Federal Reserve Unsupported by Credibility - 1

Federal Reserve Power Unsupported by Credibility

By Henry C.K. Liu

Part I: No Exit

This article appeared in AToL on September 11, 2009 as Boogged Down at the Fed

Ben S. Bernanke, a Republican who was first appointed by President Bush nearly four years ago as Chairman of the Board of the Federal Reserve, has been reappointed to a second term by Democratic President Obama. The announcement during the President’s summer vacation in Martha’s Vineyard served to divert attention from unwelcome figures released on August 25 by the White House budget office that forecast a cumulative $9 trillion fiscal deficit from 2010-2019, $2 trillion more than the administration estimated in May. The federal government will spend $2.98 trillion in fiscal 2009, $3.766 trillion in fiscal 2010 and $5.307 trillion in fiscal 2019, all substantially more than projected revenue.

Moreover, the figures show the national debt doubling by 2019 to $20.78 trillion, reaching three-quarters of the projected gross domestic product (GDP), with alarming projections of additional $2 trillion from $12.8 trillion in 2009 to $14.5 trillion in 2010. In fiscal 2008, according the Bureau of the Public Debt, a division of the Treasury Department, the federal government paid $451 billion in interest on the debt. In July 2008, the Treasury was paying an average interest rate of 4.382% on that debt. A year later, in July 2009, Treasury was paying an average interest rate of 3.418%, even as the Fed was doing its utmost to keep interest rates down. If interest rates go up in the out years as expected, the Treasury would be forced to pay more per year to service the national debt—even if the debt itself did not grow.

The President characterized Bernanke’s reappointment as seeking to keep “a mood of stability in the financial markets” while acknowledging that economic recovery can be expected to be a long way off. The reappointment was a sign of continuity of long-standing Fed monetary policy in contrast to Obama’s campaign rhetoric of “change we can believe in.”

Bernanke is closely identified with Fed policies that had landed the global economy in its current sorry state. Many, particularly conservative Republicans, Blue Dog Democrats, and even progressives, are concerned about Obama’s proposals to expand the powers of the Fed, in view of its history of persistent failure to spot and preempt pending systemic financial crises. Critics question the wisdom of giving an institution with such poor record of performance the prime role as a systemic risk regulator in the proposed regulatory overhaul of the financial system.

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 had 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 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. (Please see my August 24, 2007 AToL article: Central Bank Impotence and Market Liquidity)

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” has depressed US interest rates since 2000. Echoing this view, Greenspan testified before Congress on July 20 that this glut is one of the factors behind the so-called “interest rate conundrum”, i.e., 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 spent dollars in their domestic economies without inflation. (more)