The Bennett Newsletter
"Beleaguered Fed" - by Neville Bennett PhD
Ben Bernanke is almost as beleaguered as General Custer in his last stand. Congress tried recently to force him to admit explicitly that he had no bullets left. No one under siege can admit to a lack of ammunition, but from Bernanke’s perspective the situation is bleak. These are his problems:
- The need for more stimulus. At the June meeting, the Fed noted that US economic growth would be below trend until at least 2016. The growth rate is declining and the Fed is expected by many to do something.
- Debt. The IMF reports that US debt is projected to reach unsustainable levels. Moody’s threaten a credit downgrade.
- Deflation. There are worrying signs that deflation similar to Japan’s is setting in.
- Capital adequacy. The banks are lobbying successfully and irresponsibly against tighter requirements.
The Stimulus Question
While Bernanke has been assailed for bailing out Wall Street and issuing “funny money”, can or should he try to intervene to save a declining recovery? Bernanke would lower interest rates if he was able, but cannot as they are now about zero. He stopped buying securitised mortgages because the gap between mortgage and treasury rates was wide but is narrow now. Pushing mortgage rates down further has no payoffs. Nor would buying US Treasuries, in order to lower the yield curve, have a dependable benefit. Indeed, bond vigilantes could object and drive up rates. Bernanke’s only last weapon is helicopters, which he has confined to barracks.
Some observers want the Fed to increase money supply, but that depends upon the banks creating credit. They ignore Bernanke’s wishes: US money supply is contracting at the fastest rate since the 1930’s.
External Critics
Moody’s have warned that the current debt trajectory of the US may imperil its future. It says the US lacks a plan, risking a credit downgrade to Aaa. This would be extraordinarily humiliating and expensive.
The IMF also demands “decisive policy action” to limit US debt. It remarks that budget deficits would be 5%-8%p.a. over the coming decade. It almost demands tax increases and spending cuts and an unconventional reform of near-sacred entitlements such as farm subsidies, pensions and health benefits. Americans will squirm as they have had deficits in 49 of the last 50 years.
One doubts any significant political group would cut subsidies to farmers or increase the age for receiving pensions. But the budget deficit will soar as retirement and health costs spur spending.
The IMF predicts significant increases in the 10-year bond yield average from 3.6% this year to 6.5% after 2013. This will make debt servicing a nightmare as debt could increase to 100% of GDP by 2020.
Deflation
Deflation is now the elephant in the room. It has been part of blogs and op-eds for some time, but was acknowledged last week by James Bullard (Fed, St Louis) who feared the economy being ‘enmeshed in a Japanese-style deflationary outcome”. Bullard is normally an inflation-hawk, so his shift is significant: 3/10 Fed members now fear deflation. Mr. Bullard was contradicted by 2 other Fed members.
The Fed is conducting orthodox policy to avert deflation by promising it will keep interest rates low for an extended period ( NBR Japanese Deflation 30/07) but this is a double-edged sword as it lowers inflation expectations.
As it happens, US growth is slowing. It's current rate is 2.4%, down from 5% in the first quarter. This bodes ill for the rest of the year, although business is profitable and investment high. The problem is finding a domestic buyer: consumption increased by only 1.6% and surveys suggest consumer sentiment is weakening. This happened in Japan; consumers deferred buying items, confident that they would be cheaper in the future as desperate sellers kept slashing prices and credit costs.
Many other indicators for the US are weak. 46 states are in deficit and slashing budgets. This is important as state expenditure is 12% of GDP, and this is dragging down national growth. Public pensions are a tremendous problem: many managers before 2008 assumed that 8% annual growth was the norm: contributions were slashed and benefits increased. Managers often took great risks to increase yield: several ventured into subprimes. Among the disasters, Massachusetts lost 40% of assets in 2008. Illinois’s pensions consume 30% of revenue. Unemployment is not falling: 2 million jobs have been lost in two months. Housing is a disaster too, with sales of new homes in May the lowest since 1963.
As the recovery deflates, the chances of deflation increase(It is too soon to make the call).
Capital Adequacy.
The US Treasury has insisted that banks should improve their capital ratios in order to conform to BIS standards and improve loss-absorbing buffers. The international banks have lobbied successfully against Basel, using the effective argument that increasing their capital could diminish lending in the short-run.
An important new paper* supports Basel. It takes a macroprudential approach, which suggests that capital adequacy for one bank is not enough; we have to worry about a crisis in which banks dump assets to preserve their balance sheets. Forced sales cascade causing asset prices to fall rapidly (as in 2008) leading to a near collapse of the market.
In a crisis, banks do not worry about the externalities of their actions, but the cumulative effects are systemic collapse, and a deep recession. If the banks had more capital they may not panic so much.
The paper also suggests controlling leverage on different kinds of assets. The authors suggest a higher margin on asset-backed securities (such as CDOs) but no other authority is suggesting this change of regulatory behaviour.
More challengingly the paper suggests that increasing capital requirements would not limit credit growth which is a banker’s claim, supported by their think-tank the Institute of International finance. This is a brutal conflict, vital to the future of regulatory reform.
Bernanke is holding on- just! His latest line is that more monetary loosening is inappropriate, but while he cannot do anything he would welcome fiscal loosening, provided there is a credible plan to reduce the deficit later. Custer is sending for reinforcements.
* http://www.economics.harvard.edu/faculty/stein/files/JEP-macroprudential-July22-2010.pdf
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