Beware Bernanke

"The enemy is anybody who's going to get you killed, no matter which side he's on." ~ Joseph Heller, Catch 22

Bernanke’s appointment to chairman of the Federal Reserve is hardly a surprise. He has been the frontrunner for some time. This Harvard-educated, MIT-refined, Princeton-immersed economist has spent so many years in the elite cloisters of Ivy League academia that surely no-one inside the beltway could possibly object to his credentials. His confirmation seems assured.

So why is it that there is still something so deeply disturbing about his appointment? Let’s dig a little deeper and see if we can find out whether we really should be worried at all. It turns out that there are several problems. I can find 5 reasons why we may have to watch Bernanke very carefully. We will need to be on guard.

1. Too clever by far

Bernanke seems to have the overconfidence of the straight A student. He seems to believe the economic world is his to command. So much so that his supreme self-confidence has resulted is some of the bluntest language ever spoken by a central banker. Just the title of his famous November 21, 2002 speech, while at the Federal Reserve, says it all – “Deflation: Making Sure “It” Doesn’t Happen Here”.

First of all he fails to adequately explain why deflation is such a bad thing. Most people would consider that the US has done remarkably well overall for the last 300 years and yet over this period the US was in deflation around half the time (see chart in Market Notes 56). Apparently deflation by itself is not so much of a problem despite bernanke’s implicit assumption.

Even supposing deflation is a problem he confidently asserts that at the Federal Reserve’s command it could not happen in the US. Such is his power over the economy. One can only be astonished at the arrogance of this statement. He can get away with this in today’s world because he is politically astute enough to realize that he is playing to his base.

The banks are the Federal Reserve’s shareholders and the last thing they feel they can afford, given the debt ridden state of the economy and their balance sheets, is deflation. No wonder Bernanke gets their vote. Nevertheless his assumptions, prescription and self-confidence are far from convincing.

 

2. Too politically acceptable

Many people doubt that the Federal Reserve needs a chairman, or even that America needs a Federal Reserve. After all the US did fine without one until 1913, and it was Thomas Jefferson’s opinion that a central bank was unconstitutional. But if we are going to have a central bank, it only makes any sense if it is credible that the central bank could say “no” to the politicians. The more cosy the relationship between the Federal Reserve Chairman and the White House, the less credibility the central bank has.

The relationship is far too cosy. Having received the banking vote Bernanke was sent to the White House, not only to be closely vetted but also to become an advocate of White House economic policy. This is essentially the role of Bernanke’s current job as Chairman of the Council of Economic Advisors. That after such a period of intense political vetting, when he is more or less forced to condone current White House economic policy, there is not even any pretence of any independence.

Both in substance and in presentation the manner of his appointment diminishes the credibility of the institution he will soon represent.

3. “Savings Glut” Nonsense

Once your job becomes one of policy advocacy you need not only to promote policy but also to defend it. The US dollar has fallen by around 30% since its recent highs in 2001, but still the current account deficit continues to widen to around 6% of GDP. Not only is this a disturbing level but there is still little sign of any reversal.

One approach to defending uncooperative economic statistics is to dream up a new theory which somehow seems to explain the phenomenon, so after all it’s not really a problem at all, just a result of some other new development. So Bernanke came up with the “Savings Glut” theory.

The US current account deficit has its counterpart in capital flows into the US. As the US lives beyond its means it offers US dollars to make up the difference. So someone else is buying up all these dollars. Bernanke’s theory essentially reverses cause and effect. The “Savings Glut” theory states that the rest of the world saves too much and is so desperate to buy US assets that the excessive demand for US dollars forces Americans to live beyond their means.

Not only does this sound absurd but it isn’t even vaguely true. Over the last 4 years overseas investors would almost certainly have lost money from US assets given a 30% dollar devaluation. Overseas investors are not that stupid that they feel compelled for more of the same treatment. The real buyers of US dollars have been foreign central banks. They have done this as a political defence mechanism to try and stem the fall of the dollar, but despite in excess of a Trillion dollars of adding to reserves they have only managed to slow the dollars decline.

The “Savings Glut” theory is just a politically convenient argument to defend current economic policy, but it is disturbing how much credibility it has received and how little criticism. Clearly, political expediency trumps objective analysis in policy making circles these days. Bernanke may have done a good job, but how credible is his economic analysis, and to what extent are his pronouncements politically motivated?

4. Deflation Obsession

Bernanke’s main research seems to have revolved around deflation. As his famous 2002 speech suggests he believes he has got this all figured out.  But his solution and conviction should send shivers down the spine of any holder of US dollars. The most disturbing paragraph from this speech is given below:

"Like gold, U.S. dollars have value only to the extent that
they are strictly limited in supply. But the U.S.
government has a technology, called a printing press (or,
today, its electronic equivalent), that allows it to
produce as many U.S. dollars as it wishes at essentially no
cost. By increasing the number of U.S. dollars in
circulation, or even by credibly threatening to do so, the
U.S. government can also reduce the value of a dollar in
terms of goods and services, which is equivalent to raising
the prices in dollars of those goods and services. We
conclude that, under a paper-money system, a determined
government can always generate higher spending and hence
positive inflation."

Let’s be clear what the implications of this statement are. Rather than risk deflation it would be preferable to destroy the value of the currency through printing excessive amounts of dollar bills. This third world solution will no doubt arise if we refuse to put our own economic shortcomings right by falsely blaming others for our own problems. For example, by blaming our current account deficit on foreigners with the specious “Savings Glut” theory.

 5. Policy Activism

The other disturbing element of Bernanke’s 2002 report is the degree of policy activism that he appears to be in favour of. This came through again in a 2004 speech.

"We believe that our findings go some way to refuting the strong hypothesis that nonstandard policy actions, including quantitative easing and targeted asset purchases, cannot be successful in a modern industrial economy."

In everyday language, "targeted asset purchases" translates to state-sanctioned purchase of private assets in the event of a crisis. Such action would not be unprecedented, even for a modern, democratic, free-market economy. Hong Kong, that bastion of bootstrap capitalism, did it openly and brazenly in 1998. Nevertheless it is a major departure from the free market capitalism that we hear so often is regarded as the strength of the US system. Nationalizing assets for the “public good” would be yet another departure away from the private sector in favour of the state. We never heard this kind of talk from Alan Greenspan.

Summary

The Federal Reserve Chairman’s rhetoric and stature have obvious psychological weight and clearly influence short term market movements. The Chairman leads interest rate policy and money supply. He also influences policy making and economic policy thinking through his constant interaction with congress and the banking system. Above all the key in managing the flawed paper money system is to maintain the illusion of confidence and control, much of the game is psychological.

Bernanke fits the bill. He has the economic credentials, political awareness and has supported his backer’s interests at key junctures. It is, therefore, hard to see any reason why he should not be confirmed. As such he is a powerful economic figurehead that the considerable vested interests in our economic system will seek to support and even deify.

This may satisfy most people, but if we examine Bernanke’s statements in detail there is a great deal that is disturbing. The whole process has been far too political for genuine credibility, and his policy solutions are either disingenuous or deeply troubling. Taken together with his overconfidence and policy activism there will be clear concerns about this appointment from the markets.

 

 

 

 

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