A Missed Appointment

This is the economic post that I've been planning for about a week now, but haven't gotten around to yet. I'm glad I waited, as today is the perfect time for it. Why?

This morning, President Obama re-appointed Ben Bernanke as Chairman of the Fed.

The same Ben Bernanke who, less than 18 months ago, declared that "the subprime contagion can be contained, and is unlikely to spill over to the broader economy." (We'll get back to that quote shortly.)

The same Ben Bernanke who has grossed up the Fed's balance sheet to unprecedented proportions in a Ponzi scheme that makes Bernie Madoff look like a piker. How?

As a general rule, central banks are prohibited from printing currency to fund government spending. So as Congress appropriates massive amounts of money that we do not have, and that diminished tax revenues cannot possibly hope to support - now or in the near future - the Treasury issues record amounts of debt to fund the appropriations.

Now, there aren't enough buyers to gobble up all that debt without interest rates going through the roof, as investors, foreign and domestic, demand yields on Treasuries that reflect the risk premium of an increasingly risky borrower. (Think about the letter you're likely to get from your credit card company when you max out every card you have, and even go over the limit. You know, the one where they inform you that they've just raised your rate by 10%.)

China - the single largest foreign holder of US debt - has been systematically decreasing its Treasury holdings. There are fewer primary dealers on Wall Street to buy up Treasuries - no more Bear Stearns, no more Lehman, no more Merrill Lynch. So the demand just isn't there.

Now, as an aside, the increased aversion to risk on the part of big banks is supporting demand to a degree; the big banks still hold billions of dollars in "legacy assets" (new-speak for "toxic assets). And the Congress-forced relaxation of mark-to-market accounting rules means that they can lie about the value of those assets and breathe a little easier - for now. Until the assets eventually default and they have to write them off altogether.

So they're not lending, and they're not investing in risky assets anymore. They're hoarding cash, in the form of Treasuries, to pay the piper when the assets go to zero. But that can only last so long.

So the Fed's been buying up Treasuries, grossing up its balance sheet. Then, it'll pump reserves into the banking system, where the money trickles down to your pocket and mine. That's called monetization of the debt. And it's effectively an end-around to the legal restrictions on the central bank simply printing currency to fund the debt. It should be criminal, and Ben Bernanke should be sharing a cell with Bernie.

Instead, we're lauding his praises, thanks in no small part to his recent round of stumping to pat himself on the back for the way he's reacted to the financial crisis, in an effort to get himself re-appointed. The Fed chair is supposed to be independent from the politicians, and instead Ben's been campaigning like a ... well, like a politician.

And see, how he's reacted to the financial crisis isn't the biggest problem I have with Ben.

No, it's the fact that he's reacted at all.

See, given his quote from last year, cited above, I'd prefer a Fed chairman that, instead of reacting to a financial crisis, had the ability to foresee what so many of us foresaw, and avert a crisis, rather than react to one.

Now, Ben's a smart dude, and an astute student of past economic cycles. I've read his research on them, and he's studied them well. The trouble is, he has zero ability to apply what he's learned from past policy mistakes to forecasting future ones, and can only recognize a bubble after it's burst.

Nouriel Roubini called this crisis. So did Joe Stiglitz, though he was a proponent of the then-record-low interest rates that brought it on. So did Robert Shiller. So did Michael Gasior of AFS Seminars.

So did I.

And you know what? It's certainly possible for a central bank to do the same, and avert disaster. Let's look at an example, but first, let's talk about what the Fed's job is.

Per the Humphrey-Hawkins Act, the Fed has a dual policy mandate: control inflation and promote full employment. Those mandates run counter to each other. Stimulate the economy too much to create jobs, and you risk fueling inflation. Raise rates too much in an effort to control inflation, and you choke off growth, resulting in job cuts. It's a delicate balancing act.

In recent years - from about 1998 through today - the Fed, under Bernanke and his predecessor, Alan "Mr. Bubble" Greenspan, has erred on the accommodative side, bowing to political pressure to gain favor by keeping rates too low, thereby fueling growth beyond sustainable levels. Nobody seems to mind at the time; asset values are soaring at rates heretofore unseen, household wealth is growing, tax receipts are up, the fat cats in Washington are able to justify all the pork they want - life is good.

But what's really happening is that unsustainable growth is creating a bubble, be it in dot-com stocks or real estate. And bubbles burst. And when they do, calamity ensues.

Now to our example. Over the past couple of years, real estate prices in Australia were inflating rapidly. The Aussie central bank recognized this, and, fearing a bubble was forming, decided to temporarily suspend its own dual policy mandate, and focus instead on gently deflating a pending asset bubble before it could fully form - and thereby avoiding the catastrophic consequences thereof.

So the Aussie central bankers began taking a hard look at housing data. Recognizing how inefficient government is at collecting data on a timely basis, it charged the private sector - Australian banks and real estate firms - with assembling the data it needed. They looked at things like the ratio of home prices to income in order to assess the debt burden home buyers were taking on relative to their ability to repay, the amount of mortgage borrowing for investment - rather than owner-occupied - purchases, etc. All the things that led to the US housing bubble.

And when the data showed them what people like Roubini, Stiglitz, Shiller et al were able to figure out here in the US, they acted. They didn't react, they acted. Proactively.

They stubbornly kept rates high even as the Aussie economy was slowing, defying the politicians' outcry for easy-money policy to stimulate the economy. By so doing, they priced mortgages out of the reach of the un-creditworthy and the investors looking to make a quick buck flipping homes in an escalating-price environment, financed with cheap money.

And they slowed housing demand gradually, bringing prices back down to earth and averting catastrophe.

If the Aussie central bank can do it, so can the Fed. But not under Helicopter Ben Bernanke. And for that reason, this is one appointment that missed the mark in terms of what the US needs if it is to ever recover from this crisis, without forming a new bubble in the process.