Green Hornet or Mickey Mouse?*

Fed Chairman Bernanke is superhero to some and villain to others as he kicks off a fourth round of money printing

By Echelon.

Published on March 08, 2013 with No Comments

Hamiltonicus

By Hamiltonicus

Are you obsessed with Ben Bernanke yet? Is the U.S. Federal Reserve Chairman an unsung superhero, single-handedly saving the world as well as America from disastrous renewed recession? Or is he a foolish sorcerer, releasing ‘stagflation’ in his reckless conjuring of powers beyond his ken? Some contend that the most powerful person in the world today is Chairman Ben, not President Obama. The future livelihoods of millions may turn as never before on the decisions of one academic bureaucrat in Washington, D.C. In December, the Federal Reserve (or ‘Fed’), the U.S. central bank, announced that it would pursue ‘quantitative easing IV,’ (QE 4), the latest phase in a novel policy initiative launched back in 2008 and maintained intermittently since then. In the next several months under QE 4, the Fed will buy billions of dollars in long-term government debt (Treasury bonds or T-bonds) and mortgage backed securities (MBSs). The Fed finances these purchases by simply crediting its own account with magically-conjured new money, which it then uses to buy the bonds (mainly newly-issued T-bonds) and MBSs. Inaugurating QE 4 indicates that the Fed holds a bleak view of the near-term economic future.

The main objective, as I explain below, is to keep interest rates at rock-bottom levels so as to stimulate borrowing for new business investment and home purchases, thereby promoting recovery. There may be secondary objectives and side-benefits as well: less expensive government borrowing to finance deficits; increased spending through the ‘wealth effect’ of boosted stock values; and payoff of government debt with inflation-cheapened dollars. The danger is that QE will fail to boost growth and will spark inflation through massive increase in the money supply and prolonged low interest rates. Don’t look now, but Chairman Ben presides over the biggest, most unprecedented experiment in monetary history.

Printing money to fight recession is hardly a new idea of course. From right and left respectively, both Milton Friedman and John Maynard Keynes advocated it. Friedman facetiously suggested throwing money from helicopters while Keynes favoured the working class, suggesting that government bury bags of money and pay unemployed folks to dig them up. Get money into people’s hands fast so they will spend, spend, spend.

Of course, nothing is that simple. If we could defeat recession by simply issuing more and more money, we could prevent recession forever by printing infinite money. The obvious problem is that the money would thereby become worthless. If there is logic to fighting recession with monetary expansion, it must be balanced against controlling inflation by limiting expansion. Friedman, for one, believed inflation to be entirely caused by excess money supply. That he nevertheless advocated monetary expansion in recessionary times should give pause to Chairman Bernanke’s right-wing critics. It may make sense to risk inflation when recession stalks the land just as you leap into the river when flames lick your heels.

It’s hard to escape suspecting that the world has fallen into chronic stagnation. The causes appear deeper and more systemic than the 2008 bank crisis, which seemed to trigger a sudden U-turn in a world economy surging upward. The bank crisis may have been less a cause than symptom. Singly and together, economies worldwide may face ‘structural obstacles’, sharply constraining growth for the foreseeable future. Spotlight Chairman Ben, stage center, top hat and cane. Can he keep the house in business until the show as advertised resumes?

Like central banks elsewhere, the Federal Reserve (or ‘Fed’) manipulates interest rates by expanding or contracting supplies of circulating money. In normal times it does this by buying and selling short-term T-debt (government or ‘Treasury’ debt).

Fed purchase of T-debt puts cash into the hands of sellers (usually banks), thereby increasing the active money supply. With money more abundant, less interest can be charged to lend it: interest rates fall correspondingly.

Fed T-debt purchases push interest rates downward through a second mechanism as well. They bid up T-debt re-sale prices, thereby reducing their ‘yield’ when paid off at maturity. (Regardless of its cost when purchased originally from the government (let’s say $85), a T-debt instrument that will pay $100 when redeemed at maturity carries an effective yield of 25% (20/80) if bought for $80 in the re-sale market but only 11% (10/90) if bought for $90.)

Falling yields on T-debt push general interest rates downward as lenders migrate away from safe but low-yield T-debt and starts competing elsewhere for borrowers who will pay interest on new loans. As more potential loan capital chases the limited supply of sound lending opportunities, borrowers bid down what lenders can charge them in interest. The resulting low interest rates may boost production and growth by making it cheaper to borrow.

QE is something you try when you want economic stimulus, but interest rates are already so low that short-term T-debt purchases lose effectiveness. Instead of short-term T-debt, the Fed buys less liquid assets it normally avoids, such as long-term T-debt, corporate debt and MBSs. All such purchases push cash out into the active economy, putting downward pressure on interest rates. Debt purchases meanwhile push bond prices up and give interest rates an additional downward nudge along lines indicated above.
MBS purchases foster job creation in their own roundabout fashion. MBSs arise as collection rights on multiple mortgages (typically many thousands) get sold in packages. Lenders selling mortgages get cash promptly in hand instead of waiting through the durations of the loans and running risk of defaults. For their part, buyers of packaged mortgages (MBSs) acquire chances to win big, through collecting repayments on multiple loans. Because the original lenders reduce their risks through mortgage sales in MBS markets and quickly replenish cash for further lending, interest rates on home loans theoretically fall. This can stimulate home-buying. By pushing MBS prices upward, Fed purchases stimulate the MBS market and thereby encourage low mortgage rates and increased home-buying. This fosters job creation through revival of the critical and currently-moribund construction sector. That’s Ben’s theory, at least.

Some observers praise QE1–$1 trillion between late 2008 and June 2010, mainly in MBS purchases–for ameliorating the U.S. financial emergency by loosening credit. Applause is more muted for QE2: $600 billion between November 2010 and June 2011, mainly in long-term T-debt. Aimed at stoking more rapid growth, QE2 instead left continued sluggishness, with unemployment stuck at levels that would be high for a normal recession, let alone a ‘recovery.’

Then came QE3, known as ‘Operation Twist,’ which ran for several months before terminating last June. ‘Twist’ sought to stimulate new borrowing by pushing down long-term interest rates without increasing the overall size of Fed securities holdings. It did so by purchasing long-term T-debt while selling short-term T-debt in equal volumes. This may seem like bailing from the front of the boat into the back, but Chairman Ben presumably thought long-term rates more important than short-term. ‘Twist’ did not produce resounding growth, but maybe the benchmark of ‘success’ has shifted from accelerating recovery to forestalling renewed recession.

The Fed announced last February that it did not expect interest rates to rise before 2015. This amounted to predicting what its own situation and actions would be over the next three years: it will not feel compelled to stifle accelerating inflation with hiked interest rates because price increases will remain at acceptable levels. Stocks performed impressively through the year on Bernanke’s forecast of continued low interest rates. This may be a secondary benefit of QE: creating a ‘wealth effect’ whereby shareholders see their portfolios fatten and start spending.

But if we seek a ‘wealth effect,’ why just for stock owners? Why not hand magic money out to everyone, as Friedman and Keynes suggest? Congress could do that with requisite legislation, but the Fed cannot do so unilaterally. The Fed is, oddly enough, partly owned by private banks who deposit reserves there by law (hence, Federal Reserve Bank). It can use funds at its disposal to buy securities but cannot simply give money, even magic money, away for free, though its QE purchases almost amount to free money for securities sellers.

Concern is mounting that Bernanke’s extraordinary past, present and possibly future moves will touch off ruinous inflation and wreak other damage without having accomplished much that’s positive. Monetary stimulus has been analogized to ‘pushing on a string’ even in normal times and these are not normal times.
An apparently superior counter-recession policy would be increased government spending for stimulus. But the deficit-hawk Republican Congress will not tolerate this. They cite deficits or at least bloated government as a leading cause of recession in the first place. Even if this is wrong, fighting recession with spending hikes at a time when deficits are already soaring is a scary proposition. Keynes favoured anti-recessionary spending from a baseline of balanced budgets, against cyclical downturns. But we don’t have balanced budgets now and the recession we confront may be something more dreadful than a mere cyclical downturn. If so, Ben may be all we’ve got.

Critics feel Bernanke is underplaying the risk of serious inflation and some see echoes of the situation and policies that produced ‘stagflation’—prolonged stagnation combined with substantial inflation—back during the seventies and eighties. Chairman Ben projects low inflation based on ‘core’ numbers that exclude food and energy prices because they both tend to fluctuate a lot. But if food and energy are included, inflation already registers closer to 3% than 2%. The World Bank warned in November that rising food prices may be a ‘new normal’ despite worldwide recession. If so, they should perhaps be indexed somehow into ‘core’ inflation. And QE itself may push energy prices up, as inflation expectations drive investors toward commodities in general and oil in particular. Completing the loop, higher oil prices mean more expensive food.

Of course, some feel that a little inflation right now might be OK. It would allow debtors—including the U.S. government—to pay debts down with more abundant, cheaper dollars. And it could prompt households and firms to spend now rather than later when things will cost more. For households this seems especially dubious, however, at least for the moment. U.S. household spending is sharply down since 2008 as families save to get out of debt. They are not there yet.

Moreover, say Ben’s critics, we’re tumbling not toward a little inflation but a lot. On the fiscal side, inflationary pressure is heavily wired into enormous and rapidly growing government deficits: Uncle Sam persistently pushing out way more money in expenditures than it collects back in taxes. There is no reason to think that the current budget gridlock—Republicans refusing to raise taxes and Democrats refusing to cut spending—will resolve itself any time soon.

In the developing world, QE’s monetary expansion may fuel asset bubbles and perhaps produce dollar depreciation hurtful to countries dependent on exports to America, along with bidding energy prices upward as mentioned.

In response to reproaches, Bernanke would probably remind us that worldwide recovery depends heavily on restoring prosperity and high spending to the American consumer, which is exactly what he’s trying to do. He has been shelled heavily for QE by figures like Ron Paul and Rick Perry, before they lost their bids to become the Republican presidential nominee. In the face of excoriating denunciation, Chairman Ben exemplifies at least one superhero virtue. He doesn’t back down.

*Mickey Mouse was ‘The Sorcerer’s Apprentice,’ in the Disney cartoon classic, ‘Fantasia.’

A graduate of Harvard Law School, Hamiltonicus lives in Pelawatte with his family.

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