Monday, February 28, 2005

Federal Reserve Governor Ben Bernanke: Warnings?

Federal Reserve Governor Ben Bernanke: Doug Noland

And the counterpoint view to this article: The Overstretch Myth

“The current account deficit is a concern. What that is basically – there are two ways of looking at the current account deficit. One is looking at it from the trading perspective, which most people are familiar with the idea that we are actually importing a lot more than we are exporting. So, in that sense we have a current account deficit. But another way to look at it is that we are investing more than we’re saving. If you look at investment in terms of capital investment by firms, you look at residential investment - that is building new houses. You have seen a lot of investment but we have a relatively low savings rate. And so, having a low savings rate, we have to borrow from foreigners to make up the difference between our saving and the investment we want to do. So, what’s called capital inflows – the money flowing in from foreigners to finance our investment is another way of looking at the current account deficit. So these different perspectives give you different ways of thinking about how you would address this problem. The trade perspective says, yes, part of the issue is getting balance in our trade. And that suggests that we should work with the world trade organization and other trade agencies to try to get fairer and free trade with other countries... On the other side, we have the savings and investing perspective. We have relatively low savings, we have a federal deficit which is subtracting from our savings. And that suggests that part of reducing the current account deficit would be to try to stimulate our savings. Reduce the deficit and take other actions that would increase our savings and therefore reduce capital inflows that are coming in – which is the other face of the current account deficit. Depending how you look at it, there are a variety of policies that should be undertaken. I think the current account deficit is going to be with us awhile. It will take a while to unwind. It can’t go on at this level for ever. It is going to eventually have to come down. And I think it will eventually come down. But policies like increasing our savings would probably be a step in the right direction to help that happen.”


The U.S. economy generates $600 billion-plus Current Account Deficits because we “invest” so much? Such econobabble from a prominent central banker does not inspire confidence. And, more than ever, instilling dollar confidence is an imperative. Tuesday the dollar was hammered on news of the Bank of Korea’s plan to diversify its dollar-denominated reserves. There was also the revelation of an Asian policymakers meeting this week to discuss “global economic imbalances” and how to deal with the faltering dollar. And from today’s Australian: “[Australia’s Treasurer] Peter Costello’s closest advisor fears the US is heading for a devastating financial crash that could ravage Australia’s economic growth. …Treasury Secretary Ken Henry likened the flood of money pouring into the US to support its budget and current account deficits to the stockmarket’s dotcom bubble of the late 1990s. Were it suddenly to stop, there would be shockwaves felt throughout the world’s economies.”

Languish over the likelihood that the U.S. is on course to precipitate global financial crisis has spilled out into the open. This is surely related ot the heightened appreciation by market participants and global policymakers that the Federal Reserve is not up to the task of reining in U.S. financial and economic excess. Moreover, the much anticipated marketplace-induced adjustment process has failed to materialize. Indeed, exuberant global markets and propagating asset Bubbles ensure a calamitous future “adjustment.” Global policymakers and central bankers should be apprehensive.

The weak dollar has certainly failed to rectify or even slow imbalances – global, domestic or otherwise - and there is little prospect that further devaluation will be any more successful. In the past, a weak currency would induce higher market rates – rates necessary to tighten financial conditions, temper over-consumption and undermine speculative dynamics. Yet the old rules no longer apply to contemporary finance, a momentous blow to the capacity for orderly market-based corrections and adjustments. The need for strong-minded central bankers to guard against inexorable market distortions has never been as great, while, ironically, never has a central bank (the Greenspan Fed) placed greater faith in the efficiency of market processes. And Dr. Bernanke’s comments above suggest that policy efforts to constrain American consumption aren’t on the table – “consumption” being a four-letter word not even open to discussion. Accordingly, the prospect of the Fed purposely precipitating a meaningful economic slowdown to assist the U.S. Current Account Deficit “unwind” is nonexistent. Commencing the arduous process of reestablishing Monetary Order is, then, at a logjam.

This week from Morgan Stanley’s Stephen Roach: “Global rebalancing does not occur spontaneously. It takes adjustments in economic policies and asset prices to spark a meaningful realignment in the mix of global growth. Shifts in currencies and real interest rates are the two major instruments of rebalancing… In the end, it will also require a narrowing of the growth differentials between the US and the rest of the world… A narrowing of the growth spread between the US and the rest of the world is key for a resolution of America’s trade- and current-account imbalances.”

These excerpts do not do Mr. Roach’s exceptional analysis justice; they instead provide the opportunity to distinguish the focal points of my analysis: I have reached the point of having lost what little faith I had in the efficacy of “global rebalancing.” Imbalances simply cannot be rectified by heady non-U.S. global growth. Such a scenario would ensure myriad problematic bottlenecks, shortages and price pressures including significantly inflating global energy and commodities prices. At the same time, global policymakers – especially the Fed – refuse to take decisive action. They respectively missed their opportunities to act. The costs and risks are these days much too high for aggressive policy response – individually or in concert. There is no will to face The Bubble Issue.

Importantly, asset inflation has become a global systemic issue. Mortgage Credit is growing at double-digit rates in the U.S., Europe, and China (and elsewhere). Meanwhile, speculative securities leveraging and attendant liquidity creation is endemic internationally, and there is no international body or coordinated central bank policy response to moderate – let alone rein in - Global Wildcat Finance. Resulting uncontrolled liquidity excess is The New Global Phenomenon, nonetheless central bank balance sheets balloon on the back of unrelenting dollar flows. It is amazing that marketplace perceptions of quiescent inflation persist in the face of today’s unparalleled global backdrop of abundant liquidity and Endemic Easy Credit Availability.

Importantly, global interest rates have converged like never before, and they have consolidated right down toward artificially low U.S. levels. Moreover, the massive international liquidity pool offers an overhang of constant downward pressure on the converged price of global finance. Less appreciated but no less significant, financial systems internationally have “converged” toward the U.S. model. Depressed interest rates augment already intense worldwide asset-based lending and securities speculation, only exacerbating the Global Liquidity Bubble. The dysfunctional U.S. Credit system has now fully impaired the global financial system, leaving faint hope that market pricing mechanisms will instigate either a gradual or orderly “adjustment process.”

The bottom line is that the entire spectrum of international rates – the global price of finance - needs to shift meaningfully higher. This amounts to the only effective policy measure to rein in asset-based lending and speculating excess. The dilemma is that central bankers from the ECB to China and Asia are frozen by the vulnerable dollar and the prospect of financial crisis. To raise rates would only incite greater financial flows away from the U.S. and its ailing currency. There is, as well, the issue of massive speculative leveraging throughout. The Fed is locked into a policy of “baby steps” that ensures that U.S. rates at best stay barely a half-step ahead of rising inflationary pressures, while inciting only greater speculative excess.

There is much written these days referencing “real” and “neutral” rates, but these notions have little practical meaning without an effort to factor in asset inflation. Asset prices are, after all, the centerpiece of contemporary Credit and liquidity creation. To instead fixate on CPI – the misplaced contemporary inflation target – guarantees ineffectual monetary management. Having succumbed to this analytical misjudgment and, in the process, having fallen so far behind the curve, there is now the prospect that much higher Fed funds may be required to garner any meaningful impact on U.S. and global excesses and imbalances.

Dr. Bernanke is deluding himself if he actually believes that stronger global growth and more equitable trade treaties and practices will work to rectify our Current Account Quagmire. I also think he is too optimistic in expecting that today’s deficits can be sustained “for awhile” and “take awhile to unwind.” The inevitable adjustment period will commence only with the problematic bursting of the Mortgage Finance Bubble; no more, no less. And, not surprisingly, this Mighty Bubble scoffs at Cowardly Little Baby Steps. Are speculators suffering from higher financing costs? Are 4% ARMs to dissuade manic California, Florida, or Manhattan mortgage borrowers? Then how about even lower teaser and interest-only mortgages? And let’s not forget that 2004 saw the greatest inflation of home equity in history, and it’s there just waiting to be tapped to upgrade to a more appealing residence or to boost consumption. January then brought another $10,000 windfall to the average California homeowner. Credit conditions are easier today than they were a year ago – or ever were.

My fear that we are heading toward financial crisis is not rooted in the mindless ranting of an embittered permabear – but from the discipline of my analytical framework. The U.S. Credit Bubble is creating unrelenting and unwieldy dollar liquidity that continues to inundate global financial systems. The marketplace pricing mechanism for global finance is severely impaired, while speculative dynamics are empowered. Excess is only begetting greater excess, and policymakers, meanwhile, function like deer caught in headlights.

The question I ponder this evening is how this expected crisis manifests. Does it unfold first in the currency or interest-rate markets? Is it precipitated by a spike to $60 or $70 crude and a panic “melt-up” in global commodity markets? What market “accident” could set off a chain reaction of speculator unwind? Are spreads an accident in wait? The ten year? MBS? And, of course, the dollar is certainly vulnerable to a marketplace dislocation, although we can also assume that global central bankers are now on heightened alert. I will admit to being absolutely intrigued by the degree of complacency that is now ingrained in The Bulletproof Bond Market. All the recent talk of a shortage of bonds recalls major Bubble tops of years past. The reality of the situation is that it would require only a marginal bout of de-leveraging to create way more than adequate supply.

Out of Aces - 1907

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