2%.
That's nowhere near high enough in the long run.
However it is sufficient to put all the
zero-interest-rate games out of business, and to
reduce or eliminate the "gapping" profits from
borrowing in the short-term market and investing
in long-term bonds, which have so egregiously
benefited the banking system and eliminated its
incentive to lend to small businesses.
The
initial interest rate rise probably would not
quite eliminate the gap between interest rates and
inflation, since even reported inflation by early
2013 is likely to be running around 3% (if
reported inflation is higher than that, the
initial jump in interest rates must be
correspondingly larger). However by changing the
market's psychology it would begin the prolonged
secular rise in long-term interest rates that is
needed. At the same time, it would knock out such
large speculative entities as the agency mortgage
REITs, which today have over $250 billion in
assets and will collapse once the current interest
rate pattern reverses. Thus the initial rate rise
should be held for a lengthy period of perhaps six
months before further rises are undertaken, to
allow the market to adjust to the reality that
there is no more free money. During that period,
unexpected bankruptcies will occur, but we can be
absolutely certain, with interest rates still
below the level of inflation, that those
bankruptcies are merely the worst excrescences of
the bubble period and contain nothing of any
long-term economic value.
During the
six-month period while the money market is
reacting to the first interest rate rise, it will
be essential to cut the budget deficit back to
size. To achieve this, it will be necessary to
make adjustments totaling a minimum of $500
billion in the first full year, or $5 trillion
over the next 10 years. That's just about the size
of the "fiscal cliff" due to take effect January
1, which according to the Congressional Budget
Office reduces spending by $103 billion in the
next fiscal year and increases taxes by $399
billion.
Needless to say the "fiscal
cliff" balance is wrong - most of the deficit
reductions should come in spending, since that is
the factor that has soared out of control in the
last decade. Furthermore, some of the tax
increases, such as the total 61% federal tax on
dividends (when President Obama's health-care tax
is added and corporate tax is included) and a
return to 55% tax on estates, would be thoroughly
economically damaging, as well as unfair. The
fiscal cliff's spending cuts must thus be roughly
trebled, to around $300 billion annually, while
the tax increases are limited to perhaps another
$250 billion. There will be a fiscal "drag" from
tax increases, but not from spending cuts, which
will be matched by activity increases in other
more productive sectors of the economy.
As
well as entitlements (of which more presently)
possible targets for spending cuts include
education, reversing the 2001 bloating of the
Education Department and ideally abolishing it,
and agriculture and energy subsidies, both of
which should be abolished. It wouldn't hurt to
abolish the Energy Department and to cut back the
Environmental Protection Agency drastically,
folding its remnants into the Commerce Department,
where they will be surrounded by people with a
proper regard for the health of the US economy.
Naturally Fannie Mae, Freddie Mac and the FHA
should go, getting the federal government out of
the housing finance business.
On the tax
side, rates should be raised only at the margins,
perhaps raising the rate on capital gains to 20%
from its current 15%, while the estate tax should
be cut to a maximum of 15-20% and dividends should
be made tax-deductible at the corporate level (and
fully taxable at the individual level) thereby
eliminating much corporate tax sheltering at a
stroke. To raise most of the $250 billion required
a massive axe should be taken to tax deductions.
The mortgage interest tax deduction, the state and
local tax deduction, the health insurance tax
deduction and above all (because of its massive
structural economic damage) the charitable
contribution tax deduction should all be swept
away, as should the myriad of smaller deductions
that litter the US tax code. That should easily
provide sufficient revenue, but if not, a modest
increase in gasoline tax would do no harm and
might produce some possible environmental benefit.
Finally, entitlements should be tackled.
On the Social Security side, this is easy; the
step-by-step increase in the retirement age,
taking it up 2 years in 1-month annual increments
from 2004-26, should be extended indefinitely, so
the retirement age reaches 68 in 2038, 69 in 2050
and 70 in 2062. Instantly, the long-term social
security deficit would disappear. As for Medicare,
something like the Ryan plan, converting those
under 55 to a premium support system, would have
passed political muster if the Romney-Ryan ticket
is elected, and should hence be introduced as
quickly as possible.
Once this combination
of fiscal changes is in place, reducing the
federal deficit to $500 billion initially and zero
once the economy has recovered properly, the Fed's
quantitative easing should be reversed gradually,
by no more than $250 billion annually, to avoid
over-burdening the bond market. At the same time,
interest rate rises should resume, taking the
Federal Funds target above the current inflation
rate as quickly as possible, and within 2-3 years
to a level perhaps 3% above the then-current
inflation rate, thereby allowing US savings to be
rebuilt, the economy to be recapitalized and
long-term growth to return to its historical
robust level.
Internationally, US fiscal
and monetary policies should reduce the
accumulation of idle balances in central banks and
elsewhere, thereby allowing capital to be deployed
once more to productive uses. A Romney
administration should on no account allow the Fed,
the IMF or any other body over which the US has
some control to bail out the profligate members of
the eurozone. Instead it should encourage the EU
and ECB authorities to allow the market to work
properly, detaching the more hopeless eurozone
members such as Greece and Italy and allowing the
others to form one, two or more separate currency
blocs as they may see fit. Similarly, it should
encourage Britain to implement in full its
excessively delayed budget cuts, and the Bank of
England to raise interest rates in line with US
rates and above all to stop buying gilts. Japan
should be encouraged to bite the bullet and cut
spending properly, getting its fiscal house in
order, while China should be encouraged to
recognize the gigantic hidden losses in its
banking system.
By these means,
Bernankeism can be reversed and the US and global
economies restored to full health, with only a
moderate amount of economic pain being inflicted.
Allowing Bernankeism to continue, or being less
swift and careful in the steps taken to reverse
it, will cause further severe problems in the US
economy and doom Romney like his predecessor to
electoral defeat after a single term.
Martin Hutchinson is the author
of Great Conservatives (Academica Press,
2005) - details can be found on the website www.greatconservatives.com
- and co-author with Professor Kevin Dowd of
Alchemists of Loss (Wiley, 2010). Both are
now available on Amazon.com, Great
Conservatives only in a Kindle edition,
Alchemists of Loss in both Kindle and print
editions.
(Republished with permission
from PrudentBear.com.
Copyright 2005-12 David W Tice &
Associates.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
