THE BEAR'S LAIR 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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