Bernanke Sidesteps the Three Big Questions, Again

by Gary North
by Gary North
Recently by Gary North: When Atlas Shrugs: The Great Default

In a recent international Bloomberg poll, Bernanke was rated by investors as the greatest central banker, the man who saved the world's economy.

All it took was a doubling of the monetary base and $3 trillion – as of today – of government bailout money.

The FED still faces three problems. (1) If it deflates, the financial markets will collapse. (2) If it does nothing, there will be mass price inflation if banks start lending, making use of the FED's doubling of the monetary base. (3) If banks don't start lending, the recovery will not appear. The FED wants to avoid all three.

How?

His testimony on July 21 was a successful attempt to keep the public gulled. He avoided all three issues. He appeared before the House Committee on Financial Services, whose chairman is Barney Frank.

Bernanke reiterated the fact that the global financial system nearly collapsed in late 2008.

Aggressive policy actions taken around the world last fall may well have averted the collapse of the global financial system, an event that would have had extremely adverse and protracted consequences for the world economy. Even so, the financial shocks that hit the global economy in September and October were the worst since the 1930s, and they helped push the global economy into the deepest recession since World War II.

I think he is correct. He never saw it coming. With one exception, the chairman of the central bank of Lebanon, none of his peers saw it coming. Their solution has been the same: monetary inflation.

Now he has a selling job ahead of him. He has to persuade Congress that this near miss is behind us. Having come close to a financial collapse, central banks' lowering of overnight interest rates saved the day. Trust him, he says.

Today, financial conditions remain stressed, and many households and businesses are finding credit difficult to obtain. Nevertheless, on net, the past few months have seen some notable improvements.

He says that the FED saved the day.

Many of the improvements in financial conditions can be traced, in part, to policy actions taken by the Federal Reserve to encourage the flow of credit. For example, the decline in interbank lending rates and spreads was facilitated by the actions of the Federal Reserve and other central banks to ensure that financial institutions have adequate access to short-term liquidity, which in turn has increased the stability of the banking system and the ability of banks to lend.

Basically, he told Congress that merely by announcing lower rates, the FED kept the world's economy from collapsing. If it was that easy, why did the economy come so close to collapse? How did central banks so completely misjudge conditions? If they were blind then, are they blind now?

It was not that the FED lowered overnight rates. It was that it doubled the monetary base and swapped T-bills for toxic assets at face value, thereby authorizing accounting subterfuge: "American banks own liquid assets." They borrowed liquid assets. They still own hundreds of billions of dollars worth of unmarketable junk. Will the FED ever swap back? No.

Congress doesn't understand any of this. If it did, it would still do nothing.

Is the economy that vulnerable? It is. But to admit this is to admit that the recovery should not be trusted.

He assured the committee that "Better conditions in financial markets have been accompanied by some improvement in economic prospects." What improvements? The best he could point to was tapering off of decline. There were no green shoots mentioned. Tapering off = positive signs.

Despite these positive signs, the rate of job loss remains high and the unemployment rate has continued its steep rise. Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending. The possibility that the recent stabilization in household spending will prove transient is an important downside risk to the outlook.

There will be a slight increase in output in the second half of 2009, gradual recovery in 2010, and "some acceleration" in 2011. Unemployment will continue to rise in 2009.

He promised an exit strategy from monetary expansion. He always does. He does not say how or what. With the monetary base doubled, the FED now has to cut it by 50%. How? Silence.

Accordingly, as I mentioned earlier, the FOMC believes that a highly accommodative stance of monetary policy will be appropriate for an extended period. However, we also believe that it is important to assure the public and the markets that the extraordinary policy measures we have taken in response to the financial crisis and the recession can be withdrawn in a smooth and timely manner as needed, thereby avoiding the risk that policy stimulus could lead to a future rise in inflation. The FOMC has been devoting considerable attention to issues relating to its exit strategy, and we are confident that we have the necessary tools to implement that strategy when appropriate.

Sure the FOMC has the tools. The question is this: How to use them without bringing economy to the edge of another collapse?

Perhaps the most important such tool is the authority that the Congress granted the Federal Reserve last fall to pay interest on balances held at the Fed by depository institutions. Raising the rate of interest paid on reserve balances will give us substantial leverage over the federal funds rate and other short-term market interest rates, because banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk free by holding balances at the Federal Reserve.

Raising the rate of interest paid on deposits has the same effect as increasing the reserve requirement. I am all for this. But then where will the recovery come from? Banks are not lending.

He continued.

The attractiveness to banks of leaving their excess reserve balances with the Federal Reserve can be further increased by offering banks a choice of maturities for their deposits.

Great! Then why will they lend to private industry? They won't.

He said the FED can do other things.

For example, we can drain liquidity from the system by conducting reverse repurchase agreements, in which we sell securities from our portfolio with an agreement to buy them back at a later date.

That is monetary deflation. Watch the economy fall into an even greater recession!

If necessary, another means of tightening policy is outright sales of our holdings of longer-term securities. Not only would such sales drain reserves and raise short-term interest rates, but they also could put upward pressure on longer-term interest rates by expanding the supply of longer-term assets.

Raise interest rates! Yes! That is what the FED did in 2006 through 2007. We know what happened.

Ben is putting the shuck on Congress. Congressmen never ask the obvious: What will prevent a collapse next time?

Then there is the Federal budget. Stern Uncle Ben lectured the committee, knowing that the committee will do nothing.

Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in the costs of Medicare and Medicaid.

Prompt attention! Say, that's a great idea! I have been waiting for 50 years, when my high school civics teacher said that Social Security would go bust in our lifetimes. Nothing so far.

Addressing the country's fiscal problems will require difficult choices, but postponing those choices will only make them more difficult.

That's what I said in print back in 1976. Nothing so far. Congress is still letting the programs go unfunded. It's still "pay as you go" until the day it's "print as you go."

Moreover, agreeing on a sustainable long-run fiscal path now could yield considerable near-term economic benefits in the form of lower long-term interest rates and increased consumer and business confidence. Unless we demonstrate a strong commitment to fiscal sustainability, we risk having neither financial stability nor durable economic growth.

He is correct. That is why we are going to get neither financial stability nor durable economic growth.

He then called for financial reform, meaning more power for the FED.

The Federal Reserve has taken and will continue to take important steps to strengthen supervision, improve the resiliency of the financial system, and to increase the macroprudential orientation of our oversight.

He wants more transparency.

The Congress and the American people have a right to know how the Federal Reserve is carrying out its responsibilities and how we are using taxpayers' resources. The Federal Reserve is committed to transparency and accountability in its operations.

This does not include an audit by the FED by an agency not hired by the FED: the Government Accountability Office. Such an intrusion is a very bad idea, he said.

The Congress, however, purposefully – and for good reason – excluded from the scope of potential GAO reviews some highly sensitive areas, notably monetary policy deliberations and operations, including open market and discount window operations. In doing so, the Congress carefully balanced the need for public accountability with the strong public policy benefits that flow from maintaining an appropriate degree of independence for the central bank in the making and execution of monetary policy. Financial markets, in particular, likely would see a grant of review authority in these areas to the GAO as a serious weakening of monetary policy independence. Because GAO reviews may be initiated at the request of members of Congress, reviews or the threat of reviews in these areas could be seen as efforts to try to influence monetary policy decisions. A perceived loss of monetary policy independence could raise fears about future inflation, leading to higher long-term interest rates and reduced economic and financial stability. We will continue to work with the Congress to provide the information it needs to oversee our activities effectively, yet in a way that does not compromise monetary policy independence.

In short, "hands off!"

Here ended his lesson.

You have read my analysis. Presumably, it makes sense. I am not quoting out of context. I am quoting verbatim. You can see it's a smoke screen. The FED doesn't know what to do next.

Congress cannot see this. The stock market ignores this. No one cares.

They also didn't care with Greenspan, who was hailed as a genius. Where did he get us?

July 23, 2009

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2009 Gary North

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