Market Review: Monetary Mischief

The financial news dominating the headlines this week is undoubtedly the appointment of Ben Bernanke as the new Fed chief, replacing Alan Greenspan, who will step down in January.

What can I say about Bernanke that has not already been hashed out in the press? I will spare you the recitation of Bernanke’s qualifications, his sterling academic background and other resume-like details.

What we’re interested in is how is this going to affect the market? Does it matter?

To me, central bankers are dreamers. They are like bad poets, who make the world out to be something other than what it is. For the central bankers, it’s always about what levers to pull and what buttons to push. And the accuracy of their tools is highly overrated. They no more control the economy than a weatherman controls the weather.

Yet, they can make things worse, much worse. In their capacity to do wide-scale harm, they have no peers on the financial scene.

In Bernanke, I think we get a Fed chief who will reliably stay with the Greenspan playbook, at least in the near term. But I think Bernanke will prove easier than Easy Al.

In the minds of many financial observers, Bernanke is famous for two ideas. First, he was the author of a speech, in November of 2002, in which he thought the Fed should do everything in its power to stave off deflation (in this case, generally falling prices), including dropping money from helicopters.

Assuredly, the latter remark was said tongue-in-cheek. At least, we hope. Nevertheless, the old-timers quaked at this, thinking that here was a man who would not hesitate to destroy the dollar.

Bernanke also openly discussed the possibility of unconventional methods of monetary manipulation — such as the Fed buying assets in the marketplace to achieve its goals.

Again, the hearts of the old-timers skipped a beat and their fingers trembled. In Bernanke, we have a fellow who will not hesitate to innovate and find new ways to wreak havoc.

Based on these ideas and my impression of his public comments, I would gather that Bernanke would err on the side of being too easy, rather than too tight. This means printing money and creating credit. In short, we can expect more and greater levels of inflation.

Market observers had a phrase for this notion that Greenspan always came to the rescue with easy money when things got a little rough. They called it the Greenspan put, the idea being that investors always had Greenspan in their pockets to bail them out. What do we make of the Bernanke put?

Edward Chancellor, author of Devil Take the Hindmost, had it right in a Tuesday editorial published in The Wall Street Journal ("When the BuzzDies Down"). "One day," Chancellor mused, "the financial markets may wake up to the hyperinflationary implications of the Bernanke put."

One man believes he has an answer. John Hathaway, manager of the Tocqueville Gold Fund, was a speaker at Grant’s Fall Investment Conference. He was, perhaps not surprisingly, bullish on gold.

He opened with the image of the Zimbabwe dollar. In 1999, about six Zimbabwe dollars were worth one U.S. greenback. Today, it would take 50,000 Zimbabwe dollars to buy one U.S. dollar. The central banker of Zimbabwe was quoted as saying that it would be wise for Zimbabweans not to be caught with too much cash.

The quip got a chuckle from the crowd, but Hathaway’s point was that we are more sophisticated in our deceptions and they take a much longer time to play out. The United States is not Zimbabwe, of course, and Hathaway in no way meant to imply that it was. But the endgames are not so far apart.

The dollar, even the American one, is a dying currency, which loses a little more of its value with each passing year.

In any event, to bring the thing back around to Bernanke, the gathering at Grant’s was not too impressed with the new Fed chief. But then again, it is the position itself and not the man that ruffles the feathers.

As James Grant noted in his address, the Federal Reserve itself is the root of all monetary mischief. Better to abolish the Fed, institute a gold standard and let markets work. Too much to hope for, I think.

Grant concluded, "Bernanke’s big mistake will not be his alleged easy money genes. It’s that he thinks he knows the future before it happens."

That, indeed, is the fault of all central bankers

Chris Mayer
for The Daily Reckoning

October 30, 2005

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Stimulating Aggregate Demand
by John Mauldin

Let’s forget for the moment the debate about whether Fed policy can actually stimulate demand at all times and places – obviously, Bernanke and the Fed board believe that is does. Beliefs will translate themselves into action.

The Fed, when faced with slowing demand and deflation, will act in very predictable ways based upon their beliefs. They will work to stimulate demand. Bernanke viscerally believes in the ability of the Fed to stimulate demand and prevent deflation.

In a typical business cycle, if the economy gets "overheated" and inflation starts to rise, a central bank can raise interest rates and tighten the money supply, thus slowing business growth and profits and lowering demand and therefore, price inflation. If the economy gets into recession, a dose of low rates and easy money is the prescription. "Don’t fight the Fed" is a rule we have been taught. It was a good rule to follow, until 2001, when there was a disconnect between the markets and fed policy.

My concern is that we are not in a typical business cycle. Just as a number of different economic factors all came together to cause the boom and then bubble of the 80’s and 90’s (disinflation, lower interest rates, lower taxes, lower international tariffs, the demographics of the Boomer

Generation, stability, etc.), I think there are now forces at work which may not respond to the Federal Reserves levers (such as inflated housing prices, a monster trade imbalance, large government deficits, huge personal debt burdens and a boomer generation which will need to save more to retire, among many issues). But that does not mean the Fed will not pull them.

For Bernanke, "Deflation is in almost all cases a side effect of a collapse of aggregate demand–a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers."

The deflation that will be coming to us in our future will not come as a result of a drop in aggregate demand, but as a result of excess production capacity and the rising influence of China and other markets where cheap labor accompanied by the build-up of too much production capacity is driving down production costs. It is acerbated by the continued competitive currency devaluation upon the part of many of the trade partners of the U.S. This is a tide of deflation that is sweeping the world. It is a global phenomenon, and not isolated to just one economy.

My concern is that the United States, in isolation, cannot prevent global deflation from coming to our shores without help from the rest of the world. And to date, we are not getting any help at all.

Bernanke is going to have a difficult task as he faces a slowing U.S. economy. When does he shift policy? I doubt he knows today. But if he raises rates too high or keeps them there too long, he risks more than a mere slowing economy. Let’s hope he has the touch. Stay tuned.

Regards,

John Mauldin
for The Daily Reckoning

Editor’s Note: John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly economic e-mail Thoughts from the Frontline. As well as being a frequent contributor to The Daily Reckoning, Mr. Mauldin is the author of Bull’s Eye Investing (John Wiley & Sons), which is currently on The New York Times business best-seller list.

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