Monetarists from across the world can mostly agree on one thing. The US Federal Reserve caused the Great Recession.
Fed chair Ben Bernanke kept policy far too tight after the US economy buckled in early to mid 2008. He allowed a collapse in the money supply to run unchecked, causing avoidable disasters at Fannie, Freddie, Lehman, and AIG later that year.
Call it the “Bernanke Depression” if you want, a term gaining traction in elite circles. The indictment is a little unfair. The European Central Bank was worse. It raised rates into a deflationary oil shock in August 2008, and worsened a run on the dollar that constrained Fed actions.
There was little that Bernanke could do about the deeper causes of the crisis, whether the ‘Savings Glut’ of Asia and North Europe, the ‘China Effect’, the $10 trillion reserve accumulation by the world’s rising powers.
Yet three heavyweight books now lay the blame squarely on the Fed: the ‘Great Recession’ by Robert Hetzel, a top insider at the Richmond Fed; ‘Money in a Free Society’ by Tim Congdon from International Monetary Research; and ‘Boom and Bust Banking: The Causes and Cures of the Great Recession’ by David Beckworth from Western Kentucky University.
They do not agree on everything. Hetzel denies that there was a serious debt bubble before the crisis. Beckworth and Congdon think there was, and I am with them. Total debt levels in the OECD club of rich states rose from 167pc of GDP to 330pc in 30 years. This was the blow-off phase of a Kondratieff debt cycle. The system was primed for a crisis.
But monetarists of all stripes concur on the one key point. Bernanke blew it at a crucial moment. Thankfully, his Great Depression scholarship alerted him to the dangers thereafter. We have avoided a 1931 sequel so far.
Less clear is whether US money has been too tight ever since, trapping America in a ‘Japanese’ Lost Decade. Less clear yet is whether a third blast of quantitative easing (QE3) at this late stage is wise.
Simon Ward from Henderson Global Investors says the Fed is committing yet another “pro-cyclical” blunder, gunning the economy just as the money supply is coming back to life anyway. “The Fed’s decision to launch QE3 was at best otiose and at worst will prove destabilising,” he said.
His gauge — six-month real M1 money –is gathering pace and surged by 8.5pc in August. This reflects a shift into cash by households and firms, a precursor to rising spending. It is a leading indicator of industrial output half a year ahead.
He fears the stimulus will hit before companies are ready to crank up output. It is a recipe for inflation. “Yet again, incompetent, short-termist policy-making risks wrecking a promising economic outlook.”
Tim Congdon says the case for further QE is “far from compelling”. The broad M3 money supply (which the Bernanke Fed no longer tracks) has been growing at a 7.9pc rate over the last six months. Bank deposits up $330bn so far this year to $8.82 trillion.
He too suspects that the Fed has over-egged the pudding. The economy will take off in early 2013. Bernanke’s pledge to keep interest rates near zero until mid-2015 will prove “folly of a high order”. Inflation will force him to tighten much earlier in a humiliating volte-face.
This may prove correct. Yet it does not change my view that the Fed was right to launch QE3 . It is the lesser of evils at a dangerous juncture.
The US labour participation rate has fallen to 63.5pc. The numbers in work have contracted by 314,000 over the last two months. Industrial output fell 1.2pc in August.
The economy has been close to stall speed for months. A hard-landing in China and a double-dip recession in Europe are already under way. One more shock will push the entire global system into a very nasty “feedback loop”.
Nathan Sheets from Citigroup — an expert on “stall speeds” from his Fed days — said that once the US economy has slowed to 1.5pc growth on a “rolling four-quarter basis”, it tends to fall 3pc over the following year and takes the world with it.
By his estimates, the US ‘fiscal cliff’ would amount to net tightening of $800bn or 5pc of GDP if Congress fails to strike a deal. “A major U.S. misstep could edge the global economy closer to a point at which markets entirely lose confidence in the ability of policymakers to manage their economies,” he said.
One suspects that the Fed’s real motive for QE3 — whatever it claims — is to prime-pump the US economy pre-emptively just in case. If all goes well, the stimulus can be drained later.
The Fed has been tightening this year, a fact overlooked in the Weimar/Zimbabwe slapstick of the last two weeks. Yields on 10-year inflation-indexed Treasuries or TIPS — a proxy of inflation expectations — have crashed zero to minus 0.7pc since January. If this is the start of hyperinflation, nobody told the bond markets.
The Fed’s balance sheet has shrunk by $120bn to $2.82 trillion since February as the old schemes run off — the ‘TALF’ and suchlike.
Assets reached a plateau of around 16pc of GDP two years ago and have not changed much since then. This is exactly the same as in 1951 before the Fed’s last great experiment was unwound. It is also lower than the balance sheets of the ECB, Bank of England, Bank of Japan, or — arguably — China’s central bank.
Bernanke’s QE3 will now add a further $40bn a month by purchasing mortgage bonds. A switch in maturities means the net stimulus to M3 money will be about $70bn a month. This is a fine-tuning operation. It is what you do when interest rates reach the “zero-bound”. Is it really that different from a half point cut in rates?
If the Fed’s decision is “historic” — as widely asserted — this is because the arguments used are shifting, not because the sums of money are large. Bernanke has switched overnight from inflation targeting to jobs targeting.
He seems to have espoused a variant of the “7/3” proposals of Chicago Fed chief Charles Evans: that they will keep adding stimulus until unemployment drops to 7pc, so long as inflation stays below 3pc.
His colleague Narayana Kocherlakota has even talked of a 5.5pc jobless target, reversing is longstanding claim that the US jobs crisis is caused by a structural mismatch in skills — not by lack of demand — and is beyond the reach of monetary policy.
Modern monetarists — or market monetarists as they call themselves — have achieved a bittersweet victory. They have been calling for QE3 all year. They are widely credited with forcing the Fed to capitulate. Their influence is now extraordinary.
Yet the Fed is dressing up its policy shift in dubious terms. Instead of adopting a “pure” monetarist target — say a 5pc trend growth rate for nominal GDP — the Fed is implicity arguing that a little more inflation is a worthwhile trade-off if it creates more jobs.
Bill Woolsey from Monetary Freedom says we are back edging back towards the ‘Phillips Curve’ temptations of the 1960s and 1970s, which ended with stagflation and the misery index.
“Targeting real variables is a potential disaster. Expansionary monetary policy seeking an unfeasible target for unemployment was the key error that generated the Great Inflation of the Seventies,” he said.
Bernanke’s attempt to push down borrowing costs is at odds with monetarist orthodoxy. Woolsey argues that successful QE should cause rates to rise — not fall — because the goal of such policy should be to put money into the hands of businesses that then invest, spending on machinery and real expansion.
The Fed is barking up the wrong tree with its doctrine of credit yield manipulation, or “creditism”, straying far from the quantity theory of money.
Most of the criticism levelled against Ben Bernanke and QE3 is jejune at best, or just plain rubbish. The real objection is that Bernanke is not a monetarist, takes no interest in money, systematically ignores monetary warning signs — whether too hot in 2006, or too cold in 2008 — and yet controls the most important monetary lever in the world. He will almost certainly make further mistakes as a result.
So back the Fed’s QE3 with a clothes-peg on your nose.
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