Bernanke Ponders the "Nuclear" Option

Rolling the Dice
By MIKE WHITNEY

Ben Bernanke's speech on Friday in Boston could turn out to be a real barnburner. In fact, there's a good chance the Fed chairman will announce changes in policy that will stun Wall Street and send tremors through Capital Hill. Along with another trillion or so in quantitative easing, Bernanke is likely to appeal to congress for a second round of fiscal stimulus, this time in the form of a two-year suspension of the payroll tax. That's what he figures it will take to jump-start spending and rev-up the flagging economy. It could be an extraordinary intervention.

Bernanke laid out the details in a speech he gave in May 2003 to the Japan Society of Monetary Economics, in which he outlined the policies Japan should enact to beat deflation. Here's what he said:

“Rather than proposing the more familiar inflation target, I suggest that the BOJ consider adopting a price-level target, which would imply a period of reflation to offset the effects on prices of the recent period of deflation. Second, I would like to consider an important institutional issue, which is the relationship between the condition of the Bank of Japan's balance sheet and its ability to undertake more aggressive monetary policies.... Finally, and most important, I will consider one possible strategy for ending the deflation in Japan: explicit, though temporary, cooperation between the monetary and the fiscal authorities."

There it is. Bernanke is planning to reflate asset prices, purchase more government bonds, and enlist congress's support to pump liquidity into the broader economy. It's an ambitious strategy that could push the dollar over the edge, but the alternatives are equally bleak. Bernanke knows that "at best" GDP will hover around 1 to 2 per cent through 2011 while the public grows increasingly restless about soaring unemployment. He also knows that when interest rates are stuck at zero the only way the central bank can zap the economy back to life is by increasing inflation expectations. That means, the Fed has to persuade people they've “lost it” and are planning to destroy the currency via the printing presses. It's all baloney. The Fed won't destroy the dollar. They just want to use the element of surprise to give the economy a good jolt. Gold bugs think the Fed is steering the country towards hyperinflation, but they're mistaken. It's all part of a larger calculation.

Bernanke may be a died-in-the-wool class warrior, but he's no moron. His policies are designed to overshoot in order to change expectations and get consumers out of their funk. He even says so in the speech. Here's a clip:

"A concern that one might have about price-level targeting, as opposed to more conventional inflation targeting, is that it requires a short-term inflation rate that is higher than the long-term inflation objective."

The only way to stimulate economic activity is to convince people that the dollar they presently have in their pockets will be worth less tomorrow. That's what puts the Jones's back into the minivan scuttling off to the mall. But what seems like profligate spending on the Fed's part, (QE) is really just a way of restoring the pre-crisis price level. Call it asset inflation if you want, but the bottom line is, Bernanke is not going to sit back while disinflation turns to deflation, the real value of personal debts rise, and the bankruptcies, defaults and foreclosures continue to mount. He's going to pull out all the stops and carpet bomb the economy with monetary and fiscal stimulus. Here, again, is how Bernanke lays out his thesis:

"One possible approach to ending deflation in Japan would be greater cooperation, for a limited time, between the monetary and the fiscal authorities. Specifically, the Bank of Japan should consider increasing still further its purchases of government debt, preferably in explicit conjunction with a program of tax cuts or other fiscal stimulus."

Good. So Bernanke realizes that he can't go it alone. He has to get congress on board if he wants to succeed. (which is probably why the Fed's meeting was scheduled after the midterms)

Bernanke again:

“... Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt--so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.

Under this plan, the BOJ's balance sheet is protected by the bond conversion program, and the government's concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but--because the BOJ purchased government debt in the amount of the tax cut--no current or future debt service burden has been created to imply increased future taxes. Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices."

This is truly radical, but it could work. And, the quickest way to engage the policy would be by slashing the payroll tax which would, in effect, give every working man and woman in the country a raise in pay.

Bernanke's comments are also a tacit admission that the banking system is still dysfunctional and cannot provide the credit needed for the next expansion, so he is bypassing the privately-owned system altogether and transferring money to consumers directly. Naturally, this will have a positive effect on spending and on any prospects for a recovery.

The cagey Bernanke has even concocted the public relations rationale for fending off the deficit hawks who will undoubtedly point to his plan as an example of wasteful government spending.

Bernanke:

"Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.....More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public's expectations of future tax obligations."

The Bernanke plan seems to do everything except whiten teeth. But wouldn't it make more sense to restructure the banking system so the toxic assets can be removed and the banks can lend freely again? And wouldn't it be better to strengthen labor unions (so that wages keep pace with productivity) so workers can generate sufficient demand to keep the economy running smoothly without panicky injections of emergency stimulus? Of course, that would mean a truce in the ongoing class war which wouldn't fly with plutocrats who take joy in seeing the unemployment lines wind from one side of the country to the other.

Bernanke's plan could work. Congress could pass emergency legislation to suspend the payroll tax for two years stuffing hundreds of billions of dollars into the pockets of struggling consumers. The Fed could make up the difference by purchasing an equal amount of long-term Treasuries keeping the yields low while the economy resets, employment rises, asset prices balloon, and markets soar. As the economy rebounds, the dollar will steadily lose ground triggering a sharp rise in commodities and an increase in exports that will spark a clash with foreign trading partners. Then what?

Yes, Bernanke's "nuclear option" could help to resuscitate economy, but it could also erode confidence in the dollar leading to the untimely demise of the world's reserve currency. It's all a roll of the dice.

Time for a Second Stimulus

A General Fall
By MIKE WHITNEY
Alan Greenspan has joined the ranks of the deficit hawks and is calling for austerity measures to reduce government spending. In an op-ed in last Thursday's Wall Street Journal titled "U.S. Debt and the Greece Analogy", Maestro Greenspan made the case for fiscal belt-tightening and disputed leading economists, like Nobel prize winners Paul Krugman and Joseph Stiglitz, who believe that the Obama administration should provide a second round of stimulus. In the opening paragraph, Greenspan dismisses the idea that cuts in government spending will push the economy back into recession. Here's an excerpt:

"I believe the fears of budget contraction inducing a renewed decline of economic activity are misplaced. The current spending momentum is so pressing that it is highly unlikely that any politically feasible fiscal constraint will unleash new deflationary forces."

The op-ed features the same circular logic which became Greenspan's trademark during his tenure at the Fed. The real point of the article does not become clear until the very end when the ex-Fed chief levels an attack on Social Security. Here's a clip:

"The federal government is currently saddled with commitments for the next three decades that it will be unable to meet in real terms. This is not new. For at least a quarter century analysts have been aware of the pending surge in baby boomer retirees. 

We cannot grow out of these fiscal pressures. The modest-sized post-baby-boom labor force, if history is any guide, will not be able to consistently increase output per hour by more than 3% annually. The product of a slowly growing labor force and limited productivity growth will not provide the real resources necessary to meet existing commitments. (We must avoid persistent borrowing from abroad. We cannot count on foreigners to finance our current account deficit indefinitely.) 

Only politically toxic cuts or rationing of medical care, a marked rise in the eligible age for health and retirement benefits, or significant inflation, can close the deficit. I rule out large tax increases that would sap economic growth (and the tax base) and accordingly achieve little added revenues." ("U.S. Debt and the Greece Analogy", Alan Greenspan, Wall Street Journal)

Greenspan has been riding the "private accounts" bandwagon for more than a decade. Not satisfied with having reworked Social Security (under Reagan) to serve as a de facto flat tax levied on the working poor; Maestro now wants to divert the Mississippi River of revenue-streams into Wall Street's coffers. "The major attraction of personal accounts is that they can be constructed to be truly segregated from the unified budget, and therefore are more likely to induce the federal government to take those actions that would reduce public dis-saving," Greenspan opined in testimony before Congress in 2005.

Greenspan has allied himself with a small army of like-minded elites who continue to boost austerity as a path to prosperity. Deficit hawkery has replaced supply-side theory as the latest viral-form of voodoo economics. It turns established economic principle on its head to achieve a given political objective. This is from Bloomberg:

"Governments have proven they can spur expansion by focusing their belt-tightening on spending cuts rather than tax increases, according to studies by Harvard University professor Alberto Alesina and Goldman Sachs Group Inc. economists Kevin Daly and Ben Broadbent.

“There have been mountains of evidence in which cutting government spending has been associated with increases in growth, but people still don’t quite get it,” Alesina said in an interview. He made a presentation to European finance chiefs on the topic during their April meeting in Madrid. 

The key is an emphasis on cutting spending rather than raising taxes, said Goldman Sachs economists Broadbent and Daly in London. Lower spending means consumers and companies don’t fear higher taxes, so demand accelerates. A smaller public sector also helps reduce borrowing costs and makes economies more competitive as fewer government workers lighten labor expenses." ("Cameron Bets on Growth From Austerity as U.S. Delays", Simon Kennedy and Rich Miller, Bloomberg)

Cutting spending reduces economic activity and slows growth. The Bloomberg article merely presents the rationale for class warfare. Fiscal strangulation is not the path to economic recovery. Still, the deficit hawks have mounted an impressive public relations campaign and have powerful friends at the Fed, the Treasury, the White House, and Brussels. In the U.S., President Obama has appointed former Republican Sen. Alan Simpson to head a bipartisan commission to "fix the federal government's long-term budget problems", which is code for gutting social programs. In the E.U., German Chancellor Angela Merkel has taken the lead promising to hack $80 billion from the country's modest deficits. Even Tokyo, after enduring 15 years of excruciating deflation, is planning to slash long-term government spending. The groundswell for hair shirts increases the probability of another severe downturn.

Here's the problem: The bursting of a giant asset bubble pushed the economy into a long-term slump that required emergency action by the Central Bank. Fed chair Ben Bernanke's liquidity injections and zero rates helped to pull the financial system back from the brink, but households and consumers are still deep in the red. Now, their only choice is to pay-down debt and increase personal savings. But if consumers aren't spending, then the government must fill the void or unemployment will spike and the economy will shrivel.

As of March, the average U.S. household’s debt-to-disposable income ratio was 122%, considerably lower than its peak of 131% at the beginning of 2008. Economists believe that that number will eventually return-to-trend at 100% which portends years of sluggish consumer spending and slow growth. With more families forced to cut back to patch their balance sheets, fiscal stimulus must increase or the economy will slip back into recession. Belt tightening now will only increase the deficits by reducing government tax revenues. In a recent interview, Nomura economist Richard Koo was asked if the US should try to reduce their deficits by cutting back stimulus. Here's how Koo responded:

"Not until private sector deleveraging is over. At present, private sectors in the US, UK, Spain, Portugal, and Italy are still deleveraging. This means these countries should not try to reduce fiscal stimulus. Any attempt to cut deficit in these countries is likely to result in a weaker economy and a larger deficit as seen in Japan in 1997.... When private sector is deleveraging, money multiplier is negative at margin. No monetary stimulus will work in such an environment where people are trying to reduce debt, even with zero interest rates, in order to repair their damaged balance sheets. 

Until people realize that they have contracted a completely different disease called balance sheet recession where the private sector is minimizing debt instead of maximizing profits, a constructive policy dialogue is not likely to be possible. Once the exact nature of the disease is understood, the remedy (sufficient and sustained fiscal stimulus until private sector balance sheets are repaired) will become obvious to everyone." ("Interview: Richard C. Koo, Nomura Research Institute", Acemaxx Analytics)

Koo does not believe that the current recovery is self sustaining. The rebound is stimulus-driven and merely reflects improvements in the financial sector (and the markets) which plunged after Lehman Bros collapsed. The heavy-lifting of repairing household balance sheets (which suffered losses of nearly $12 trillion) is still in its early stages. President Obama's $787 billion fiscal stimulus has helped a bit, but it's mainly been used to pay unemployment claims, provide tax cuts and to make up for the losses in state revenues. And while it is not true that the stimulus "has done nothing" as the deficit hawks claim (IHS Global Insight, Macroeconomic Advisers and Moody's Economy.com all estimate it created around 2.5 million jobs.) its effects have largely been canceled-out by the gigantic state budget gaps. Conservative economist Bruce Bartlett explains in the Washington Post:

"The Center on Budget and Policy Priorities estimates that in 2011, the states will have to come up with a total of $180 billion. These budget shortfalls are the equivalent of a massive anti-stimulus....And because they cannot run deficits to hold them over until their economies improve, they're cutting services and raising taxes. Using the data for 2009 and 2010, and then projecting for 2011 and 2012, the Center on Budget and Policy Priorities expects the total state shortfall will reach $610 billion. Because some of the federal stimulus dollars were saved rather than spent, the effective stimulus we've had has been less than the $789 billion that's often touted. It might even be less than $610 billion shortfall in the states. Which would mean the anti-stimulus overwhelmed the stimulus. Or, you could look at it in reverse: Nick Johnson, who directs the State Fiscal Project at CBPP, says that "the effect of the federal stimulus was to wipe out the negative effect of the state contraction." ("You've seen the stimulus. Now, meet the anti-stimulus", Ezra Klein, Washington Post)

The Obama stimulus was a good start, but there's more work to be done. It prevented a downward spiral of falling asset prices and debt-deflation, but it wasn't big enough to put a dent in skyrocketing unemployment or lay the groundwork for another expansion. There needs to be a renewed commitment to long-term stimulus until households regroup and the economy gets back on track. Monetary policy alone will not succeed. The monetary transmission mechanism is on the fritz so reserves are piling up at the banks, but not getting into the hands of people who can generate more activity.

Consumer spending is flat, home prices are set to fall, unemployment will likely edge higher, private sector credit is still contracting, capacity utilization is far below pre-crisis levels, the CPI is slipping, and yields on US Treasuries are priced for deflation. The government must pick up the slack or their will be a general fall in prices that will trigger more layoffs, larger deficits, and social unrest. Premature fiscal consolidation can have unintended consequences as noted by Richard Koo:

"Pushing ahead with these misguided policies risks a collapse of social and economic foundations and could even threaten the survival of democratic structures."