Bernanke's Dilemma
By Mike Whitney
October 27, 2010 "Information Clearing House" --
Ben Bernanke is in a real fix. His quantitative easing
(QE) program is designed to boost stock prices, lower
bond yields, and weaken the dollar. But the market has
already priced all that in, so when he announces the
start of the program on November 3, there's a good
chance that things will either stay the same or head in
the opposite direction. That's bad for Bernanke. Just
imagine if the dollar strengthens just as the Fed
chairman begins buying-up Treasuries to push the
dollar down. He'll look pretty foolish. But that could
happen because the dollar has already slipped nearly
7% since August and is overdue for a rebound.
So, what should he do? Should he go ahead and launch
his program anyway knowing it could backfire and
further damage his credibility or scrap the whole deal
and move on to Plan B?
The truth is, he has no choice. If he doesn't follow
through now, investors will accuse him of "withdrawing
liquidity" and send the market into a nosedive. So, he
has to go forward and let the chips fall where they may.
If QE2 turns out to be a bust, so be it.
A new report from Goldman Sach's economist Jan
Hatzius figures that "the Fed will need to print $4
trillion...to close the Taylor gap." (zero hedge) That
means it will take roughly $4 trillion for QE to do what
it's supposed to do. New York Times columnist Paul
Krugman's estimates are even higher. He thinks it will
take $8 to 10 trillion of QE to push down long-term
rates enough to sustain the recovery. Of course, no one
is even considering expanding the Fed's balance sheet
by that amount because it would put the central bank's
future at risk and might not work anyway. Instead,
Bernanke plans to take baby steps, purchasing $200 to
$300 billion in Treasuries at a time, hoping that the
smaller amounts buoy stocks and increase investment in
the real economy. In other words, QE2 is not a really
serious commitment of resources to address
deflationary pressures, excess capacity or high
unemployment at all. It's more like giving aspirin to a
cancer patient. There may some temporary relief, but
the overall effects will be negligible.
That's not to say that the Fed isn't a powerful
institution. It is. The Fed controls short-term interest
rates and short-term rates can either stimulate growth or
send the economy into a tailspin. They can guide the
economy to years of productivity and prosperity or
generate gigantic speculative bubbles that end in
disaster. But, in a liquidity trap--when interest rates are
stuck at zero—monetary policy is largely ineffective so
the Fed is dead-in-the-water. It doesn't matter how
cheap money is when people aren't borrowing. And,
people aren't borrowing because they're broke. The Fed
doesn't have the ability to change that. Bernanke may
wish he was "Helicopter Ben" and could drop bundles
of greenbacks over America, but the truth is, only
congress has that power and they're not taking
advantage of it. They're more worried about deficits.
So, QE won't succeed because it doesn't address the real
issue, which is demand. In theory, when the Fed buys
bonds, it pushes investors into riskier assets, like stocks.
That, in turn, inflates equities prices which
(supposedly) triggers additional hiring and lowers
unemployment. It's a persuasive theory, but it won't
work. Here's an excerpt from an article in the Wall
Street Journal which explains why:
"While more quantitative easing will help to keep
interest rates low, primary dealer banks aren't fully
convinced that the move will prove to be the U.S.
economy's knight in shining armor.
"It may help to lower rates temporarily," said Ward
McCarthy, chief financial economist and managing
director of the fixed-income division at Jefferies & Co.
in New York, "but is unlikely to have a significant
beneficial effect on the economy."
That is because such a program won't ease credit
conditions for small businesses that are dependent on
banks for lending, he said, nor will it lower borrowing
costs for homeowners who are unable to refinance their
mortgages because home prices have fallen." (No Fix in
Quantitative Easing, Deborah Lynn Blumberg, Wall
Street Journal)
So, if QE doesn't help small businesses (which create
most of the country's new jobs) or homeowners, than
how can it lower unemployment, trim excess capacity,
or increase aggregate demand? It can't. At best, it will
merely boost asset prices and create more bank reserves
while the real economy continues to languish in a near-
Depression.
Naturally, the prospect of the Fed adding trillions of
dollars to the money supply has trading partners in a
panic forcing some to regulate capital inflows and
prepare for a savage round of competitive devaluation.
At this weekend's meeting of the G-20 in Gyeongju,
South Korea, German finance minister, Rainer
Brüderle lashed out at the Fed's QE program saying,
“Excessive, permanent money creation in my opinion is
an indirect manipulation of an exchange rate.” The
irony of the Brüderle's remarks were lost on Treasury
secretary Timothy Geithner who used the meetings to
point the finger at China and to make his case for
"numerical limits" on current account balances. This is
from Bloomberg:
"Seeking to find common ground on currency
valuation, officials agreed to “move toward more
market-determined exchange rate systems that reflect
underlying economic fundamentals.” And they pledged
to “refrain from competitive devaluation of currencies”
— an effort to calm anxiety over a wave of
protectionism in which countries would weaken their
currencies to bolster their own exports."
It makes you wonder how the attendees could listen to
Geithner's disingenuous blather knowing that the Fed is
planning to print up hundreds of billions of dollars that
could wreak havoc in the currency markets?
Even so, Geithner is right to be worried about the
widening trade deficits. The massive imbalances
inevitably lead to crises as they did when Lehman
defaulted and global trade plummeted. In the last
decade, US exports to China have totaled just $417
billion while Chinese imports have soared to $2,160
billion. Much of China's earnings have been recycled
into US Treasuries to keep the price of their currency
artificially low while they add to their $2.6 trillion in
reserves. This gives them an unfair advantage in
competing head-to-head with better-paid US workers.
In August, the trade gap widened more than analysts
had predicted to $46 billion putting more pressure on
the Fed to weaken the dollar so that more US jobs are
not lost to foreign competitors and so that monetary
stimulus (designed to kickstart the US economy) is not
siphoned off via the trade deficit.
The bottom line: Economic recovery is impossible
unless exchange rate issues are resolved. Bernanke may
think that QE2 will scare China into reversing its
current policy (and agree to move toward more marketoriented
exchange rate system) but it's just as likely that
Beijing will follow the dollar downward buying up
even more US Treasuries and undermining any hope for
a rebound in the US. That means that congress must get
involved and threaten to levy import duties and tariffs
on China if they refuse to let their currency appreciate.
Congress also needs to acknowledge the limitations of
monetary policy. QE is not the right tool for dealing
with a "balance sheet recession". (when households are
reducing their debts and slashing spending) A second
round of fiscal stimulus is the only way to lower
unemployment, increase spending, and lay the
groundwork for a sustainable recovery.
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