Thursday, July 29, 2010

Looming Changes at the Fed; Will the US Repeat Japan's Mistakes?

The Fed is mulling over its options for dealing with an outbreak of deflation. For a long time, Fed chairman Ben Bernanke dismissed the idea that deflation could be a problem because, as he noted, "The Fed has a technology called the printing press which allows the Fed to produce as many dollars as it wished at no cost." That's true, but increasing the money supply has not worked as planned. Bernanke has stuffed the banks with $1.7 trillion in reserves, but lending is still in the tank, consumer credit is shrinking at 5% per annum, and M3 has slipped into negative territory (- 6%). True, there's plenty of money, but it's not circulating fast enough (velocity) through the economy to produce a robust recovery. That's why Bernanke is looking for new ideas.

Last Thursday, James Bullard, President of the Federal Reserve Bank of St. Louis, issued a paper titled "Seven Faces of 'The Peril'" which warned that the US economy "may become enmeshed in a Japanese-style deflationary outcome within the next several years." The presentation surprised many because, up until then, Bullard had been more concerned about inflation. Now he's joined the deflationistas. As one of the central bank's brightest stars, Bullard's recommendations are worth considering as they are likely to shape future monetary policy.

Regrettably, Bullard is locked in the same ideological box as Bernanke and is equally committed to the same type of Friedmanite monetarism. Here's a key quote from the document which summarizes his analysis of the problem the economy faces: "I emphasize two main conclusions:

(1) The FOMC's "extended period" language may be increasing the probability of a Japanese-style outcome for the US, and

(2) on balance, the US quantitative easing program offers the best tool to avoid such an outcome." ("Seven Faces of 'The Peril'", James Bullard, The Federal Reserve Bank of St. Louis)

Bullard figures that the Fed's "extended period" (of zero rates) language is sending the wrong message to consumers and, thus, and lowering inflation expectations. This is critical, because the Fed wants people to believe that the currency in their wallets today will be worth less tomorrow. That way, they'll be more inclined to spend freely and give the economy a much-needed boost. But now--according to Bullard-- everyone assumes the Fed will keep rates at rock bottom for the foreseeable future, so the policy has become counterproductive. The solution: Change the language and adjust the policy so it reflects the Fed's determination to achieve its target rate of inflation. To do that, the Fed must "credibly raise the inflation target" which means restarting the Fed's bond purchasing program (quantitative easing).

Bullard is persuasive, but his analysis ignores the central problem, which is that people are so far in debt they need time to dig out before they can spend again. For Bullard, the fact that people are broke is a minor inconvenience that can be resolved by luring them into taking on more debt. In fact, the Fed's manipulation of inflation expectations is a subtle form of social engineering that works like this: The Fed expands its balance sheet by exchanging trillions in reserves for government (or, perhaps, corporate) bonds which scares the bejesus out of ordinary working people who figure the government is deliberately debasing the currency to create hyperinflation. Naturally, people figure that their best choice is to maximize their buying power by spending their money as soon as possible. This is the Bullard/Bernanke remedy; getting people to buy more things they don't need with money they don't have.

Bullard fails to mention that Bernanke's first round of quantitative easing never sparked a credit expansion or even increased inflation expectations. In fact, the dollar has grown stronger, bond yields have plunged, and deflationary pressures have continued to mount. Where's the beef? Bullard's thesis may sound convincing, but there's zero evidence that it will work.

Bullard does not put a price-tag on his plan, but the costs are bound to be significant. Every economist who has explored the issue, believes that to "credibly raise the inflation target" will require many trillions of dollars. Keep in mind, that the Fed's objective is to convince people that it is debauching the currency by "monetizing the debt". In reality, it is just exchanging one asset for another. The Fed can drain reserves as it pleases. There's no immediate danger of inflation.

As for the costs; here's an excerpt from a post by economist Bradford DeLong who puts a price on what is being called "QE2":

"The Federal Reserve has already increased the monetary base to a previously unimaginable extent and has doubled its balance sheet to $2 trillion. Even though there is good reason to think that further increases in the money stock alone will have little effect on the economy--that conventional monetary policy is tapped out--the Federal Reserve could always further increase its balance sheet to $3 trillion or $4 trillion. Such quantitative easing would be highly likely to eliminate fears of possible deflation or other lower tail risks and act as a powerful spur to investment. Such an enormous expansion of the balance sheet would produce a qualitative improvement in the assets held by the private sector, which would greatly reduce risk spreads and make funding available to American companies on much more attractive terms."

("A Keynesian voice crying in the wilderness", Bradford DeLong, Grasping Reality with Both Hands)

It is worth mentioning that Bullard rejects the Keynesian approach which would implement massive fiscal stimulus to sustain positive growth while the private sector repairs its balance sheet. The St. Louis Fed chief argues that to achieve that goal, the government would have to (credibly) "threaten to behave unreasonably" for a long period of time. (to change inflation expectations) Considering the gridlock on Capital Hill over budget deficits and "austerity measures", Bullard sees little possibility that congress would support such a strategy. He's probably right.

Bullard is correct in anticipating a "Japanese-style deflationary outcome", but his grasp of what happened in Japan appears to be sketchy at best. The Japanese tried quantitative easing, but the bond purchasing program failed to revive the economy or reignite consumer spending. Bullard thinks that Japan's central bank just threw in the towel too soon; that if they stuck with it, eventually the plan would have succeeded. But is the Fed really willing to make a multi-trillion dollar leap of faith on such flimsy evidence?

Nomura's chief economist, Richard C. Koo, has written brilliantly on Japan's battle with deflation, ("US Economy in Balance Sheet Recession: What the US can learn from Japan's Experience 1990-2005") labeling the phenomenon a "balance sheet recession", which means that people have reoriented their behavior from "profit maximization" to "debt minimization" strategies. Koo understands that consumer spending is not an inexhaustible resource that can be tapped into by merely lowering rates or adjusting inflation expectations. There are limits to how much debt people will take on. This is a lesson that neither Bullard nor Bernanke seem to grasp.

Koo's razor-sharp analysis is invaluable for anyone who wants to understand the present state of the economy. He provides a blueprint for easing the effects of deleveraging and for lifting GDP from the doldrums. His Keynesian solutions are the exact opposite of Bullard's, in fact, he states unequivocally that, "Fiscal policy is the only real remedy for balance sheet recession". Koo insists that once the government commits to fiscal stimulus, it must sustain deficit spending until the private sector has patched its collective balance sheet and is able to spend again at precrisis levels. That will take a long time and require political consensus.

The Fed doesn't have the tools to reverse the slide into deflation or to stop the hellstorm of debt liquidation and default. Low interest rates have lost their traction and another round of QE won't help. The economy has reset at a lower level of activity and monetary policy alone cannot create sufficient demand to sustain the recovery. When the private sector is deleveraging, fiscal remedies are needed to make up for flagging consumer spending and dwindling business investment. The best monetary policy can do, is make money cheaper (lower interest rates) and increase reserves at the banks by purchasing long-term government bonds. But increasing reserves does not put money in the hands of the people who will spend it and generate growth. In fact, there are times when people will not borrow no matter how cheap or available money is, which is why the Fed is unsuited for the task ahead. It's time for Obama to step up and do what's needed.

Koo notes that it took 15 years for Japan to muddle through its balance sheet recession, mainly because the problem had not really been understood before. "Now that the experience of Japan is available for anyone to see," Koo opines, "there's no reason for the US to repeat the same mistake."

Koo's "must read" report can be found here: "US Economy in Balance Sheet Recession: What the US can learn from Japan's Experience 1990-2005", Richard C. Koo, Chief Economist, Nomura Research Institute

(NB--Pay special attention to the graphs which show the effects of Quantitative Easing.)

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