Monday, October 31, 2005

Bernanke - Bubble Perpetuator

A Bubble Perpetuator
By Doug Noland

To frame my analysis of Dr. Bernanke as Fed Chairman, I thought it worthwhile to highlight comments made yesterday by the highly respected Reserve Bank of New Zealand (RBNZ): “The Reserve Bank has increased the Official Cash Rate (OCR) by 25 basis points to 7.00 percent. Reserve Bank Governor Alan Bollard said: ‘As noted in our September Monetary Policy Statement, medium term inflation risks remain strong. Persistently buoyant housing activity and related consumption, higher oil prices and the risk of flow-through into inflation expectations, and a more expansionary fiscal policy are all of concern. While there has been a noticeable slowing in economic activity, and a particular weakening in the export sector, we have seen ongoing momentum in domestic demand and persistently tight capacity constraints. Hence, we remain concerned that inflation pressures are not abating sufficiently to achieve our medium term target, prompting us to raise the OCR today. The most serious risk to medium term inflation is the continuing strength of household spending, supported by a relentless housing market and rapid growth in mortgage lending. Significant dis-saving by the household sector is showing through in a worsening current account deficit, now 8 percent of GDP. Borrowers and lenders alike need to recognise that the current rate of debt accumulation is unsustainable. The correction of these imbalances and associated inflation pressures will require a slowdown in housing, credit growth and domestic spending. We also expect a significantly lower exchange rate. The longer these adjustments in behaviour and asset prices are deferred, the more disruptive they are likely to be. Today’s increase in the OCR, combined with higher world interest rates and pipeline effects from the repricing of fixed rate mortgages, are expected to slow the housing market and household spending over the coming months. However, the prospect of further tightening may only be ruled out once a noticeable moderation in housing and consumer spending is observed. Certainly, we see no prospect of an easing in the foreseeable future if inflation is to be kept within the 1 percent to 3 percent target range on average over the medium term.”

RBNZ Governor Alan Bollard is successfully filling the large shoes left by his predecessor - the legendary Dr. Donald Brash, in the process upholding the high esteem long afforded the Reserve Bank. Please note how their pronouncement leaves little doubt where the Reserve Bank stands or what key fundamental factors drive policy decisions. No obfuscation necessary: “The correction of these imbalances and associated inflation pressures will require a slowdown in housing, credit growth and domestic spending.” Policymaking becomes unduly complex only when central banking drifts from traditional central banking analysis and doctrine, as it has (and is about to take another giant step) in the U.S.

We will certainly not be reading RBNZ-like language from the Bernanke Federal Reserve. Dr. Bernanke comes at central banking from a completely different perspective and analytical framework (note: the issues of transparency and inflation targeting become moot when applied within the context of a flawed framework). And while there is some media banter with respect to the “dove” or “hawk” label, there is no question that Dr. Bernanke is An Impassioned Inflationist. As for fighting inflation: he’ll talk the talk – of course, and there will come a day when talk will not suffice. In the past, I have labeled chairman Greenspan both an Inflationist and monetary policy radical. Incredibly, Professor Bernanke takes these to a whole new, dangerous extreme.

I was very much hoping Donald Kohn would be Alan Greenspan’s replacement, but would have been satisfied with several potential candidates including Roger Ferguson and Larry Lindsey. And I can say with complete seriousness that of all the leading economists in the country, Mr. Bernanke would be my least favored pick. Is it mere coincidence that the candidate at the very bottom of my list is at the top of the Administration’s and Wall Street’s? Of course not.

I have no reason to doubt that Dr. Bernanke is a “kind and decent man,” as such described by our President. He conveys an aura of integrity, and he is clearly extremely intelligent and a very hard worker. He is said to be a nice guy, and I like nice guys. I very much respect all of these attributes. And I do sense that his instincts are to be a straight-shooter. The nature of his new position, however, will demand a change, and it appears this process is well underway. He has no chance of becoming the master obfuscator, like his predecessor, or attaining Greenspan's amazing capacity to dodge every tough question and “never take a punch.” Dr. Bernanke will provide an easy target. I am tempted to fault Dr. Bernanke for “being an academic,” although it is more clearly stated that I view his background as a distinct handicap for presiding over this New Age of Wall Street Market and Speculation-based Finance in what I expect to be an increasingly hostile environment.

Candidly, I am concerned that he is such an accomplished econometrician and theorist. He has decades invested in his models and analytical framework; he’s too intellectually, analytically and emotionally committed to a perspective of how the financial sector and economy work, one I don’t expect will serve him well. Not only will his talents and perspective bias his view of the uncertain world in which we live, it is my fear that an econometrician’s analytical framework leaves one today at a decided disadvantage in discerning and appreciating the nuances of contemporary Wall Street Finance.

From Steven Pearlstein of the Washington Post: “Bernanke is smart and will figure out the markets before long.” Well, I’m not sure it’s that easy. It’s not about “smarts” or even so much with his lack of market experience. I don’t believe career “marketicians” would be well-suited for economic research. Do econometricians have an analytical perspective conducive to “figuring out the markets”? I believe the Bernanke chairmanship is likely to illuminate the major divide that exists today between academic research and real world markets – a chasm not commonly recognized. (note: warning to academia – your research is being set up as The Fall Guy.)

I don’t believe there’s any hope for effectively modeling complex financial systems or markets. Greed, fear and speculative dynamics are not generally the favored elements of the econometrician. Furthermore, it is my view that models don’t offer much value (negative value?) when it comes to the underlying complexities, subtleties, and whims of Credit expansion, financial flows, speculative dynamics and asset inflation/Bubbles. The model-maker must work to radically simplify a perplexing, convoluted and changing world. For example, instead of the nebulous and difficult to quantify “Credit,” there will be a modelers bias toward the more easily quantified parameter – such as (narrow) money supply. Cause and effect will be, conveniently, in the eye of the beholder.

Dr. Bernanke and I actually have something in common. As he wrote in his book – Essays on The Great Depression, a compilation of his papers on the subject – “I guess I am a Great Depression buff, the way some people are Civil War buffs.” But while my studies and analytical framework lead me to focus on the excesses and distortions of the Roaring Twenties – in particular the commanding effect that speculative liquidity came to possess on the asset markets and, consequently, on the nature of spending, investing and financial claims creation/intermediation – Professor Bernanke’s preoccupation is with supposed policy errors committed by the Fed commencing (late in the game) in late-1928. Apparently, he has little problem with the boom. My view is that the unsound U.S. boom ensured a commensurate bust. Sure, there were post-boom mistakes that worsened the outcome. Yet policy confusion and error should be recognized as an integral and unavoidable aspect of the late-boom and post-Bubble environment, and why the best cure for a Bubble is to ensure it doesn’t develop to begin with (as Dr. Richebacher informs us). “Mopping up” should absolutely never evolve into a concerted strategy, but recognized only as a last resort “long-shot.”

And I have my own theory as to Professor Bernanke’s stunning meteoric rise to prominence. As a disciple of Milton Friedman and as one of the leading academics in the field of post-Bubble reflationary monetary policies, he was a natural selection for the Fed when nominated in late-2001. It was the Greenspan Fed’s view that the U.S. economy had entered a post-Bubble environment, and there were some real advantages associated with procuring the esteemed academic research and analytical firepower to dignify their plan for less-than-admirable inflationary policies.

I will conjecture that if the markets had responded negatively to the new Fed governor’s open discussion of “helicopter money,” “government printing presses,” “pegging the 10-year Treasury yield,” “unconventional measures,” and the “global savings glut,” well, he would have been sent packing back to Princeton and the seasoned central banker Donald Kohn (nominated as Fed Governor with Bernanke) would be slated as our next Chairman. But an anxious Wall Street was quickly smitten with the temerity of “Helicopter Ben” and what he represented for the extreme direction of Federal Reserve policies. If there was ever an “all’s clear” message signaled directly and unmistakably from one of our leading policymakers to the markets, it was given in late 2002 by Dr. Bernanke. Go out and speculate in junk bonds; better cover your short positions in Ford bonds and Credit default swaps; buy stocks and CDOs; aggressively accumulate emerging market debt and equities; load up on commodities, get out of “money” instruments and grab any risk asset available (while you have a chance!). What ensued was one of the greatest redistributions of wealth in history.

Not quite as barefaced, Dr. Bernanke’s long-time emphasis on fighting deflationary risk by inflating the “money supply,” lent strong support to a vulnerable Wall Street “structured finance” apparatus. Recall that in 2002 the corporate debt crisis was at risk of jumping the firewall to the household sector (Household Finance, Ford Credit, etc.), with the potential to engulf the burgeoning ABS marketplace. Wall Street investment bankers working closely with their “financial engineers” had become prominent producers of contemporary U.S. “money” stock. So Dr. Bernanke’s long obsession with remedial “money” supply inflation ensured that he was both a proponent for and potentially powerful asset of Wall Street Finance. When Governor Bernanke made assurances that the Fed would do absolutely anything and everything to avoid “deflation,” Wall Street rightfully understood that Fed inflationary policies were in the process of expunging what had been a looming risk of systemic debt collapse. The sophisticated leveraged speculators were immediately emboldened; bankers were emboldened; investors were emboldened; and Wall Street “structured finance” was really emboldened (outstanding ABS has since doubled). At that point, seemingly no degree of Credit or speculative excess was too much, not with Professor Bernanke and the determined Greenspan Fed ready and more than willing to experiment with “mopping up” strategies.

There is one overriding fundamental issue I have with this whole amazing development: the view that we had fallen into a post-Bubble environment was flawed from the get-go. The technology Bubble had burst, but it was only an offshoot of the much greater Credit Bubble that was very much still Bubbling. Rather than combating deflationary forces and stabilizing some (fictitious) general price level, aggressive inflationary policies were instead poised to most intensely inflate markets already demonstrating the strongest inflationary biases (i.e. real estate, Treasuries, agencies, MBS and asset markets generally). Rather than buttressing an impaired post-Bubble Credit system, reflation stoked the Stalwart Mortgage Finance Bubble to unimaginable excess (and power). Instead of inflationary policies working to “stabilize” financial and economic conditions as the dauntless monetary theorist would ascertain, the resulting unprecedented Credit and speculative excesses guaranteed Precarious Monetary Disorder and Myriad Unwieldy Bubbles Both at Home and Abroad.

I will admit to being sympathetic to the theoretical premises supporting post-Bubble monetary stimulus. As we have witnessed, however, such policies will invariably be used prematurely – in the process acting to bolster boom-time dysfunctional Monetary Processes, resulting in only progressively precarious asset/speculative Bubbles, financial fragility and economic maladjustment. And, as we are also living these days, the greater and more precarious the Bubble(s), the more likely seductive notions of benevolent inflation will resonate throughout the entire system. To be an Eager Implementer of Reflationary Programs – an especially natural bias for someone of Dr. Bernanke’s intellectual perspective – virtually guarantees worldly mutation to Closet Bubble Perpetuator. They go (Un-Invisible) Hand in hand. The only hope against such an unfavorable outcome would be a keen understanding and appreciation for the dynamics of Credit and speculative excess, as well some regard for a “Mises” view of economic mal-adjustment. I have seen no indication suggesting that such mitigating factors will be at play for Dr. Bernanke.

What our system desperately needs right now is some Reserve Bank of New Zealand determination to rein in excess – pure and simple. I would be shocked to see such an approach from the new Fed Chairman. He holds special disdain for “Bubble Poppers,” and faults the post-Benjamin Strong Fed for the Great Depression. (“…it is now rather widely accepted that Federal Reserve policy turned contractionary in 1928, in an attempt to curb stock market speculation.”) At Milton Friedman’s ninetieth birthday party, he stated, “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we [the Fed] did it. We’re very sorry. But thanks to you, we won’t do it again.” These days, he continues to downplay the risk of inflation. And from Nell Henderson’s Wednesday article in the Washington Post: “Ben S. Bernanke does not think the national housing boom is a bubble that is about to burst, he indicated to Congress last week…. U.S. house prices have risen by nearly 25 percent over the past two years, noted Bernanke… But these increases, he said, ‘largely reflect strong economic fundamentals,’ such as strong growth in jobs, incomes and the number of new households.”

Take and hour or so and carefully read his April 2005 speech, “The Global Savings Glut and the U.S. Current Account Deficit.” I can honestly say – with a conscious effort to avoid hyperbole – that it is one of the most flawed and suspect pieces of analysis I have ever read from a respected economist. And the subject matter is one of the most pressing issues that must be confronted by our policymakers. It actually does seem like he is oblivious to the fact that our intractable Current Account Deficit is foremost a reflection of unrelenting Credit excess, inflated asset prices, over-consumption and economic distortions. He is similarly oblivious to the reality that this “global savings glut,” being accumulating by our trading partners, is largely IOU’s we created in the process of mortgage and asset-based borrowings. Yet, this line of reasoning is consistent with his analytical framework. From the preface of his book: “I believe that there is now overwhelming evidence that the main factor depressing aggregate demand [during the Great Depression] was a worldwide contraction in world money supplies. This monetary collapse was itself the result of poorly managed and technically flawed international monetary system (the gold standard, as reconstituted after World War I).” Dr. Bernanke has a troubling (Friedman-like)) penchant for looking outside the U.S. Credit apparatus, financial system and markets when it comes to identifying the true source of instability.

And from his 1995 article, The Macroeconomics of the Great Depression: A Comparative Approach: “To understand The Great Depression is the Holy Grail of macroeconomics… We do not yet have our hands on the Grail by any means, but during the past fifteen years or so substantial progress toward the goal of understanding the Depression has been made… To my mind…the most significant recent development has been a change in the focus of Depression research, from a traditional emphasis on events in the United States to a more comparative approach that examines the experiences of many countries simultaneously.”

And from his March 2004 speech, Money, Gold, and the Great Depression: “Some important lessons emerge from the story. One lesson is that ideas are critical. The gold standard orthodoxy, the adherence of some Federal Reserve policymakers to the liquidationist thesis, and the incorrect view that low nominal interest rates necessarily signaled monetary ease, all led policymakers astray, with disastrous consequences. We should not underestimate the need for careful research and analysis in guiding policy. Another lesson is that central banks and other governmental agencies have an important responsibility to maintain financial stability. The banking crises of the 1930s, both in the United States and abroad, were a significant source of output declines, both through their effects on money supplies and on credit supplies. Finally, perhaps the most important lesson of all is that price stability should be a key objective of monetary policy. By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy and, through the workings of the gold standard, the economies of many other nations as well.”

I do agree with the notion that “ideas are critical.” Unfortunately, our new Fed chief has some very flawed and dangerous ideas of how to deal with critical events that could very well develop early in his term. He should be talking restraint and the risks associated with attempting a “soft-landing.” But he and his fellow Inflationists will have none of that. And while the stock market has already demonstrated its stamp of approval, the bond market and dollar could not quite shield their grimaces. There remains this dogged hope that a housing cool-down will damp inflationary pressures – allowing Dr. Bernanke to cut rates early next year. At this point, I wouldn’t bet that a moderation in mortgage Credit growth will significantly alter the inflationary backdrop. Inflationary pressures are becoming only increasingly pronounced and oblivious to little baby-step rate increases. The system beckons for an actual tightening of financial conditions, a development certainly not accomplished by a little restraint employed at the fringe of mortgage lending excesses.

And, if I had to place a bet, I would wager that the more folks (certainly including our foreign creditors) delve into Dr. Bernanke, the more the bond and currency markets will question his credibility. And a novice Fed Chairman with credibility issues is not – I would hope – going to quickly reverse course and stimulate. Where’s the “continuity” in that? And whether he does or does not, we’ve not heard the last growl from the Dollar Bear. I do not envy Dr. Bernanke. He attained the pinnacle of success he has always dreamed. His chairmanship is quite likely going to be a nightmare. The wrong man - and his deeply flawed analytical framework - at the wrong time. How could it be? A Bubble Perpetuator.


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