Commentary

Fed Up

There’s a lot of finger pointing going on over who’s to blame for the financial crisis: bankers, derivatives traders and the regulators who failed to keep an eye on them. Let me add two names that usually escape the dragnet: Fed chairman Ben S. Bernanke and his predecessor, Alan Greenspan.

Rather than confess and repent, the folks in Washington are running the recovery plan with the same misguided prescriptions: more government spending, more government regulation and a fivefold increase in lending capacity for the global deadbeat assistance agency called the International Monetary Fund. These won’t work.

One of our problems is the Fed’s preoccupation with the risk of deflation. Fixated on this risk in 2002 and 2003, Greenspan pumped out dollars, cutting the Fed funds rate down to 1%. The easy credit boom continued, inflating asset prices. We’re living with the aftereffects of asset speculation now. And now the Fed is prescribing more of the same medicine: easy credit. The overnight lending rate for Fed funds is down to 0%.

What the Fed has failed to realize is that most deflations are good ones, not bad ones. During the last two centuries there have been many deflations throughout the world. Almost all of them have been good ones precipitated by technological innovation, rising productivity, global capital flows and sustained economic growth. If farm mechanization cuts the price of wheat, you get a rising living standard. This is good.

Instead of lowering interest rates seven years ago, the Fed should have raised them. This would have blunted the credit boom that led to the bubble. The most visible excess was a buildup in debt relative to GDP and a deterioration of debt quality. Combined government, corporate and household debt is now 250% of annual GDP, double what it was a generation ago. A lot of the debt on both corporate assets and houses is junk. It can be repaid only by refinancing on the back of ever higher asset prices.

Tightening instead of loosening in 2002 and 2003 would have saved the U.S. dollar from the white-knuckle ride it has taken over the last seven years. As the Fed fought deflation, the dollar tumbled. From January 2002 until mid-July 2008 the greenback lost 44% of its value against the euro. This ignited the global commodities bull market that pushed crude to $145 a barrel and led to food riots in Egypt and Uzbekistan. Then, as financial markets seized up and the demand for dollar liquidity surged, the greenback abruptly reversed course. In a little over three months last summer and fall, the dollar appreciated by 28% against the euro. Commodity prices collapsed. These swings in value cause enormous economic damage.

Now the Fed has opened the money floodgates again and its balance sheet has more than doubled in size since August. Investors watching the recent rally may think that the Fed has stabilized the markets and saved the day but its approach is fraught with danger.

As the self-regenerative powers of the market system kick in, the demand for money will fall and the velocity of money will correspondingly go up. Unless the Fed shrinks its balance sheet by selling bonds and mopping up excess dollars, inflation will roar back with a vengeance. I am worried that the Fed will sit on its bloated balance sheet for too long. After all, a move to significantly reduce its size would require the Fed to sell hundreds of billions of dollars in bonds. These sales would cause bond prices to fall and yields to rise. Higher rates would be felt in the mortgage and corporate lending markets, and could give rise to another recession.

It is likely that the Fed will opt to put off these tough decisions for at least two years. Remember that in 2010 Bernanke’s term expires (in January) and another congressional election occurs in the fall. Still, the Fed will eventually have to bite the bullet and shrink its balance sheet to fight inflation.

I believe we are headed for a W-shaped recovery, with a down-up-down pattern. We are approaching an up segment now, but my advice is to avoid being suckered into any stock market rallies. You should keep your eye on what is around the corner: some inflation, a shrinking of the Federal Reserve’s balance sheet and another spate of economic weakness. Stick with the Treasury Inflation-Protected Securities (TIPS) that I have been recommending for some time. You should also own some gold, via commodity futures or an exchange-traded fund.

Steve H. Hanke is a professor of applied economics at the Johns Hopkins University and a senior fellow at the Cato Institute.