Bernanke House Committee Transcript

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From the first day:

(EDITED)

BERNANKE:

Well, mortgage rates are down some from before this whole thing began.

But we have a problem, which is that the spreads between, say, treasury rates and lending rates are widening, and our policy is essentially, in some cases, just offsetting the widening of the spreads, which are associated with various kinds of illiquidity or credit issues.

So in that particular area, you’re right that it’s been more difficult to lower long-term mortgage rates through Fed action.

Seems he isn’t aware the tools he has to peg the entire term structure of rates as desired.

G. MILLER (?):

On January 17th, you presented your near-term economic outlook to the House Budget Committee. In that outlook, you indicated the future market suggests (inaudible) prices will decelerate over the coming year. However, since then, oil prices have reached record highs in nominal terms.

Questioning the Fed’s ability to forecast oil prices and the use of futures markets for forecasting.

If oil continues to remain at its current levels, thereby adding further pressure on the overall inflation, it may be more difficult for the Fed to cut interest rates. And if that were the case, what option do you have, beyond cutting interest rates, are you considering to help spur the economic growth?

BERNANKE:

Oil prices don’t have to come down to reduce inflation pressure. They just have to flatten out. And if they —

I would suggest that even if they flattened out, it will be years before all the cost push aspects of the current price filters through.

G. MILLER (?):

But if they don’t flatten out?

BERNANKE:

Well, if they continue to rise at this pace, it’s going to be a — create a very difficult problem for our economy. Because, on the one hand, it’s going to generate more inflation, as you described. But it’s also going to, you know, create more weakness because it’s going to be like a tax that’s extracting income from American consumers.

BERNANKE:

Well, we don’t know what oil prices are going to do. It depends a lot on global conditions, on demand around the world. It also depends on suppliers, many of which are politically unstable or politically unstable regions or have other factors that affect their willingness and ability to supply oil. So, there’s a lot of uncertainty about it.

But our analysis, combined with what we can learn from the futures market, suggests that we should certainly have much more moderate behavior this year than we have. But, again, there’s a lot of uncertainty around that estimate.

Still using futures markets for forecasting.

And he is also forecasting growth to pick up in Q3 and Q4 and inflation to moderate. Seems contradictory?

BERNANKE:

Our easing is intended to, in some sense, you know, respond to this tightening in credit conditions, and I believe we’ve succeeded in doing that, but there certainly is some offset that comes from widening spreads, and this is what’s happening in the mortgage market.

Has to be frustrating – they cut rates to hopefully cut rates to domestic borrowers, but those rates don’t go down, only the $ goes down and imported prices rise further.

FRANK:

The gentleman from Texas, Mr. Neugebauer?

RANDY NEUGEBAUER, U.S. REPRESENTATIVE (R-TX):

Thank you.

Mr. Chairman, I want to turn my attention a little bit.

You mentioned in your testimony a little bit about the dollar and the fact that it has increased our exports — because American goods are more competitive. But at the same time, it’s created — it swings the other way and the fact that it raises price — it has an inflationary impact on the American consumer.

I believe one of the reasons that oil is $100 a barrel today is because of our declining dollar. People settle oil in dollars, and I think a lot of them have, obviously, just increased the price of the commodity.

And so I really have two questions.

One is, what do you believe the continuing decline of the dollar is — what kind of inflationary impact do you think that is going to have?

And then, secondly, as this dollar declines, one of the things that I begin to get concerned with is all of these people that have all of these dollars have taken a pretty big hickey over the last year or so and continue to do that.

At what point in time do people say, you know, “We want to stop trading in dollars and trade in other currencies”? And what implication do you think then that has on the capital markets in U.S.?

BERNANKE:

Well, Congressman, I always need to start this off by saying that treasury is the spokesman for the dollar. So let me just make that disclaimer.

We, obviously, watch the dollar very carefully. It’s a very important economic variable.

As you point out, it does increase U.S. export competitiveness, and in that respect it’s expansionary but it also has inflationary consequences. And I agree with you that it does affect the price of oil. It has probably less effect on the price of consumer goods or finished goods that come in from out of the country, but it does have an inflationary effect.

Our mandate, of course, is to try to achieve full employment and price stability here in the United States, and so we look at what the dollar’s doing. And we think about that in the context of all the forces that are affecting the economy, and we try to set monetary policy appropriately.

So we don’t try to — we don’t have a target for the dollar or anything like that. What we’re trying to do is, given what the dollar’s doing, we try to figure out where we need to be to keep the economy on a stable path.

Sidestepped the heart of the question.

With respect to your other question, there is not much evidence that investors or holders of foreign reserves have
shifted in any serious way out of the dollar to this point.

The drop in the trade deficit = The change in non-resident desires to hold $US financial assets.

And, indeed, we’ve seen a lot of flows into U.S. treasuries,

Those are not evidenced of increased foreign holding of $US financial assets

which is one of the reasons why the rates of short-term U.S. treasuries are so low, reflecting their safety, liquidity and general attractiveness to international investors.

Who are scared of other $US financial assets.

In fact, the low treasury rates are probably partially responsible for the rush to get out of $US financial assets.

So we’ve not yet seen the issue that you’re raising.

And he is sincere in that answer.

NEUGEBAUER:

One of the other questions that I have — and just your thoughts — is the U.S. economy is based on encouraging the consumer to consume as much as he possibly can. And, in fact, the stimulus package that we just passed the other day, $160 billion, was really, by and large, saying to the American people, “Go out and spend.”

And this consumption mentality away from any kind of a savings mentality concerns me that makes the economy always going to be a lot more volatile because there’s not much margin.

And now — a year ago, people were testifying before this — “Don’t worry about the low savings rates,” because people had these huge equities in their homes, and so that was compensating for the lack of savings in the U.S.

That now, we see, as some reports, devaluation of real estate, 10, 12, 15 percent, and the savings rates at zero and negative rate.

Does that concern you long term that we’re trying to build an economy on people to use up every resource that they have?

BERNANKE:

Yes, Congressman.

Wonder if he is aware the only source of net financial assets for the non-government sectors is government deficit spending, by identity?

I think we — in the long term, we need to have higher saving, and we need to devote our economy more toward investment and more to foreign exports than to domestic consumption.

This is a troubling long-term view and reflects his mercantilist tendencies reviewed in earlier posts.

And that’s a transition we’re going to have to make in order to get our current account deficit down, in order to have enough capital in

(I think it should be ‘and’ – transcript error?)

foreign income to support an aging population as we go forward the next few decades.

This is a very peculiar position to be taking, not to mention formulating policy on this notion.

The stimulus package, which is going to support consumption in the very near term, there’s a difference between the very short run and the long run.

In the very short run, if we could substitute more investment, more exports, that would be great.

Exports better than consumption? He’s calling for a reduced standard of living -lower real wages- just like what has been happening.

But if we — since we can’t in the short run, a decline in total demand will just mean that less of our capacity’s being utilized, we’ll just have a weaker economy.

So that’s the rationale for the short-term measure. But I agree with you that over the medium and long term we should be taking measures to try to move our economy away from consumption dependence, more toward investment, more toward net exports.

Restating the same mercantilist view that’s non-applicable with non-convertible, floating fx $US as in my previous posts.

GREGORY MEEKS, U.S. REPRESENTATIVE (D-NY):

Thank you, Madam Chair.

Good to be with you, Mr. Chairman.

You know, you get some of these conditions, and you do one thing and it helps or you do something else and it hurts. And such is the situation that I think that we’re currently in.

It seems to me that if you move aggressively to cut interest rates and stimulate the economy, then you risk fueling inflation, on top of the fact that we’ve got a weak dollar and a trade deficit. You know, you’ve got to go into one direction or another.

Which direction do you think — are you looking at focusing on first?

BERNANKE:

Congressman, I think I’ll let my testimony speak for itself in terms of the monetary policy.

I just would say that, you know, we do face a difficult situation. We have — inflation has been high. And oil prices and food prices have been rising rapidly.

We also have a weakening economy, as I discussed. And we have difficulties in the financial market and the credit markets.

So that’s three different areas where the Fed has to, you know, worry about — three different fronts, so to speak. So the challenge for us, as I mentioned in my testimony, is for us to try to balance those risks and decide at a given point in time which is more serious, which has to be addressed first, which has to be addressed later.

That’s the kind of balancing that we just have to do going forward.

MEEKS:

So you just move back and forth as you see and try to see if you can just have a level —

BERNANKE:

Well, the policy is forward looking. We have to deal with what our forecast is. So we have to ask the question where will the economy be six months or a year down the road? And that’s part of our process for thinking about where monetary policy should be.

And that forecast is for growth to increase and prices to moderate.

Seems contradictory.

MEEKS:

Well, let me also ask you this: The United States has been heavily financed by foreign purchasers of our debt, including China, and there has been a concern that they will begin to sell our debt to other nations because of the falling dollar and the concerns about our growing budget deficits.

Will the decrease in short-term interest rates counterbalance other reasons for the weakening dollar enough to maintain demand for our debt? And, if that happens, what kind of damage does it do to our exports?

MEEKS:

And I’d throw into that, because of this whole debate currently going on about sovereign wealth funds, and some say that these sovereign wealth funds are bailing out a lot of our American companies. So, is the use of sovereign wealth funds good or bad?

BERNANKE:

Well, to address the question on sovereign wealth funds, as you know, a good bit of money has come in from them recently to invest in some of our major financial institutions.

I think, on the whole, that it’s been quite constructive. The capitalization — extra capital in the banks is helpful because it makes them more able to lend and to extend credit to the U.S. economy.

The money that’s flowed in has been a relatively small share of the ownership or equity in these individual institutions and, in general, has not involved significant ownership or control rights.

So, I think that’s been actually quite constructive. And, again, I urge banks and financial institutions to look wherever they may find additional capitalization that allow them to continue normal business.

More broadly, we have a process in place called the CFIUS process, as you know, where we can address any potential risks to our national security created by foreign investment. And that process is — I think is a good process.

Otherwise, to the extent that we are confident that sovereign wealth funds are making investments on economic basis for returns, as opposed to for some other political or other purpose, I think that’s — it’s quite constructive and we should be open to allowing that kind of investment.

Bernanke doesn’t realize there is no need for investment $ per se from sovereign wealth funds.

Part of the reciprocity of that is to allow American firms to invest abroad, as well. And so, there’s a quid pro quo for that, as well.

MEEKS:

What about the first part of my question?

BERNANKE:

I don’t see any evidence at this point that there’s been any major shift in the portfolios of foreign holders of dollars. So, I — you know, we do monitor that to the extent we can, and so far, I have not seen any significant shift in those portfolios.

Sad, but true.

SPENCER BACHUS, U.S. REPRESENTATIVE (R-AL):

Thank you.

Chairman Bernanke, have the markets repriced risk? Where do we stand there?

You know, we talked about the complex financial instruments, and…

BERNANKE:

That’s an excellent question.

Part of what’s been happening, Congressman, is that risk perhaps got underpriced over the last few years. And we’ve seen a reaction, where, you know, risk is being, now, priced at a high price.

It’s hard to say, you know, whether the change is fully appropriated or not. Certainly, part of it, at least — certainly, part of the recent change we’ve seen is a movement toward a more appropriate, more sustainable pricing of risk.

But in addition, we are now also seeing additional concerns about liquidity, about valuation, about the state of the economy, which are raising credit spreads above, sort of, the normal longer-term level. And those increased spreads and the potential restraint on credit is a concern for economic growth. And we’re looking at that very carefully.

But he does recognize they, too, are market pricing of risk.

This implies that markets are ‘functioning’.

BACHUS:

I see.

One thing you didn’t mention in your testimony is the municipal bond market and the problems with the bond insurers. Would you comment on its affect on the economy and where you see the situation?

BERNANKE:

Yes, Congressman.

The problems — the concerns about the insurers led to the breakdown of these auction-rate securities mechanisms which were a way of using short-term financing to finance longer-term municipal securities.

And a lot of those auctions have failed, and some municipal borrowers have been forced into, at least for a short period, have been forced to pay the penalty rates.

So there may be some restructuring that’s going to have to take place to get the financing for those municipal borrowers.

But as a general matter, municipal borrowers are very good credit quality. And so my expectation is that within a relatively short period of time we’ll see adjustments in the market to allow municipal borrowers to finance reasonable interest rates.

Agreed!

BACHUS:

Let me ask one final question.

You’re a former professor, and I think the word is “financial accelerator process.” What we mean there is problems in the economy cause sentiment problems; a lack of confidence.

Where do you see — is negative sentiment a part of what we’re seeing now?

I know I was in New York, and bankers there said there were a lot of industries making a lot of money who were just waiting, because of what they were reading in the papers as much as anything else, to invest.

BERNANKE:

Well, there’s an interaction between the economy and the financial system, and perhaps even more enhanced now than usual, in that the credit conditions in the financial market are creating some restraint on growth.

So far, the pass-through to the real economy has been modest, which means he’s saying that in normal times it’s even less.

I agree with that.

And slower growth, in turn, is concerning the financial markets because it may mean that credit quality is declining.

And so that’s part of this financial accelerator or adverse feedback loop is one of the concerns that we have, and one of the reasons why we have been trying to address those issues.

Never mentions in countercyclical tax structure – the automatic stabilizers that Fed research has shown to be highly effective in dampening cycles since WWII.

RON PAUL, U.S. REPRESENTATIVE (R-TX):

Thank you, Mr. Chairman.

(rant snipped)

And when you look at it — and I mentioned in my opening statement that M3, now, measured by private sources, is growing by leaps and bounds. In the last two years, it increased by 40, 42 percent. Currently, it’s rising at a rate of 16 percent.

It’s all in the definition of that aggregate.

The Fed dropped it for a good reason.

(more rant snipped)

So if we want stable prices, we have to have stable money. But I cannot see how we can continue to accept the policy of deliberately destroying the value of money as an economic value. It destroys — it’s so immoral in the sense that, what about somebody who’s saved for their retirement and they have CDs and we’re inflating the money at a 10 percent rate? Their standard of living is going down.

And that’s what’s happening today. The middle class is being wiped out and nobody is understanding that it has to do with the value of money. Prices are going up.

So, how are you able to defend this policy of deliberate depreciation of our money?

BERNANKE:

Congressman, the Federal Reserve Act tells me that I have to look to price stability — price stability, which I believe is defined as the domestic prices — the consumer price index, for example — and that’s what we aim to do. We look for low domestic inflation.

CPI and core is way above Fed comfort zones and rising.

Now, you’re correct that there are relationships, obviously, between the dollar and domestic inflation and the relationships between the money supply and domestic inflation. But those are not perfect relationships. They’re not exact relationships.

And, given a choice, we have to look at the inflation rate — the domestic inflation rate.

Now, I understand that you would like to see a gold standard, for example, but that it is really something for Congress. That’s not my decision.

PAUL:

But your achievement — we have now PPI going up at a 12 percent rate. I would say that doesn’t get a very good grade for price stability, wouldn’t you agree?

BERNANKE:

No, I agree. It’s not — the more relevant one, I think, is the consumer price index, which measures the price consumers have to pay, and that was, last year, between 3.5 and 4 percent.

It finished the year North of 4%.

And I agree, that’s not a good record.

PAUL:

And the PPI is going to move over into the consumer index, as well.

BERNANKE:

We’re looking forward this year and we’re trying to estimate what’s going to happen this year. And a lot of it depends on what happens to the price of oil.

And if oil flattens out, we’ll do better. But if it continues at the rate in 2007, it’ll be hard to maintain low inflation. I agree.

PAUL:

Thank you.

Expected more from Mr. Paul.

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Plosser speech

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From Philadelphia Fed President Plosser:

To be more concrete, many versions of the simple rules that I refer to when gauging the current stance of monetary policy call for a funds rate that is above the current funds rate.

‘Taylor Rule’ etc.

But the severity of the events affecting the smooth functioning of financial markets suggests that rates, perhaps,

PERHAPS???

should be somewhat lower than simple rules might suggest. However, determining the appropriate extent of such extra accommodation is difficult to quantify, but should also be disciplined by systematic policy.

Consequently, there are, and should be, limits to such departures from the guidance given by simple rules.

Seems he’s in the camp that the Fed is at or near its limits regarding rate cuts when inflation is this threatening.

One cannot, and should not, ignore other fundamental aspects of policy, especially the tendency for inflation to accelerate when policy is unduly easy.

This is the mainstream view – inflation doesn’t just go up, it accelerates when expectations begin to elevate.

Moreover, departures from the more systematic elements of making policy decisions must be relatively transitory and reversed in due course if we are to keep expectations of future inflation well-anchored.

Bernanke conspicuously left this out of his testimony last week.

Otherwise we risk eroding the public’s confidence in monetary policy’s commitment to deliver price stability, and we know from the 1970s and early 1980s that the cost of regaining the public’s confidence can be quite high.

Sounds like he’s in the Fisher camp and not inclined to favor another cut with inflation where it is.

The benefits of operating in an environment with the transparency afforded by simple rules is that it gives monetary policymakers the ability to anchor expectations and affords them the opportunity to temporarily deviate from the simple rules in extraordinary circumstances without eroding central bank credibility. We are now, perhaps,

‘PERHAPS’ again – meaning we might not be.

in a period of extraordinary circumstances and have deviated from the benchmarks suggested by simple rules. But such deviations should be temporary and limited and promptly reversed when conditions return to normal.

Can’t be more clear on this.

Monetary policymakers should continue to pursue their efforts to develop and put into practice more rule-like behavior. It is one of the more important paths to sound monetary policy over the long-run.

Looks like more movement to the Fisher camp as the March 18 meeting approaches.

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Re: falling interest rates

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(an intersibling email)

>
> On 3/3/08,  seth wrote:
> who is buying 2 year notes at 1.63????
> seth
>

simple:

high food and gas prices= weaker consumer= fed cutting rates = weaker $= even higher food and gas prices= even weaker consumer = fed cutting rates even more= even weaker $… = prices at infinity and rates at minus infinity

get long!!!

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Central bank debate: Is it inflation or deflation?

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Here’s how the inflation can persist indefinitely:

  1. In addition to the India/China type story for resource demand, this time around nominal demand for commodities is also coming from our own pension funds who are shifting more of their financial assets to passive commodity strategies.

    Pension funds contributions have traditionally been invested primarily in financial assets, making them ‘unspent income’ and therefore ‘demand leakages.’ Other demand leakages include IRAs (individual retirement accounts), corporate reserve funds, and other income that goes ‘unspent’ on goods and services.

    Supporting these demand leakages are all kinds of institutional structure, but primarily tax incentives designed to increase ‘savings’.

    These come about due to the ‘innocent fraud’ that savings is necessary for investment, a throwback to the gold standard days of loanable funds and the like.

    A total of perhaps $20 trillion of this ‘unspent income’ has accumulated in the various US retirement funds and reserves of all sorts.

    This has ‘made room’ for the government deficit spending we’ve done to not be particularly inflationary. In general terms, the goods and services that would have gone unsold each year due to our unspent income have instead been purchased by government deficit spending.

    But now that is changing, as a portion of that $20 trillion is being directed towards passive commodity strategies. While the nature of these allocations varies, a substantial portion is adding back the aggregate demand that would have otherwise stayed on the sidelines.

    That means a lot less government deficit spending might be needed to sustain high levels of demand than history indicates.

    And, of course, the allocations directly support commodity prices.
  1. We are faced with the same monopoly supplier/swing producer of crude oil as in the 1970’s.

    Back then the oil producers simply accumulated $ financial assets and were the source of a massive demand leakage that caused widespread recession in much of the world. And didn’t end until there was a supply response large enough to end the monopoly pricing power.

    But it did persist long enough for the ‘relative value story’ of rising crude prices to ‘turn into an inflation story’ as costs were passed through the various channels.

    And a general inflation combined with the supply response served to return the real terms of trade/real price of crude pretty much back to where they had been in the early 1970’s.
  1. This time around rather than ‘hoard’ excess oil revenues the producers seem to be spending the funds, as evidence by both the trillions being spent on public infrastructure as well as the A380’s being built for private use, and the boom in US exports- 13% increase last month.

    This results in increased exports from both the US and the Eurozone to the oil producing regions (including Texas) that supports US and Eurozone GDP/aggregate demand.

    At the macro level, it’s the reduced desire to accumulate $US financial assets that is manifested by increasing US exports.

    (This reduced desire comes from perceptions of monetary policy toward inflation, pension fund allocations away from $US financial assets, Paulson calling CBs who buy $US currency manipulators and outlaws, and ideological confrontation that keeps some oil producers from accumulating $US, etc. This all has weakened the $ to levels where it makes sense to buy US goods and services – the only way foreigners can reduce accumulations of $US is to spend them on US goods and services.)

    The channels are as follows:

    1. The price of crude is hiked continuously and the revenues are spent on imports of goods and services.
    2. This is further supported by an international desire to reduce accumulation of $US financial assets that lowers the $ to the point where accumulated $ are then spent on US goods and services.

    For the US this means the export channel is a source of inflation. Hence, the rapid rise in both exports and export prices along with a $ low enough for US goods and services (and real assets) to represent good value to to foreigners.

  1. This is not a pretty sight for the US. (Exports are a real cost to the US standard of living, imports a real benefit.)

    Real terms of trade are continually under negative pressure.

    The oil producers will always outbid domestic workers for their output as a point of logic.

    Real wages fall as consumers can find jobs but can’t earn enough to buy their own output which gets exported.

    Foreigners are also outbidding domestics for domestic assets including real estate and equity investments.
  1. The US lost a lot off aggregate demand when potential buyers with subprime credit no longer qualified for mortgages.

    Exports picked up the slack and GDP has muddled through.

    The Fed and Treasury have moved in an attempt to restore domestic demand. Interest rate cuts aren’t effective but the fiscal package will add to aggregate demand beginning in May.

    US export revenues will increasingly find their way to domestic aggregate demand, and housing will begin to add to GDP rather than subtract from it.

    Credit channels will adjust (bank lending gaining market share, municipalities returning to uninsured bond issuance, sellers ‘holding paper,’ etc.) and domestic income will continue to be leveraged though to a lesser degree than with the fraudulent subprime lending.

    Pension funds will continue to support demand with their allocations to passive commodity strategies and also directly support prices of commodities.
  1. Don’t know how the Fed responds – my guess is rate cuts turn to rate hikes as inflation rises, even with weak GDP.
  1. We may be in the first inning of this inflation story.

    Could be a strategy by the Saudis/Russians to permanently disable the west’s monetary system, shift real terms of trade, and shift world power.
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Here’s how Congress sees it…

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Congress sees their voters facing prices that are rising faster than incomes due to Fed rate cuts driving the $ down.

Bernanke testifies that price hikes for food and energy are not a problem for the Fed until wages go up.

So, he’s going to keep cutting rates and driving the cost of living higher until wages go up or Wall Street recovers.

Then, he hikes rates if inflation isn’t behaving.

Hardly a comforting response to those working for a living and getting squeezed by the high prices.

With elections coming, I anticipate the Congressional opposition to escalate.

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FT.com The Economists’ Forum (cont.)

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On 3/1/08, Wray, Randall wrote:

agreed supervisors/regulators need to do their job. however there is also something to be said for economic growth restoring balance sheets. i think his proposal to clamp down hard on banks now to get capital ratios up would make things worse.

Yes, seems it could hurt current demand. The government of Japan wound up buying preferred stock from the banks at the expense of shareholders, much like the sovereign wealth funds are doing today in the US.

No one seems to understand the US doesn’t ‘need money’ from any source, and instead feels the nation owes a debt of gratitude to those who invest $ here.

For a long time no one understood the fundamentals: exports are costs, imports benefits, no govt solvency issues, nominal vs real issues, what is and isn’t a function of interest rates, financial equity for one sector must come from another, savings is the accounting record of investment, loans create deposits, CBs are about price not quantity, etc.- but it didn’t matter that much they all had it wrong on the way up.

On the way down it is turning what was potentially a non-event for the US real economy into a massive real loss for the US standard of living.

The ‘answer’ to restoring domestic demand and enhancing price stability and real wealth remains:

Offer a public service job to anyone willing and able to work:

  1. better price anchor than unemployment
  2. can produce useful output
  3. reduces social costs of current system
  4. provides a channel to ‘distribute’ productivity gains from the bottom up
  5. let’s the market set the budget deficit

Eliminate using the liability side of banking for ‘market discipline’ by lowering the discount rate to the target interest rate and opening it to any bank with any ‘bank legal’ collateral for any gross $amount. The net will be very small in any case.

Use capital requirements for market discipline and also regulate assets as currently is the case.

Get the treasury out of the capital markets by eliminating government securities and leave the excess balances from government deficit spending in bank reserve accounts.

Leave interest rates at zero, and let the Fed concentrate on regulation.

Unilaterally eliminate restrictions on exports to the US apart from quality and env. concerns.

To keep domestic industries deemed essential for national security have government buy from them, but let the private sector source anywhere.

Restore the notion of real terms of trade to national politics.
etc.

But since none of that is going to happen, I see continued weakness and a lower standard of living via ever higher prices and deteriorating terms of trade.

And a Cervantesesque Fed pursuing a merchantalist ideal.

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FT.com The Economists’ Forum: Why Washington’s rescue cannot end the crisis story

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Why Washington’s rescue cannot end the crisis story



by Martin Wolf

Last week’s column on the views of New York University’s Nouriel Roubini (February 20) evoked sharply contrasting responses: optimists argued he was ludicrously pessimistic; pessimists insisted he was ridiculously optimistic. I am closer to the optimists: the analysis suggested a highly plausible worst case scenario, not the single most likely outcome.

Those who believe even Prof Roubini’s scenario too optimistic ignore an inconvenient truth: the financial system is a subsidiary of the state. A creditworthy government can and will mount a rescue. That is both the advantage – and the drawback – of contemporary financial capitalism.

Any government with its own non-convertible currency can readily support nominal domestic aggregate demand at any desired level and, for example, sustain full employment as desired.

The ‘risk’ is ‘inflation’ as currently defined, not solvency.

In an introductory chapter to the newest edition of the late Charles Kindleberger’s classic work on financial crises, Robert Aliber of the University of Chicago Graduate School of Business argues that “the years since the early 1970s are unprecedented in terms of the volatility in the prices of commodities, currencies, real estate and stocks, and the frequency and severity of financial crises”*. We are seeing in the US the latest such crisis.

Yes, price volatility has seemingly substituted for output gap volatility.

All these crises are different. But many have shared common features. They begin with capital inflows from foreigners seduced by tales of an economic El Dorado.

With floating fx/non-convertible currency ‘capital inflows’ do not exist in the same sense they do with a gold standard and other fixed fx regimes.

This generates low real interest rates and a widening current account deficit.

The current account deficit is a function of non-resident desires to accumulate your currency. These desires are functions of a lot of other variables.

Non-residents can only increase their net financial assets of foreign currencies by net exports.

This is all an accounting identity.

Domestic borrowing and spending surge, particularly investment in property. Asset prices soar, borrowing increases and the capital inflow grows. Finally, the bubble bursts, capital floods out and the banking system, burdened with mountains of bad debt, implodes.

With variations, this story has been repeated time and again. It has been particularly common in emerging economies. But it is also familiar to those who have followed the US economy in the 2000s.

The US did not get here by that casual path.

Foreign CB accumulation of $US financial assets to support their export industries supported the US trade deficit at ever higher levels.

The budget surpluses of the late 1990s drained exactly that much net financial equity from then non-government sectors (also by identity).

As this financial equity that supports the credit structure was reduced via government budget surpluses, non-government leverage was thereby increased.

This meant increasing levels of private sector debt were necessary to sustain aggregate demand as evidenced by the increasing financial obligations ratio.

Y2K panic buying and credit extended to funding of improbably business plans came to a head with the equity peak and collapse in 2000.

Aggregate demand fell, GDP languished, and the countercyclical tax structure began to reverse the surplus years and equity enhancing government deficits emerged.

Interest rates were cut to 1% with little effect.

The economy turned in Q3 2003 with the retroactive fiscal package that got the budget deficit up to about 8% of GDP for Q3 2003, replenishing non-government net financial assets and fueling the credit boom expansion that followed.

Again, counter cyclical tax policy began bringing the federal deficit down, and that tail wind diminished with time.

Aggregate demand was sustained by increasing growth rates of private sector debt, however it turns out that much of that new debt was coming from lender fraud (subprime borrowers that qualified with falsified credit information).

By mid 2006, the deficit was down to under 2% of GDP (history tells us over long periods of time we need a deficit of maybe 4% of GDP to sustain aggregate demand, due to demand ‘leakages’ such as pension fund contributions, etc.), and the subprime fraud was discovered.

With would-be-subprime borrowers no longer qualifying for home loans, that source of aggregate demand was lost, and housing starts have since been cut in half.

This would have meant negative GDP had not exports picked up the slack as non-residents (mainly CBs) stopped their desire to accumulate $US financial assets. This was Paulson’s work as he began calling any CB that bought $US a currency manipulator and used China as his poster child. Bernanke helped with his apparent ‘inflate your way out of debt/beggar thy neighbor policy’. Bush also helped by giving oil producers ideological reasons not to accumulate $US financial assets.

Our own pension funds also helped sustain GDP and push up prices with their policy of allocating to passive commodity strategies as an asset class.

The fiscal package will add about $170 billion to non-government net financial assets, and non-residents reducing their accumulation of $US financial assets via buying US goods and services will also continue to help the US domestic sector replenish its lost financial equity. This will continue until domestic demand recovers, as in all past post World War II cycles.

When bubbles burst, asset prices decline, net worth of non-financial borrowers shrinks and both illiquidity and insolvency emerge in the financial system. Credit growth slows, or even goes negative, and spending, particularly on investment, weakens. Most crisis-hit emerging economies experienced huge recessions and a tidal wave of insolvencies. Indonesia’s gross domestic product fell more than 13 per cent between 1997 and 1998. Sometimes the fiscal cost has been over 40 per cent of GDP (see chart).

Yes, interesting that this time with the boom in resource demand, emerging markets seem to be doing well.

By such standards, the impact on the US will be trivial. At worst, GDP will shrink modestly over several quarters.

Yes, that is the correct way to measure the real cost. Still high, as growth is path dependent, but not catastrophic.

The ability to adjust monetary and fiscal policy insures this. George Magnus of UBS, known for his “Minsky moment”, agrees with Prof Roubini that losses might end up as much as $1,000bn (FT.com, February 25). But it is possible that even this would fall on private investors and sovereign wealth funds.

Those are nominal losses: rearranging of financial assets. The real losses are the lost output/unemployment/etc.

In any case, the business of banks is to borrow short and lend long.

Not US banks – that’s called gap risk, and it’s highly regulated.

Provided the Federal Reserve sets the cost of short-term money below the return on long-term loans, as it has for much of the past two decades, banks can hardly fail to make money.

As above. In fact, with low rates, banks make less on free balances.

If the worst comes to the worst, the government can mount a bail-out similar to the one of the bankrupt savings and loan institutions in the 1980s. The maximum cost would be 7 per cent of GDP.

Again, that’s only a nominal cost, a rearranging of financial assets.

That would raise US public debt to 70 per cent to GDP and would cost the government a mere 0.2 per cent of GDP, in perpetuity.

Whatever that means..

That is a fiscal bagatelle.

Because the US borrows in its own currency,

Spends first, and then borrows to support interest rates, actually

(See Soft Currency Economics.)

it is free of currency mismatches that made the balance-sheet effects of devaluations devastating for emerging economies.

True. ‘External debt’ is not my first choice for any nation.

Devaluation offers, instead, a relatively painless way out of a slowdown: an export surge.

Wrong in the real sense!

Exports are real costs; imports are real benefits. So, a shift as the US has been doing is actually the most costly way to ‘fix things’ in real terms.

And it’s obvious the real standard of living in the US is taking a hit – ‘well anchored’ incomes and higher prices are cutting into real consumption that’s being replaced by real exports/declining real terms of trade, etc.

Between the fourth quarter of 2006 and the fourth quarter of 2007, the improvement in US net exports generated 30 per cent of US growth.

Yes, we work and export the fruits of our labor. In real terms, that’s a negative for our standard of living.

The bottom line, then, is that even if things become as bad as I discussed last week, the US government is able to rescue the financial system and the economy. So what might endanger the US ability to act?

The biggest danger is a loss of US creditworthiness.

Solvency is never an issue. I think he recognizes this but not sure.

In the case of the US, that would show up as a surge in inflation expectations. But this has not happened. On the contrary, real and nominal interest rates have declined and implied inflation expectations are below 2.5 per cent a year.

I think they are much higher now, but in any case, inflation expectations are a lagging indicator, and in my book cause nothing.

An obvious danger would be a decision by foreigners, particularly foreign governments, to dump their enormous dollar holdings.

The desire to accumulate $US financial assets by foreigners is already falling rapidly, as evidenced by the falling $ and increased US exports. The only way to get rid of $ financial assets is ultimately to ‘spend them’ on US goods, services, and US non-financial assets, which is happening and accelerating. Exports are growing at an emerging market like 13% clip and heading higher.

But this would be self-destructive. Like the money-centre banks, the US itself is much “too big to fail”.

Statements like that make me think he still has some kind of solvency based model in mind.

Yet before readers conclude there is nothing to worry about, after all, they should remember three points.

The first is that the outcome partly depends on how swiftly and energetically the US authorities act. It is still likely that there will be a significant slowdown.

If so, the tax structure will rapidly increase the budget deficit and restore aggregate demand, as in past cycles.

The second is that the global outcome also depends on action in the rest of the world aimed at sustaining domestic demand in response to a US shift in spending relative to income. There is little sign of such action.

True, budget deficits are down all around the world except maybe China and India, especially if you count lending by state supported banks, which is functionally much the same as government deficit spending.

The third point is the one raised by Harvard’s Dani Rodrik and Arvind Subramanian, of the Peterson Institute for International Economics in Washington DC, (this page, February 26), namely the dysfunctional way capital flows have worked, once again.

I would broaden their point. This is not a crisis of “crony capitalism” in emerging economies, but of sophisticated, rules-governed capitalism in the world’s most advanced economy. The instinct of those responsible will be to mount a rescue and pretend nothing happened. That would be a huge error.

Those who do not learn from history are condemned to repeat it.

And those who keep saying that seem to be the worst violators.

One obvious lesson concerns monetary policy. Central banks must surely pay more attention to asset prices in future. It may be impossible to identify bubbles with confidence in advance. But central bankers will be expected to exercise their judgment, both before and after the fact.

While asset prices are probably for the most part a function of interest rates via present value calculations, my guess is that other more powerful variables are always present.

A more fundamental lesson still concerns the way the financial system works. Outsiders were already aware it was a black box. But they were prepared to assume that those inside it at least knew what was going on. This can hardly be true now. Worse, the institutions that prospered on the upside expect rescue on the downside.

I’d say demand rather than expect. Can’t blame them – whatever it takes – profits often go to the shameless.

They are right to expect this. But this can hardly be a tolerable bargain between financial insiders and wider society. Is such mayhem the best we can expect? If so, how does one sustain broad public support for what appears so one-sided a game?

Watch it and weep.

Yes, the government can rescue the economy. It is now being forced to do so. But that is not the end of this story. It should only be the beginning.

‘should’ ???

Fiscal costs of bank bailouts

US yield curve

US inflation expectations

* Manias, Panics and Crashes, Palgrave, 2005.

martin.wolf@ft.com

February 27th, 2008 in US economy | Permalink

4 Responses to “Why Washington’s rescue cannot end the crisis story”

Comments

  1. Kent Janér (guest): Largely, I agree with Martin Wolf’s analysis of what went wrong and what should be done in the future to prevent the by now very familiar pattern of boom and bust in regulated financial systems.There is one aspect that I think merits more attention than it has been given, an aspect that also has some important short term effects – the equity base of the financial system. I think the equity base is currently being mismanaged, and regulators could have some tools to improve the situation.

    As everyone knows, there are much more losses in the financial system than have so far been declared. I think close to USD 150 bn has been reported at this stage. That could be compared to for example the G7 comment of 400 bn in mortgage related losses, and 400-1000 bn in total losses probably covering most private sector forecasts. At the same time new risk capital has been raised to the tune of roughly 90 bn USD (ballpark number).

    A back of the envelope calculation shows that a large part of the equity of the financial system has been wiped out, much more than has been reported. The market knows, the regulators know and the banks themselves certainly know that even though they are far from bankrupt, they are on average in truth operating at equity/capital adequacy ratios clearly below both legal requirements and sound banking practices.

    Currently, the banks are responding by reporting losses little by little, keeping up the appearance of reasonable capitalization. At the same time, they try to reduce their balance sheet, especially from items that carry a high charge to capital. This way they hope (but hope is never a strategy) that time will heal their balance sheet; earnings will over time be able to offset continued writedowns. High vulnerability to negative surprises, but no formal problems with minimum capital adequacy ratios and control of the bank, “only” weak earnings for some time.

    That is all very nice and cosy for bank´s directors, but not for the economy in general. If a small part of the banking sector has specific problems and rein in lendig, so be it. That probably has little impact on the rest of the economy. However, if the entire financial sector postpone reported losses and contract their balance sheet, that is another question altogether. The cost to rest of the economy could be very high indeed.

I am less concerned about ‘loanable funds’ with today’s non-convertible currency. I see the issues on the demand side rather than the supply side of funding. Capital ’emerges’ endogenously as a supply side response to potential profits. The reducing lending is largely a function of increased perception of risks.

So, what should be done? Pretending that banks are OK and sweat it out over time is dangerous to economy as a whole, but so is being too harsh on the banks right now.

I actually think there is an answer – the banks should be made to recapitalize quickly and aggressively. Accepting new equity capital would minimize social cost of their current mistakes. There is an obvious practical problem with that, the price at which that capital is available is not necessarily the price at which current shareholders want to be diluted. So, in essence, the banking system continues to push the cost of their mistakes to others by not coming clean on their losses and recapitalize, rather they try to muddle through by not declaring their losses in full and pull in lending to the rest of the economy.

You hit on my initial reaction here. It’s up to the shareholders to supply market discipline via their desire to add equity, and it’s up to the regulators to make sure their funds – the insured deposits (most of the liability side, actually, when push comes to shove) – are protected by adequate capital and regulated bank assets. I think they are doing this, and, if not, the laws are in place and the problem is lax regulation.

I think regulators should be tougher here, banks that clearly are below formal capital adequacy ratios with proper mark to market should be armtwisted to accept new money.

Yes, as above.

I am also looking with dismay on the fact that even some of the weaker banks are still paying dividends to their shareholders – on a global scale I think the financial system has paid out more in dividends since the start of the crisis than they have raised in new capital.

Also, a regulatory matter. Regulators are charged with protecting state funds that insure the bank liabilities.

My proposals have been to not use the liability side of banks for market discipline. Instead, do as the ECB has done and fund all legal bank assets for bank in compliance with capital regulations.

So, a likely situation is that banks with failed business models in the first part of the crisis distribute capital to their owners and somewhat later asks the taxpayer for help…

Kent Janer runs the Nektar hedge fund at Brummer & Partners AB in Sweden Posted by: Kent Janér | February 27th, 2008 at 3:06 pm |

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Answer to question re: changing mood in Congress

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jcmccutcheon Says:
February 29th, 2008 at 4:11 pm

Lots of chatter on CNBC about main street prices going up. Hardware, fast food, 1 dollar bagels et-al. Looking like main street clamoring about inflation which would translate into hawkish pressure on the Fed vs wall-street’s wanting more easing due to credit crises, stock market.

Any opinions on how this plays out politically? Doesn’t joe 6-pack look at gas prices and food prices and blame it on bush and the republicans which opens it up for Obama.

short answer:

yes

longer answer:

Most Congressmen know the voters hate inflation more than they care about unemployment. There are a lot of Ron Paul types out there when it comes to inflation, and the questions to Bernanke showed a rapidly increasing concern.

I’ve suggested this will accelerate, with the Fed soon being blamed for higher food and energy prices via the apparent weak dollar/inflate your way out of debt policy. The charts line up well enough to ‘prove’ that Fed policy caused the weak dollar, and the inflation and mainstream theory that believes all that stuff is a function of interest rates can’t deny it either.

The story ‘the record tells’ is that the Fed tried to bail out Wall st with rate cuts knowing that the majority of people working on main street would be impoverished as their purchasing power eroded and wages remained ‘well anchored.’ And if the Fed had thought wages were not well anchored they never would have cut rates. The Fed has made it clear the main channel for inflation expectations is workers demanding higher pay, and they have repeated said they haven’t yet seen signs of this so it’s still safe to cut rates, drive the dollar down and imported prices up, without triggering a wage/inflation response.

Additionally, in Bernanke’s latest testimony, he further specifically stated and repeated that he didn’t want domestic consumption to go up, but rather exports and investment. The channel for this has been higher prices for consumers keeping real consumption down, and the weaker dollar policy driving exports higher, which leads to investment in the export sector, and domestic consumption remains subdued.

Note my posts with subtitles ‘this is what an export economy looks like.’

From last week’s testimony:

Bernanke:

It depends on how the inflation — as you say, on how — if it becomes entrenched.

If inflation expectations were to rise and that were to lead to a wage/price spiral, for example,…

And:

…we want to make sure the economy is growing in a stable and healthy way which will attract foreign investment.

Foreign investment, I should emphasize, continues to be strong. We’re not seeing any shifts — significant shifts out of dollars among official holders, for example.

And I anticipate that it will continue — that we’ll continue to have the capital inflows we need.

The idea that we ‘need’ foreign investment is also an error that supports his notion of what the US economy ‘should’ look like.

And soon after from Bernanke:

With respect to inflation, I think our principal tool would be the interest rate.

And does this sound possible?:

So, what I’d like to see, essentially, is a reduction in the risks — the downside risk which I’ve talked about, particularly the risk that a worsening economy will make the credit market situation worse.

And if inflation was a problem then, what is it now?:

When we lowered interest rates on the last day of October, that morning we received a GDP report for the third quarter, 3.9 percent, which was substantially revised to 4.9 percent, and inflation was a problem.

So, in fact, I think as we look back on this episode, we will see that the Fed lowered interest rates faster and more proactively in this episode probably than any other previous episode.

As you point out, the unemployment rate is still below 5 percent.

Again, this can all be construed as bailing out the financial sector via a weak dollar/high inflation policy at the expense of working people who’s ‘inflation expectations/wage demands are well anchored.

It also can mean that if wages do start to rise the game is up and policy turns to rate hikes.

Well, if inflation were to — higher inflation were to become well embedded in inflation expectations and wages and other parts of the economy, it would be difficult, and we don’t really have new methods.

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Valance chart review

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2008-03-01-real-gdp-industrial-production-capacity-utilization-ism-manufacturing.jpg

While the actual numbers don’t look bad…

2008-03-01-philly-fed-index-chicago-pmi-ism-non-manufacturing-empire-manufacturing-index.jpg

The surveys look ominous.

2008-03-01 Retail Sales

And retail hit a soft spot at year end.

2008-03-01 Initial & Continuing Claims

Employment data not a recession levels but weaker nonetheless.

2008-03-01 Housing Starts, Housing Affordability

2008-03-01 NAHB

2008-03-01 OFHEO Home Prices

Housing subtracted 1.25% for Q4, but some signs that while weak, it won’t be nearly as negative for GDP going forward.

2008-03-01 Trading Balance

Exports (non-residents reducing their accumulation of $US financial assets) are doing their thing and supporting GDP.

2008-03-01 Government Spending, Government Revenue

Government spending making a comeback and revenues not near recession levels yet.

2008-03-01 CPI, PCE

2008-03-01 PPI, Import Prices

2008-03-01 Export Prices, CRB Index

2008-03-01 ISM, Chicago PMI

2008-03-01 Metals

2008-03-01 Traded Weighted Dollar

These charts say it all about prices.

2008-03-01 Unit Labor Costs, Employment Cost Index

These look okay. Some FOMC members are waiting for them to turn up before they are convinced we have an inflation problem. Others think it will be too late when that happens.

2008-03-01 ABC

And confidence is at an all time low.

Not the least because higher prices are making it tougher for households to make ends meet.

Might that be an inflation problem???

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2008-02-29 US Economic Releases

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2008-02-29 Personal Income YoY

Personal Income YoY (Jan)

Survey n/a
Actual 4.9
Prior 5.6
Revised n/a

Falling off some. Interest rates are partially responsible, as last I checked households are still net savers and have net interest income.

This is one reason I lean towards the view that lower interest rates tend to slow nominal growth, while higher interest rates support nominal growth.

2008-02-29 Personal Consumption Expense Nom$ YoY

Personal Expenditures Nominal$ YoY (Jan)

Survey n/a
Actual 5.5%
Prior 5.8%
Revised n/a

Nominal spending holding up. With our ‘new’ export economy, real spending gives way to exports, and GDP muddles through.

2008-02-29 Personal Consumption Expenditures Chain YoY

Personal Expenditures Chain YoY (Jan)

Survey n/a
Actual 1.8%
Prior 2.1%
Revised n/a

2008-02-29 Personal Consumption Expenditures Price YoY

Personal Expenditure Price YoY (Jan)

Survey n/a
Actual 3.7%
Prior 3.6%
Revised n/a

This is problematic for the Fed.

2008-02-29 Personal Consumption Expenditures Core YoY

Personal Expenditure Core YoY (Jan)

Survey n/a
Actual 2.2%
Prior 2.2%
Revised n/a

This is not easy for the Fed to watch, as they worked long and hard to bring it below 2% and back to their comfort zone of 1-2%. Now the concern is how hard it will be to bring down from even higher expected levels if they keep cutting rates.

2008-02-29 Personal Consumption Market Based YoY

Personal Consumption Market Based YoY (Jan)

Survey n/a
Actual 3.7%
Prior 3.6%
Revised n/a

As above, this is way too high for comfort.

2008-02-29 Personal Consumption Expendatures Market Based Core YoY

Personal Consumption Market Based Core YoY (Jan)

Survey n/a
Actual 1.9%
Prior 2.0%
Revised n/a

Also as above. Ok, but threatening to move higher and be very costly to bring back down.

2008-02-29 PCE Core YoY

PCE Core YoY (Jan)

Survey 2.2%
Actual 2.2%
Prior 2.2%
Revised n/a

As above.

2008-02-29 Chicago Purchasing Manager

Chicago Purchasing Manager (Feb)

Survey 49.5
Actual 44.5
Prior 51.5
Revised n/a

2008-02-29 Chicago Purchasing Manager TABLE

Chicago Purchasing Manager TABLE

Definitely not good, but like ISM, a survey that gets subjective responses, and price components remain high.

New orders up as well.

2008-02-29 U. of Michigan Confidence

U. of Michigan Confidence (Feb F)

Survey 70.0
Actual 70.8
Prior 69.6
Revised n/a

2008-02-29 U of Michigan Confidence TABLE

U. of Michigan Confidence TABLE

While better than expected, does not look good.

And one year inflation expectations are up to 3.6%.

2008-02-29 NAPM Milwaukee

NAPM-Milwaukee (Feb)

Survey n/a
Actual 53.0
Prior 58.0
Revised n/a

Below expectations, but positive. Probably won’t get reported anywhere else..

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