Ben Bernanke needs to close the taps, but not just yet

Irwin Stelzer: American Account

Americans look to three sources for clues about the future of our economy: President Barack Obama, in charge of fiscal policy; Federal Reserve Board chairman Ben Bernanke, in charge of monetary policy; and Warren Buffett, the “sage of Omaha” known for his decades-long record of successful investment and pithy statements.

The president has run huge deficits to stimulate the economy, first with a stimulus plan, most recently with cash-for-clunkers. The consensus is that these outlays have had a modest effect, and other measures continued from the Bush administration have done a good deal to avert the collapse of several banks deemed too big to fail. Obama has taken deficits from their peace-time level of about 6% of GDP to a staggering 13%.

As Buffett put it recently: “Fiscally we are in uncharted territory.”

Bernanke accurately describes his polices as “aggressive”. He dropped interest rates to zero to get businesses to borrow and consumers to spend; devised a variety of schemes to encourage banks to lend to one another and to businesses; and printed money with which to buy Obama’s IOUs and keep interest rates down.

At last week’s gathering of the world’s central bankers in Jackson Hole, Wyoming, Bernanke characterised his monetary policy as “complementary” to fiscal policy. His willingness to co-ordinate with the Treasury might have risked the Fed’s ability to retain its independence from the politicians seeking to gain control of Fed policies.

Which brings us to the Omaha sage. Buffett supported all the cash infusions and other steps the administration and the Fed have taken. But now he worries. Indeed, it is fair to say that the once united Obama-Bernanke-Buffett troika is no longer quite so united. The president wants to continue spending and borrowing. His healthcare plan will add trillions to the deficit over 10 years; his plan to improve education, billions; the bailout of the car companies more trillions.

Deficits have become so large they are now Americans’ No1 concern. In January voters thought the stimulus a good idea by a margin of 43% to 27%; now only 34% say it was the right thing to do, while 43% say it was not — despite an unemployment rate of 9.5%, headed towards double digits.

The government is spending almost twice as much as it is taking in, which means balancing the books will be no trivial task, especially since Democrats in Congress will resist almost any spending cuts: they have waited too long to get their pet projects and expansion of the welfare state on the books to be bothered by deficits.

Obama plans to make up some of the deficit by raising taxes. But he has promised the middle class that he will not raise their taxes by a single dime, and will instead soak the “rich”, who he feels did too well during the Bush years. The problem is that this lemon isn’t big enough to squeeze for much revenue before the pips squeak, and our corporate and other tax rates are already among the highest in the developed world.

Bernanke is dropping hints that, if fiscal profligacy remains the Obama policy, he will have to tighten sooner and harder than if deficits are brought under control. Buffett agrees. But neither man thinks that the recovery is robust enough to warrant tightening just yet.

“Economic activity appears to be levelling out … and the prospects for a return to growth in the near term appear good,” Bernanke told his fellow bankers. But — there always seems to be a but — “critical challenges remain”. If the Fed responds to recent signs of recovery by tightening now, it might repeat the error it made in the 1930s, when it aborted the recovery by tightening too soon.

The third of our key players, Buffett, agrees that the hour for tightening has not yet arrived. But he worries that when it does, the Fed might not be able to counteract such enormous federal deficits. Inflation is a politically attractive alternative to cutting spending or raising taxes. “High rates of inflation,” notes Buffett, “never require a recorded vote and cannot be attributed to any specific action that any elected official takes.” Damned attractive to political lifers.

Bernanke will have to rely on more than the stream of economic data in deciding when to pull cash out of the system. Consider only the most recent figures in his in-box.

• Sales of existing homes jumped 7.2% in July after rising 3.6% in June, to the highest level in two years. But almost one-third of the sales were of repossessed properties, and inventories of unsold homes actually rose.

• Single-family home starts are up (1.7% in July, 17.8% in June) and builders’ sentiment is improving as buyer traffic increases, but the percentage of loans in foreclosure or one mortgage payment behind is increasing at the fastest pace since records were first kept in 1972.

• The rate of job losses is declining, but the unemployment rate is not.

• Several banks are earning record profits and have repaid the money borrowed from the government, while others remain basket cases and are hoping that the inability of commercial property companies to refinance $1 trillion in mortgages maturing next year does not bring them down.

• Sharp recessions have historically been followed by rapid and substantial rebounds in economic activity, but right now consumers (70% of the economy) are staying on the sidelines, trying to rebuild their wealth and save in case the rainy days hit their families.

• The credit markets are somewhat easier, but many banks are tightening lending standards. One local banker told me that if Bill Gates applied for a mortgage he would be turned down because he is self-employed.

Conclusion: the economy is recovering, and probably already growing a bit. If the recovery continues, next year’s Jackson Hole meeting will focus on finding some exit strategy that prevents the sort of inflation that will so devalue the already-sinking dollar that the Chinese decide they are no longer interested in adding to their piles of Uncle Sam’s IOUs. (Irwin Stelzer, The Sunday Times)


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