Decision ‘08

The Blankety-Blank Economy, Or, Bring Back Paul Volcker!

I must tell you in all sincerity that I have deep, deep concerns about the American economy that I haven’t had in a long time. It’s not that we are in a slump/possible recession - it’s not the subprime meltdown/credit crisis that has me worried…it’s the pitiable, pathetic state of the once mighty U.S. dollar.

See, it’s not a minor thing, a weak dollar - those high prices you’re paying at the gas pump and the grocery store are influenced by many things, but one reason inflation is rearing its ugly head again is the fact that our currency simply has less purchasing power. Put another way - gas is $4/gallon, and $1 won’t buy as much gas as it once did - it’s saying the same thing two different ways.

A weak dollar has some advantages - it helps exporters, for one thing…but we are a consumer economy, first and foremost, and we live way beyond our means thanks to the willingness of foreign interests (read: China) to buy up our bonds and let us run huge deficits. That willingness to buy dollar-denominated financial interests is increasingly at risk - because the value of your investment declines in tandem with the decline in value of the currency it is denominated in, and right now, the Euro is looking awfully good for international investors relative to the greenback.

But the Fed has put itself in a tricky position - it lowered interest rates to a ridiculously low level again in hopes of chasing off a downturn that NEEDED to happen, because it was based on the real estate bubble…and now the downturn happened anyway (though perhaps it was lessened by the Fed’s actions), and the Fed is loathe to raise interest rates as it should (and must!) because rising interest rates in a bad economy are very difficult to stomach and tend to make matters much, much worse.

Now, there are various interpretations of the proper role of the Federal Reserve. Technically, its charter is to control the money supply. Practically, it is called on to do just about everything possible at one time or another, from targeting employment levels and interest rates to preventing panics and brokering deals with private banks when the integrity of the financial system is at stake. But surely the role of the central bank of the United States includes protecting the integrity of the dollar!

We have to raise interest rates, sooner rather than later, because inflation must be broken, before it gets out of hand. Inflation erodes the life savings of hard-working American families, and it has a disproportionate effect on the poor and working-class, who must spend a greater portion of their salaries on staples whose value is rising faster than their paychecks.

Yet on this vital (perhaps the most vital) issue facing Americans, I hear nothing but crickets chirping from the major candidates. John McCain’s economic policy page has nothing on protecting the integrity of the dollar,and Obama’s is silent as well (though it still promises to ‘fix’ NAFTA!). That’s not surprising, really -who wants to campaign on a promise to raise interest rates?

Sometimes you have to take some bad medicine, however, to get over what ails you - and the American economy needs to clean up its balance sheet, flush out the bad debt from the housing bubble, and, if need be, go through a brief, deep recession to avoid a prolonged one. And above all, we’ve got to strengthen the dollar…and it sure would be nice to know what the two people who want to run this country would do about THAT…but the Fed doesn’t have to wait on the election - though the stock market will jeer, the interest rate must be raised at the next meeting (and probably at the next half-dozen or so), until inflation gets back under control, and the dollar gets some of its legs back…

UPDATE 6:40 p.m.: Sigh…this is not one of those times you want to be proven right - but I swear I didn’t see this article until after I posted. Barclay’s Capital is sounding the warning bell on the Fed’s loss of credibility and the coming inflation crisis, in uncannily similar language to what I just used, down to the prediction of at least a half-dozen interest rate increases needed:

Barclays Capital has advised clients to batten down the hatches for a worldwide financial storm, warning that the US Federal Reserve has allowed the inflation genie out of the bottle and let its credibility fall “below zero”.

“We’re in a nasty environment,” said Tim Bond, the bank’s chief equity strategist. “There is an inflation shock underway. This is going to be very negative for financial assets. We are going into tortoise mood and are retreating into our shell. Investors will do well if they can preserve their wealth.”

Barclays Capital said in its closely-watched Global Outlook that US headline inflation would hit 5.5pc by August and the Fed will have to raise interest rates six times by the end of next year to prevent a wage-spiral. If it hesitates, the bond markets will take matters into their own hands. “This is the first test for central banks in 30 years and they have fluffed it. They have zero credibility, and the Fed is negative if that’s possible. It has lost all credibility,” said Mr Bond.

The grim verdict on Ben Bernanke’s Fed was underscored by the markets yesterday as the dollar fell against the euro following the bank’s dovish policy statement on Wednesday.

Traders said the Fed seemed to be rowing back from rate rises. The effect was to propel oil to $138 a barrel, confirming its role as a sort of “anti-dollar” and as a market reproach to Washington’s easy-money policies.

Bernanke is a disaster…

14 Responses to “The Blankety-Blank Economy, Or, Bring Back Paul Volcker!”

1 Peter Says:
June 27th, 2008 at 8:04 pm
I’ll stand up for Bernanke — I think he’s doing a superb job in uniquely difficult circumstances.

If he did not lower interest rates to the extent that he did, he risked both a severe recession and a banking collapse.

My guess is that higher oil and food prices will dampen economic activity enough to reduce the threat of inflation. Also, we don’t (yet) have wage inflation — only commodity inflation, and (at least for oil) the speculative bubble could be pricked at any time. Hence, I don’t think the Fed needs to be aggressively hawkish on inflation.

The weak dollar helps exporters by making their goods more competitive. As long as the currency does not fall precipitously, we’ll be OK. It’s self regulating, and maybe the dollar is really only worth $1.55 or $1.60 to the euro.

I give Bush credit for naming Bernanke — I think he has been given a very weak hand and played it very well.
2 Mark Says:
June 27th, 2008 at 9:40 pm
I wish I could share your opinion - I have been very disappointed in his direction.

But I’ll say this much - for once I hope you’re right and I’m wrong!…
3 Mark Says:
June 27th, 2008 at 9:46 pm
And, I might add, the markets sure don’t seem to be content with the current state of things…it’s hard for me to see how you can be sanguine, with the market in the tank, inflation breaking out of its comfort zone ($4/gas, $2 loaves of bread), rising unemployment, and anemic-to-nonexistent economic growth, and a dollar that’s heading into peso land. If that’s a good job, I’d hate to see what would have happened if things were handled poorly!…

Jeez, come to think of it, I’m sounding like the Democrat here and you’re sounding like the Republican!…
4 Peter Says:
June 28th, 2008 at 8:52 am
Well, on economic issues, I tend to agree with traditional Republican thinking. I think traditional Democratic solutions are typically wrong. Example: windfall profits tax on oil companies — why shouldn’t Exxon be able to have the same margins as Microsoft, Pfizer, or GE? It’s not the fault of the oil companies that prices are high — they just buy the stuff, refine it, and bring it here.

Many of the problems we face do not have the government or the Fed as their cause. We’ve been running a huge trade deficit for years — at some point, it will cause the dollar to fall. Our savings rate is negligible because we spend our money on foreign oil and big screen TV’s made in Asia. Commodity prices are skyrocketing, but mostly due to exogenous factors (combined with some self-inflicted wounds, such as the risk premium attached to oil since our invasion of Iraq and our ludicrous ethanol policy). Most importantly, the business cycle will rise and fall in both Democratic and Republican administrations. We’re in a trough (or approaching a trough) but at some point things will improve, as they always have in the past.

As for the stock market: I think it is woefully undervalued. The major indices are about 15% less now than they were when this century started. I bought a boatload of stocks this week. My philosophy on investing is that when everyone is on one side of the boat, you should go on the other side. I think this is a great time to make a contrarian bet against the prevailing wisdom. Things aren’t nearly as bad as they seem.
5 Peter Says:
June 28th, 2008 at 9:28 am
I told someone yesterday that the equity markets now are basically a put option on the price of oil. If you think that oil will continue to rise, then you should buy CD’s and get 3%. If you think oil will follow other speculative bubbles — dotcom stocks, real estate, Dutch tulips — then things will be much brighter once the invisible hand gets to do its thing.
6 Mark Says:
June 28th, 2008 at 9:55 am
Well, I agree the time to buy stocks is now - unfortunately, the smartest investment I can make at the moment is to pay down debt…
7 Chris J. Breisch Says:
June 28th, 2008 at 5:46 pm
Oh my God, I may faint.

I pretty much agree with everything Peter has said in this thread. Not 100%, but close enough to call us on the same page.

Since, we’re traditionally universally in disagreement, which means that one of us is traditionally completely wrong, does that mean we’re both wrong this time or both right? time will tell.

But, in essence, I agree with Peter about Bernake. He hasn’t had much choice, and has had to walk a tightrope without a net. So far he hasn’t slipped. I’ll keep crossing my fingers that he won’t.
8 Peter Says:
June 28th, 2008 at 6:24 pm
I think we’re both right.
9 Mark Says:
June 28th, 2008 at 8:34 pm
Listen, I’ll reiterate that I hope you guys are right…but I was thinking about something you said, Peter, specifically “maybe the dollar is really only worth $1.55 or $1.60 to the euro”. With all due respect, this is a nonsensical statement, because the dollar and the euro have no intrinsic value…they’re just pieces of paper. Their worth is determined by the markets based on things like economic expectations, interest rates, central bank policy, national policy - so if the dollar is slipping against the euro, it’s not because ‘that’s just what it’s worth’. That’s putting the cart before the horse - rather, it’s worth what it’s worth because the markets are giving our policymakers, including Bernake, a big thumbs down by lowering the value of our currency…
10 Peter Says:
June 29th, 2008 at 12:04 am
I disagree. The dollar is weak because the current accounts deficit is huge; because oil is dollar denominated and speculators use the dollar as a hedge against oil; and because of the interest rate differential between the US and Europe. The Fed is keeping interest rates steady at least through the elections, and Trichet will raise interest rates in Europe on Thursday. So I’m skeptical that the recent dollar weakness is because the rest of the world thinks we are going in the tank — maybe the $1.55-1.60 level is where the dollar/euro reaches an equilibrium, and a) our current accounts deficit improves because foreign goods become too expensive, b) speculators no longer make money being long oil and short the dollar, and c) the European central banks freeze interest rates so they can start exporting again.
11 Mark Says:
June 29th, 2008 at 1:03 am
Well, yes, the interest rate differential between the U.S. and Europe - and who sets the interest rates? The central bank, primarily…so we’re back to where we started. The Fed is responsible for the weak dollar - yes, there are other factors, but ultimately, this can’t continue…

But we will probably, as so often, have to agree to disagree…but the number one danger facing this economy, in my view, is inflation…because, quite frankly, the average American consumer is running on fumes. The net savings rate went below zero three months in a row recently, meaning Americans are living on credit…only problem is they can’t pay the credit because all their money is going into the gas tank and the grocery store. It’s intolerable, to me, after everything Volcker did to contain inflation, that twenty-five years later we have $4/gallon gas AND a 2% interest rate…

Yes, it is true, there is an increasing likelihood the Fed will stand pat through the November elections…and if so, you can truly put me among those calling Bernanke perhaps the worst Fed chairman of my lifetime. To let political factors influence the credibility of the dollar when inflation risks are as high as they are is borderline criminal…

Obviously, events can change, and inflation might show signs of taming - but do you see that happening if the Fed doesn’t act? I sure don’t…
12 Peter Says:
June 29th, 2008 at 9:38 am
I do. Just wait.
13 Peter Says:
June 29th, 2008 at 9:58 am
Having said that, it’s always helpful to keep in mind what Keynes once said: the markets can remain irrational longer than you can remain solvent. I’m not short oil. Somebody will make a ton of money on that trade, but it won’t be me.
14 Decision ‘08 » Blog Archive » Bernanke’s Blunder Says:
July 6th, 2008 at 10:44 am
[…] 20% off its most recent peak), I can only reiterate once again the point I made at greater length here: the investment community has officially passed a “no-confidence” vote on the economic […]