Is Bernanke blowing another bubble?

Fed Chairman Ben Bernanke mounted a spirited defense of quantitative easing on Tuesday in his semiannual monetary policy report to Congress, arguing that it’s effects were little different to conventional monetary policy:

Large-scale purchases of longer-term securities are a less familiar means of providing monetary policy stimulus than reducing the federal funds rate, but the two approaches affect the economy in similar ways. Conventional monetary policy easing works by lowering market expectations for the future path of short-term interest rates, which, in turn, reduces the current level of longer-term interest rates and contributes to both lower borrowing costs and higher asset prices.

This easing in financial conditions bolsters household and business spending and thus increases economic activity. By comparison, the Federal Reserve’s purchases of longer-term securities, by lowering term premiums, put downward pressure directly on longer-term interest rates. By easing conditions in credit and financial markets, these actions encourage spending by households and businesses through essentially the same channels as conventional monetary policy.

A wide range of market indicators supports the view that the Federal Reserve’s recent actions have been effective. For example, since August … equity prices have risen significantly, volatility in the equity market has fallen, corporate bond spreads have narrowed …

All of these developments are what one would expect to see when monetary policy becomes more accommodative, whether through conventional or less conventional means.

It’s not the first time, but Bernanke here seems to be implicitly acknowledging that higher equity prices are one of the goals of the Fed’s policy. And while this may deliver a temporary boost to consumer confidence, one really has to ask the question, at what cost?

As I noted yesterday, the huge rally in stocks from the depths of 2008 has pushed valuations so high that some observers expect US equities to struggle to even outpace inflation over the coming decade.

Furthermore, one also has to ask the question if “encouraging spending by households” is a sensible goal too, given that the process of household deleveraging arguably has some way to go before personal debt returns to more sustainable levels. As you can see from the chart below (courtesy of Steve Keen) US private debt has been growing at an exponential pace for several decades now.

Since the “Minsky moment” of 2008, you can see there has been a small tick down in the ratio as households have started to either pay down or default on their debts. But the ratio still stands at about 275% of GDP. Now, Steve Keen reckons that a sustainable level is something like 100% of GDP.

If he’s right, we should be very, very worried. It basically implies we are looking at a Japan-style “lost decade” or two. Even if he’s exaggerating, it seems pretty clear that the deleveraging process is far from over.

All of this brings me to a very interesting point made by Rajan Raghuram in the book Fault Lines: How Hidden Fractures Still Threaten the World Economy. For those of you who haven’t heard of Raghuram, he is the ex IMF chief economist who, in 2005, interrupted a major love-fest for Alan Greenspan to warn all of the world’s central bankers that the financial system was on the brink of disaster. Naturally, he was completely ridiculed at the time, but two years later, was proven to be absolutely right.

In any case, Raghuram has an interesting thesis. He argues that rising inequality and the lack of a proper social safety net (stingy unemployment benefits and no health care for the unemployed) in the US mean that the American electorate has far less tolerance for downturns than in other countries, particularly Europe. This places enormous pressure on US politicans and the central bank to “over-stimulate” — essentially to inflate new credit bubbles, whenever the economy hits severe downturns.

The US political system is acutely sensitive to job growth because of the economy’s weak safety nets. The short duration of unemployment benefits in the United States, as well as the substantially higher costs of health care for those who do not have jobs, were not excessively painful when recessions were short: they gave laid off workers strong incentives to find new jobs…

But if recessions are likely to be more prolonged than in the past, the system has to change, if only because the old social contract–short duration benefits in return for short recessions–is breaking down.

One reason is simply moral. No modern economy should force workers who lose their jobs to make such painful decisions as choosing which of their children to protect with medical insurance…

Another problem with a weak safety net is that the United States tends to overreact, and other nations underreact, to downturns. Because every country knows that the politically vulnerable United States has to respond with expansionary policies and that some US demand will spill over to the rest of the world, their inventive to change the structure of their economy, or their policies in downturns, is commensurately less.

But perhaps the most important problem is that the ad hoc policies the United States is forced into do enormous damage to the long-term health of the economy, both directly and through their effects on the financial sector…

The Federal Reserve, though ostensibly independent, has a very difficult task … If the United States cannot tolerate longer bouts of unemployment, and these bouts are here to stay, we risk going from bubble to bubble as the Federal Reserve is pressured to do the impossible and create jobs where none are forthcoming.

In Raghuram’s view, the Fed needs to pay much more attention to unsustainable rises in credit and asset prices. But as long as US politicians ignore the growing problem of inequality and the lack of a safety net for the unemployed, the Fed will not have the freedom to do this.

In fact, on the contrary, as the economy’s last defense against mass unemployment, it may be forced to blow bubble upon bubble, with potentially disastrous consequences.

I for one would not like to be in Bernanke’s shoes right now.

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  1. Sam Birmingham

    “Is Bernanke blowing another bubble?”

    That headline reminds me of my favourite Simpsons moment:

    Mother Simpson: [singing] How many roads must a man walk down before you can call him a man?
    Homer: Seven.
    Lisa: No, dad, it’s a rhetorical question.
    Homer: OK, eight.
    Lisa: Dad, do you even know what “rhetorical” means?
    Homer: Do I know what “rhetorical” means?