Ben Bernanke, US interest rates, American economy

Why Ben Bernanke's balancing act will fail

18.08.2006

by Bill Bonner

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The US Federal Reserve chief is caught between recession on one side and rampant inflation on the other. But whatever he does, the US economy is headed for a fall, says Bill Bonner

As recently as the 1980s, the world of finance looked to the money supply figures for entertainment. When the new numbers came upon the stage, the audience hissed and booed if they were high and applauded if they were low. Everyone knew that the money supply was the key to inflation. And everyone knew that controlling inflation was the key to the stockmarket and the economy.

Now it is a new era, and the old M3, which tracked the US money supply, is so much yesterday’s idol it has disappeared from the financial news. The Federal Reserve no longer even announces the numbers… and nobody cares.

Money supply has been upstaged. Former Fed chairman Alan Greenspan transformed the role of US central bankers – previously bit players on the international financial scene – into stellar performers with a combination of talents: something of the order of Britney Spears’ acting ability crossed with Brad Pitt’s skill as a heart surgeon. And now people can’t take their eyes off the Fed’s Open Market Committee, which fixes prices for short-term credit.

The financial media have listened to Fed governors and Fed economists for years. They think they know how the Fed works: it stopped raising rates this month; now it will begin lowering them. Practically everyone agrees. As rates fall, stockmarket investors, who have made nothing in America for the last eight years, will enjoy a new period of prosperity. And even if there is no new boom in housing, at least there will be a soft landing.

Inflation v. recession: US consumer exhausted

And now comes the Fed’s new leading man, Ben Bernanke, former chief of the Princeton economics department; he’s leapt upon the stage, rather like John Wilkes Booth at Ford’s Theatre. The world turns its weary eyes to him, not realising he has just shot the economy in the head. If he were smart, he’d make his getaway before anyone catches on. The Fed’s immediate challenge is that the US consumer finally appears to be exhausted. As economist Hillary Clinton put it, he can’t work harder or borrow more; nor can he save less. His spending power is being undermined both structurally and cyclically. Structurally, he faces two billion Asians who have jumped into the global labour pool and would be only too delighted to earn, say, one-tenth as much as he does. Cyclically, he has his own balance sheet to worry about.

Egged on for years by Alan “Bubbles” Greenspan, he’s got in the bad habit of squeezing the debit side of the ledger for ready cash. Now, the hapless lumpen householder owes more money to more people than any consumer ever did. And what with fuel, housing, education and health bills soaring, he finds he has nothing more to spend. In 2005, Americans spent $42bn more than they earned, turning the annual US savings ratio negative for the first time since the Great Depression.

Even Bernanke can put two and two together. The US economy is nearly 70% consumer spending. When consumers can no longer spend in the style to which they’ve become accustomed, you get a slowdown… a slump… even a genuine recession. Consumers cut back, they put their houses on the market, house prices fall, business sales go down, hiring falls, economic growth goes flat, or negative. That is the reckoning America attends.

Inflation vs. recession: central bankers only have two hands

A central banker is more of a magician than he is a juggler or sword-swallower. His trade is just as gaudy as theirs, but it requires more legerdemain. Increasing the money supply, he tricks people into thinking they are richer than they really are. Sales go up; investment increases; the economy booms. But, as Milton Friedman predicted, eventually the additional money drives up prices and people come to realise that they’ve been had. Adjusted for inflation, they’re no better off than they were before. Then they stop investing, cut back on spending, and the economy stagnates – even as prices rise. “Stagflation”, they called it in the 1970s.

As the old trick ceases to work, the authorities continue introducing more money and credit, but no one is fooled. Instead, prices rise even faster, while the economy goes soft.

This was the situation Paul Volcker faced when he stepped into the Fed back in the late 1970s. He had to whip inflation – or, more precisely, inflation expectations – before any further monetary stimulus would work. This he did, by pushing lending rates up over 15% and bringing about the worst recession since the 1930s. People were so upset with him they burned him in effigy on the Capitol steps.

Bernanke is in a much better situation. But the threat of stagflation is clear: inflation rates are creeping up, just as the consumer runs out of money. What can he do? On the one hand, he must fight inflation by increasing interest rates. On the other hand, if he doesn’t fight the slowdown right away – by lowering interest rates and increasing the money supply now – he risks letting the economy sink into a Japan-like slump.

Bernanke’s problem is that he has only two hands. He can raise rates, or he can cut them. He desperately wants to lower rates to head off recession. But then, inflation could run wild.

Earlier this month, the Fed couldn’t decide whether to raise rates or lower them. Instead, it sat on both hands. And it probably didn’t matter anyway. Because the old tricks have already done the damage. And when they lose their magic, as Paul Volcker discovered, there’s no painless way to get it back. Either you raise rates and face down the squeals from debt-laden consumers, or you cut them and watch as your currency plummets and inflation takes off.

Inflation vs. recession: housing’s negative wealth effect

What is happening is that trends that worked so beautifully on the upside are now slipping into reverse. The most important of these new trends is the housing market. When house prices were rising, homeowners enjoyed what economists call a ‘positive wealth effect’. Interest rates fell. Housing boomed. More and more people went to work in the housing industry; 20%-40% of all new employment in the last five years was in the housing sector. As everyone’s house rose in price, people felt richer and spent more money.

But now house prices have stalled and are beginning to slide back. US house prices have been falling since the fourth quarter of 2005, according to Goldman Sachs. The investment bank believes that they “may be headed for an outright decline in 2007”. While US house prices have certainly fallen for prolonged periods in the past in real terms (adjusted for inflation), this would be the first time on record that nominal property values have fallen across the entire nation.

House sellers are offering incentives such as free maid service, swimming pools and appliances – whatever it takes to move stuck merchandise. The trouble is, after ten years of boom conditions, there’s a lot of merchandise to move. And much of it is not really suited to buyers’ interests. For ten years, people have bought expensive condos – the equivalent of apartments in the UK – not because they really want a condo, but because they think it is a way to magnify the wealth effect. The more condos they own, the more effect they get.

Or, they might have decided to get more bang by putting up more bucks. Buyers signed up for plusher, pricier houses than they really needed, realising that the wealth effect was proportional to the investment. Property has been rising at 20% per year in many areas. Twenty per cent of $1,000,000 is more than 20% of $500,000. So they bought $1m houses, even though they really couldn’t afford so much space or luxury.

But now that that 20% per year froth has disappeared, homeowners no longer have an interest in owning more house than they need. It costs money to maintain a house. Property taxes, heat, mortgage payments and maintenance are all proportional to the size of the house. With nothing to gain, people naturally want to cut out the unnecessary expense. Thus we have Reuters reporting: “Homeowners say ‘downsize me’.”

The wealth effect has gone negative. The more house you own, the more it costs you to keep the place and the more you lose when prices go down.
The hapless consumer is in a bind. His real income is flat, or falling, while his expenses are starting to rise. He has to cut back.

Naturally, the first thing to go will be the house he doesn’t need, which makes the negative wealth effect even more effective and even more negative. Not just for the seller, but for everyone else. Every house sold at a discount drops the value of all equivalent housing stock – even for people who don’t intend to sell. All of a sudden, none of them are as rich as they used to be. They, too, cut back their spending.

Inflation vs. recession: rate cuts won’t save the US consumer

We know what the Fed will do once this trend builds up momentum; it will cut rates. But it is probably too late. The Fed’s magicians cannot wave a wand and make the consumer’s problems disappear. They cannot increase his real income. They cannot put more real purchasing power in his pocket. All they can give him is more credit – and consumers have caught on to that trick.

Lower rates simply won’t reverse the negative wealth effect of a falling real-estate market. Mortgage rates may go up, or they may go down (the Fed only controls short rates), but people won’t borrow at all if they sense they will have a hard time making the payments. This is because the old star-spangled circus magic has turned into a black magic… a kind of voodoo economics curse, where the tricks all go wrong: the magician pulls a rabbit out of his hat and it bites him on the nose.

A slump in America is probably unavoidable in the next 18 months. It could even turn into a deflationary depression, such as happened to Japan
in the 1990s.

A US slump will be bad news for Britain

Anatole Kaletsky is our favourite UK economics columnist. He is smart, and a good writer. He is also wrong in a way that is profoundly wrong. It's too bad you can’t count on him. A financial pundit who is always wrong is more valuable than one who is hit or miss. You just have to remember to do the opposite. But Kaletsky is like the rest of us: he is unreliable.

While nearly always bullish, Kaletsky says he turned to a “much more cautious stance” in mid-2004. That should have been a signal: back up the truck, buy UK stocks. And in fact, within a few months, our very own James Ferguson wrote in these pages that the FTSE 100 was set to hit 6,000 – it was barely above 4,800 at the time. Sure enough, the FTSE 100 did breach the 6,000 mark in May this year.

But returning to Kaletsky – in a recent column, the man wrote that he judges the storm has passed. The “dreaded ‘day of reckoning’ for the British economy may be over already, before it even began”, he writes. “In my view, a serious decline in the British economy is a worry that you… can forget about.”

We did not merely read that sentence. We stared at it like a child looking at a jack-in-the-box, hoping that something might pop out that would make sense of it. We presume he drives a car as safely as anyone else. We suppose he pays his bills and puts his trousers on without falling over. But when it comes to economics, he so misunderstands the way the world works, he tumbles on his face.

The ‘day of reckoning’ suffered by Britain must have been an odd duck. It neither quacked nor waddled. Nor did it have any feathers. And, according to Kaletsky, it died before it was ever hatched. We have yet to read the weather report that tells us of a storm that ended before it began, or the history book of wars that never took place. We imagine a very old man, awaking from a dream: “Well, hey, this is not bad… I can still watch television… I still have my family… Heaven is not so bad.”

“You haven’t died yet, honey,” his wife reminds him.

Why no ‘day of reckoning’ in Britain? The most likely explanation is that it hasn’t come yet. Kaletsky believes two absurd things at the same time. The first is that you can have a day of reckoning without ever reckoning with anything. Here’s a simple way to tell: listen for the quack; if the economy is still as lopsided and imbalanced at the end of the period as at the beginning, you haven’t had a real day of reckoning. His second absurdity is he believes privatisation, globalisation and market liberalisation – and specifically, London’s position as “the hub of the international financial system” – will protect the UK from America’s coming downturn. We don’t doubt financial services may remain a sweet-spot industry in the UK. But every industry and economy has its ups and downs. Booms beget busts; riches beget rags. That’s what days of reckoning are for.

The industry that benefited most from the US-led boom in credit – financial services – will be the one that feels the bust in credit most sharply. The US economy is still almost a third of the entire world economy. Americans import $1.82 worth of goods and services for every dollar’s worth of exports. All those excess US imports figure on foreign income statements as credits; when they disappear, there will be many empty spaces. When US consumers stop buying what they don’t need with money they don’t have, the whole world economy is going to have excess capacity it doesn’t want. That is when globalised, liberalised, privatised commerce slows down and the duck bites the City on its fat derrière.

Nor is the UK consumer resistant to the maladies that threaten America. People in the City may have got rich in the latest boom, but most people in Britain have only barely kept up with inflation, while increasing their own debt to dangerous levels. It will not take much of a shock to turn them into reluctant spenders – and to turn the UK economy more than a little sour.

Bill Bonner is the publisher of MoneyWeek. You can read more from Bill every day in the free daily email, The Daily Reckoning, at www.dailyreckoning.co.uk