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Henry, as is his want, is a bit long winded. Below are some excerpts from his piece, found at http://www.atimes.com/atimes/Global_.../KI11Dj01.html
Bernanke Re-appointment
Opposition to the reappointment of Bernanke can be traced to three aspects. The first is ideological: despite Bernanke's subscription to Milton Friedman's non-provable counterfactual conclusion that central banks can eliminate market crashes with timely and aggressive monetary easing, Bernanke is on the same ideological side of his predecessor - serial bubble wizard Alan Greenspan - who argued that monetary authorities are best positioned to clean up the mess after the bursting of asset bubbles than to pre-empt the forming of the bubble itself. This ideological fixation of the Fed's proper role as a cleanup crew rather than the preventive guardian of good systemic health, which Greenspan has since acknowledged as a grievous error, eventually led to the systemic financial collapse of 2007.
The second aspect is analytical: Bernanke, as Fed chairman-designate waiting confirmation, argued in a speech on March 29, 2005, while still a Fed governor, that a "global savings glut" had depressed US interest rates since 2000. Echoing this view, Greenspan testified before Congress on July 20 that this glut was one of the factors behind the so-called "interest rate conundrum", that is, declining long-term rates despite rising short-term rates.
In reality, there was no savings glut, only a dollar glut that went overseas as US debt from trade deficits and returned to the US as savings of low-income Asians because of dollar hegemony in which Asians cannot spend dollars in their domestic economies without inflation.
The third aspect relates to policy: Bernanke is a card-carrying market fundamentalist who believes that markets can best be self-regulated. He and Greenspan repeatedly opposed financial-market regulation beyond even ideological grounds to argue also on the operational ground that US regulation would merely drive market participants overseas to less-regulated jurisdictions and that the US will not accept international coordination that threatens national sovereignty. On regulation, Bernanke is of the school of "if I don't smoke, somebody else will"
Need to rein in the financial sector
In an interview in Prospect magazine published on August 27, Lord Turner says the debate on bankers' bonuses has become a "populist diversion" from the real need for more drastic measures to cut the financial sector down to size. He also says the FSA should "be very, very wary of seeing the competitiveness of London as a major aim", claiming the city's financial sector has become a destabilizing factor in the British economy. The Bernanke Fed has yet to take similarly progressive positions in response to the financialization of the US and global economies and the role Wall Street plays in them.
On all three aspects, there are no signs that Bernanke has turned a new leaf intellectually or professionally from his sordid past. His dysfunctional fixations have impaired the effectiveness of the Fed's unconventional policy directions and unprecedented rescue actions in dealing with the two-year-old financial crisis. The Fed's radical surgery is only revolutionary in operational protocol, aiming to keep the patient alive longer with the disease rather than to cure the disease.
Irresponsible optimism
The gathering of central bankers at Jackson Hole, Wyoming, reportedly expressed growing confidence that the worst of the global financial crisis is over and that a global economic recovery is beginning to take shape.
This is an irresponsibly optimistic assessment that borders on fantasy, by a powerful fraternity of questionable legitimacy and bankrupt credibility. The global financial system may be showing signs of zombie-stirring caused by bailout money from the Fed and other central banks, but the toxic assets that blight the global economy have not been extinguished and still pose a major threat to real recovery. The global economy is still in need of intensive care, with a debt virus that is mutating into a strain stubbornly resistant to monetary cures.
Transferring private debt into public debt
What the Fed has done in the past two years is to transfer massive amounts of private sector toxic debt to the public sector by "aggressively and innovatively" expanding the Fed's balance sheet. This approach may require a decade or more to unwind the massive amount of toxic debt in the system, both in the private and public sectors, delaying true economic recovery.
The approach adopted by the US Treasury and the Fed to deal with a financial crisis of unsustainable debt created by excess liquidity is to inject into the economy more liquidity in the form of new public debt denominated in newly created money and to channel it to debt-laden institutions to re-inflate a burst debt-driven asset price bubble.
The US Treasury does not have any power to create money. Its revenue comes mainly from taxes. But it has the ability to issue sovereign debt with the full faith and credit of the nation. When the Treasury runs a deficit, it has to borrow from the credit market, thus crowding out private debt with public debt.
The Fed has the authority to create new money, which it can use to buy Treasury securities to monetize the public debt. But while the Fed can create new money, it cannot create wealth, which can only be created by work. Unfortunately, the Fed's new money has not been going to workers/consumers in the form of rising wages from full employment to restore fallen consumer demand, but instead has been going only to debt-infested distressed institutions to allow them to de-leverage toxic debt.
Thus deflation in the equity market (falling share prices) has been cushioned by newly issued money, while aggregate wage income continues to fall to further reduce aggregate demand that will cause companies to lay off workers to reduce overcapacity. Until this vicious cycle is broken by proper monetary and fiscal policies, no economic recovery can come.
Falling demand deflates commodity prices, but not enough to restore demand because aggregate wages are falling faster. When financial institutions de-leverage with free money from the central bank, the creditors receive the money while the Fed assumes the toxic liability by expanding its balance sheet. De-leveraging reduces financing costs while increasing cash flow to allow zombie financial institutions to return to nominal profitability with unearned income while laying off workers to cut operational cost.
Thus we have financial profit inflation with price deflation in a shrinking economy. What we will have going forward is not Weimar Republic-type price hyperinflation, but a financial profit inflation in which zombie financial institutions turn nominally profitable in a collapsing economy. The danger is that this unearned nominal financial profit is mistaken as a sign of economic recovery, inducing the public to invest what remaining wealth they still hold only to lose more of it at the next market meltdown, which will come when the profit bubble bursts.
How and when
The Fed's monetary myopia shifts the problem of exiting emergency policies from "how" to "when", with the flawed assumption that pain in the future must necessarily be less acute. Focusing on lagging indicators, which reflect past situations, increases the chances that the Fed will overshoot both in degree and duration with policy stance. Credit expansion through Fed credit easing can also cause excess money creation as de-leveraging runs its course. Hyman Minsky observed: whenever credit is issued, money is created.
Writing in defense of his strategy in the Financial Times on July 21, 2009, on "The Fed's Exit Strategy", Bernanke asserted that Federal Reserve reduction of the Fed's fund rate target nearly to zero, together with a greatly expanded Fed balance sheet as a result of Fed purchases of longer-term securities and targeted lending programs aimed at restarting the flow of credit, "have softened the economic impact of the financial crisis" and "improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages."
Bernanke acknowledged that Fed accommodative policies will likely be warranted for "an extended period". Yet he did not address the issue of what happens to the value of the dollar during this extended period. The US Treasury will not go bankrupt, but the US dollar can fall to a level that will threaten the US economy with bankruptcy.
At some point after the extended period, Bernanke wrote, as economic recovery takes hold, the Fed will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. Bernanke reports that the Federal Open Market Committee, which is responsible for setting US monetary policy, has devoted considerable time to issues relating to an exit strategy, with confidence that the Fed has the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner. Thus, the question is not "how", but "when".
Bernanke notes that the Fed's exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions banks have generally held their reserves as balances at the Fed.
The Fed and liquidity trap
This is known as the Fed pushing on a credit string, with Fed money given to banks sitting idle in reserve accounts at the Fed because banks cannot find credit-worthy borrowers. Economist John Maynard Keynes called this phenomenon a liquidity trap, as with nominal interest rate lowered to near zero, liquidity preference in the market fails to stimulate the economy to full employment. In an earlier speech, Bernanke had refered to a statement made by Milton Friedman about using a "helicopter drop" of money into the economy, presumably for everyone equally, to fight deflation, earning his nickname "Helicopter Ben". But Ben's helicopter so far is sitting idle on the ground while shiploads of taxpayers' money have been sent to distressed institutions.
Bernanke explains that as the economy recovers, banks should find more opportunities to lend their reserves. Yet he was vague about how the economy would recover beyond a general faith that what goes down will eventually go back up. Yet in the history of nations, many have gone down without recovering their former greatness.
Bernanke argues that recovery when it comes will produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures - unless the Fed adopts countervailing policy measures. When the time comes to tighten monetary policy, the Fed must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.
Bernanke believes that, to some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of the Fed's short-term lending facilities and ultimately to their wind down. He points out that short-term credit extended by the Fed to financial institutions and other market participants has fallen to less than $600 billion as of mid-July 2009 from about $1.5 trillion at the end of 2008. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Fed mature or are prepaid.
However, Bernanke admits that reserves likely would remain quite high for several years unless additional policies are undertaken. He asserts that even if Fed balance sheet stays large for a while, the Fed still has two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. The Fed could use either of these approaches alone; however, to ensure effectiveness, it likely would use both in combination.
Congress granted the Fed authority in the autumn of 2008 to pay interest on balances held by banks at the Fed. This is a controversial development because it reduces pressure on banking to lend money in the economy to finance economic activities.
At present, the Fed pay banks an interest rate of 0.25%. Bernanke indicates that when the time comes to tighten policy, the Fed can raise the rate paid on reserve balances as it increases the federal funds rate target. Needless to say, this will retard economic recovery as it gathers steam.
Banks generally will not lend funds in the money markets at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they can be expected to compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.
Thus the interest rate that the Fed pays would tend to put a floor under short-term market rates, including its policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit because banks will not want to lend out their reserves at rates below what they can earn at the Fed. Thus market forces are really dictated by the Fed.
Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank's liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates. But these countries do not pretend they operate on a free-market economy but a mixed-market economy.
Despite this logic and experience, the federal funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began paying interest on reserves. This pattern partly reflected temporary factors, such as banks' inexperience with the new system. But it may also be interpreted as a measure on how weak the economy actually was.
However, Bernanke observed that this pattern appears also to have resulted from the fact that some large lenders in the federal funds market, notably government-sponsored enterprises such as Fannie and Freddie, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks in order to compete for scarce funds.
Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal funds rate and the rate the Fed pays on reserves. Bernanke argues that if that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets - the second means of tightening monetary policy.
The exit dilemma
An economy that has collapsed under the burden of excessive debt cannot recover until such debt has been extinguished. And debt can only be extinguished by wealth creation, not by creating more debt with easy credit - and wealth can only be created by employment and not by financial manipulation. Yet the Fed's response to the financial crisis thus far has been to delay the extinguishment of debts in the financial system to save it from collapsing. Recovery is not automatic and must be brought about by market correction or countervailing policies to bring about full employment. A depression begins when the business cycle fails to cycle for long periods, keeping unemployment permanent.
Next: Facing a lost decade ahead
Bernanke Re-appointment
Opposition to the reappointment of Bernanke can be traced to three aspects. The first is ideological: despite Bernanke's subscription to Milton Friedman's non-provable counterfactual conclusion that central banks can eliminate market crashes with timely and aggressive monetary easing, Bernanke is on the same ideological side of his predecessor - serial bubble wizard Alan Greenspan - who argued that monetary authorities are best positioned to clean up the mess after the bursting of asset bubbles than to pre-empt the forming of the bubble itself. This ideological fixation of the Fed's proper role as a cleanup crew rather than the preventive guardian of good systemic health, which Greenspan has since acknowledged as a grievous error, eventually led to the systemic financial collapse of 2007.
The second aspect is analytical: Bernanke, as Fed chairman-designate waiting confirmation, argued in a speech on March 29, 2005, while still a Fed governor, that a "global savings glut" had depressed US interest rates since 2000. Echoing this view, Greenspan testified before Congress on July 20 that this glut was one of the factors behind the so-called "interest rate conundrum", that is, declining long-term rates despite rising short-term rates.
In reality, there was no savings glut, only a dollar glut that went overseas as US debt from trade deficits and returned to the US as savings of low-income Asians because of dollar hegemony in which Asians cannot spend dollars in their domestic economies without inflation.
The third aspect relates to policy: Bernanke is a card-carrying market fundamentalist who believes that markets can best be self-regulated. He and Greenspan repeatedly opposed financial-market regulation beyond even ideological grounds to argue also on the operational ground that US regulation would merely drive market participants overseas to less-regulated jurisdictions and that the US will not accept international coordination that threatens national sovereignty. On regulation, Bernanke is of the school of "if I don't smoke, somebody else will"
Need to rein in the financial sector
In an interview in Prospect magazine published on August 27, Lord Turner says the debate on bankers' bonuses has become a "populist diversion" from the real need for more drastic measures to cut the financial sector down to size. He also says the FSA should "be very, very wary of seeing the competitiveness of London as a major aim", claiming the city's financial sector has become a destabilizing factor in the British economy. The Bernanke Fed has yet to take similarly progressive positions in response to the financialization of the US and global economies and the role Wall Street plays in them.
On all three aspects, there are no signs that Bernanke has turned a new leaf intellectually or professionally from his sordid past. His dysfunctional fixations have impaired the effectiveness of the Fed's unconventional policy directions and unprecedented rescue actions in dealing with the two-year-old financial crisis. The Fed's radical surgery is only revolutionary in operational protocol, aiming to keep the patient alive longer with the disease rather than to cure the disease.
Irresponsible optimism
The gathering of central bankers at Jackson Hole, Wyoming, reportedly expressed growing confidence that the worst of the global financial crisis is over and that a global economic recovery is beginning to take shape.
This is an irresponsibly optimistic assessment that borders on fantasy, by a powerful fraternity of questionable legitimacy and bankrupt credibility. The global financial system may be showing signs of zombie-stirring caused by bailout money from the Fed and other central banks, but the toxic assets that blight the global economy have not been extinguished and still pose a major threat to real recovery. The global economy is still in need of intensive care, with a debt virus that is mutating into a strain stubbornly resistant to monetary cures.
Transferring private debt into public debt
What the Fed has done in the past two years is to transfer massive amounts of private sector toxic debt to the public sector by "aggressively and innovatively" expanding the Fed's balance sheet. This approach may require a decade or more to unwind the massive amount of toxic debt in the system, both in the private and public sectors, delaying true economic recovery.
The approach adopted by the US Treasury and the Fed to deal with a financial crisis of unsustainable debt created by excess liquidity is to inject into the economy more liquidity in the form of new public debt denominated in newly created money and to channel it to debt-laden institutions to re-inflate a burst debt-driven asset price bubble.
The US Treasury does not have any power to create money. Its revenue comes mainly from taxes. But it has the ability to issue sovereign debt with the full faith and credit of the nation. When the Treasury runs a deficit, it has to borrow from the credit market, thus crowding out private debt with public debt.
The Fed has the authority to create new money, which it can use to buy Treasury securities to monetize the public debt. But while the Fed can create new money, it cannot create wealth, which can only be created by work. Unfortunately, the Fed's new money has not been going to workers/consumers in the form of rising wages from full employment to restore fallen consumer demand, but instead has been going only to debt-infested distressed institutions to allow them to de-leverage toxic debt.
Thus deflation in the equity market (falling share prices) has been cushioned by newly issued money, while aggregate wage income continues to fall to further reduce aggregate demand that will cause companies to lay off workers to reduce overcapacity. Until this vicious cycle is broken by proper monetary and fiscal policies, no economic recovery can come.
Falling demand deflates commodity prices, but not enough to restore demand because aggregate wages are falling faster. When financial institutions de-leverage with free money from the central bank, the creditors receive the money while the Fed assumes the toxic liability by expanding its balance sheet. De-leveraging reduces financing costs while increasing cash flow to allow zombie financial institutions to return to nominal profitability with unearned income while laying off workers to cut operational cost.
Thus we have financial profit inflation with price deflation in a shrinking economy. What we will have going forward is not Weimar Republic-type price hyperinflation, but a financial profit inflation in which zombie financial institutions turn nominally profitable in a collapsing economy. The danger is that this unearned nominal financial profit is mistaken as a sign of economic recovery, inducing the public to invest what remaining wealth they still hold only to lose more of it at the next market meltdown, which will come when the profit bubble bursts.
How and when
The Fed's monetary myopia shifts the problem of exiting emergency policies from "how" to "when", with the flawed assumption that pain in the future must necessarily be less acute. Focusing on lagging indicators, which reflect past situations, increases the chances that the Fed will overshoot both in degree and duration with policy stance. Credit expansion through Fed credit easing can also cause excess money creation as de-leveraging runs its course. Hyman Minsky observed: whenever credit is issued, money is created.
Writing in defense of his strategy in the Financial Times on July 21, 2009, on "The Fed's Exit Strategy", Bernanke asserted that Federal Reserve reduction of the Fed's fund rate target nearly to zero, together with a greatly expanded Fed balance sheet as a result of Fed purchases of longer-term securities and targeted lending programs aimed at restarting the flow of credit, "have softened the economic impact of the financial crisis" and "improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages."
Bernanke acknowledged that Fed accommodative policies will likely be warranted for "an extended period". Yet he did not address the issue of what happens to the value of the dollar during this extended period. The US Treasury will not go bankrupt, but the US dollar can fall to a level that will threaten the US economy with bankruptcy.
At some point after the extended period, Bernanke wrote, as economic recovery takes hold, the Fed will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. Bernanke reports that the Federal Open Market Committee, which is responsible for setting US monetary policy, has devoted considerable time to issues relating to an exit strategy, with confidence that the Fed has the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner. Thus, the question is not "how", but "when".
Bernanke notes that the Fed's exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions banks have generally held their reserves as balances at the Fed.
The Fed and liquidity trap
This is known as the Fed pushing on a credit string, with Fed money given to banks sitting idle in reserve accounts at the Fed because banks cannot find credit-worthy borrowers. Economist John Maynard Keynes called this phenomenon a liquidity trap, as with nominal interest rate lowered to near zero, liquidity preference in the market fails to stimulate the economy to full employment. In an earlier speech, Bernanke had refered to a statement made by Milton Friedman about using a "helicopter drop" of money into the economy, presumably for everyone equally, to fight deflation, earning his nickname "Helicopter Ben". But Ben's helicopter so far is sitting idle on the ground while shiploads of taxpayers' money have been sent to distressed institutions.
Bernanke explains that as the economy recovers, banks should find more opportunities to lend their reserves. Yet he was vague about how the economy would recover beyond a general faith that what goes down will eventually go back up. Yet in the history of nations, many have gone down without recovering their former greatness.
Bernanke argues that recovery when it comes will produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures - unless the Fed adopts countervailing policy measures. When the time comes to tighten monetary policy, the Fed must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.
Bernanke believes that, to some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of the Fed's short-term lending facilities and ultimately to their wind down. He points out that short-term credit extended by the Fed to financial institutions and other market participants has fallen to less than $600 billion as of mid-July 2009 from about $1.5 trillion at the end of 2008. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Fed mature or are prepaid.
However, Bernanke admits that reserves likely would remain quite high for several years unless additional policies are undertaken. He asserts that even if Fed balance sheet stays large for a while, the Fed still has two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. The Fed could use either of these approaches alone; however, to ensure effectiveness, it likely would use both in combination.
Congress granted the Fed authority in the autumn of 2008 to pay interest on balances held by banks at the Fed. This is a controversial development because it reduces pressure on banking to lend money in the economy to finance economic activities.
At present, the Fed pay banks an interest rate of 0.25%. Bernanke indicates that when the time comes to tighten policy, the Fed can raise the rate paid on reserve balances as it increases the federal funds rate target. Needless to say, this will retard economic recovery as it gathers steam.
Banks generally will not lend funds in the money markets at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they can be expected to compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.
Thus the interest rate that the Fed pays would tend to put a floor under short-term market rates, including its policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit because banks will not want to lend out their reserves at rates below what they can earn at the Fed. Thus market forces are really dictated by the Fed.
Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank's liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates. But these countries do not pretend they operate on a free-market economy but a mixed-market economy.
Despite this logic and experience, the federal funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began paying interest on reserves. This pattern partly reflected temporary factors, such as banks' inexperience with the new system. But it may also be interpreted as a measure on how weak the economy actually was.
However, Bernanke observed that this pattern appears also to have resulted from the fact that some large lenders in the federal funds market, notably government-sponsored enterprises such as Fannie and Freddie, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks in order to compete for scarce funds.
Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal funds rate and the rate the Fed pays on reserves. Bernanke argues that if that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets - the second means of tightening monetary policy.
The exit dilemma
An economy that has collapsed under the burden of excessive debt cannot recover until such debt has been extinguished. And debt can only be extinguished by wealth creation, not by creating more debt with easy credit - and wealth can only be created by employment and not by financial manipulation. Yet the Fed's response to the financial crisis thus far has been to delay the extinguishment of debts in the financial system to save it from collapsing. Recovery is not automatic and must be brought about by market correction or countervailing policies to bring about full employment. A depression begins when the business cycle fails to cycle for long periods, keeping unemployment permanent.
Next: Facing a lost decade ahead