Not Pretty: 2008 in the Windshield
In 2008, as in every year since 1971, the economy’s biggest problem is mercantilist U. S. monetary policy. But this year confronts more urgently the threat that U. S. fiscal policy, too, will be over-run by mercantilism. The recent “stimulus package” of election-year “walking around money” and the prospective expiration of the 2003 Bush tax cuts are evidence of mercantilist fiscal policy. Mercantilism is now called Keynesianism, as it has been since the 1930’s.
U. S. monetary policy is mercantilist because it seeks to manipulate domestic interest rates and asset prices, and to use currency value as a weapon of trade war. The Federal Reserve causes the dollar’s value to change drastically, which is to say it causes inflation and on occasion deflation. Since 2003, the Fed has caused the dollar’s value to drop from $350/oz of gold to February’s price above $965/oz – the lowest value in the dollar’s history.
Failed U. S. Monetary Policy
Despite its ongoing machinations with domestic interest rates and asset prices, in 2003 the Federal Reserve coincidentally arrived at equilibrium in the dollar’s value over the previous 15 years: $350/ounce of gold. The dollar’s value remained at equilibrium several months while the bank overnight lending rate was one percent and the ten-year Treasury yield was very respectable, under 4%. The Bush 2003 tax cuts were adopted in May, 2003, which allowed faster capital accumulation. U. S. economic growth gathered energy and took off, seeing its best times this decade until the Fed intervened.
The Fed caused the 2000-2002 crash in U. S. equity markets by producing a severely deflated dollar ($252/oz gold in 1999). After the brief interlude at dollar equilibrium in 2003, the Fed moved the dollar’s value in the opposite direction in June, 2004. The Fed slowed growth by hiking the funds rate, reducing demand for dollars, while injecting more liquidity. Particularly in the second year of rate hikes between June 2005 and June 2006, with the yield curve inverted, the U. S. dollar’s value plummeted. The dollar reached a post-1980 low of $735/oz in May, 2006.
In August, 2006, the FOMC finally stopped hiking the cost of bank credit, but maintained the severely inverted yield curve for another year. The inverted yield curve denied credit at reasonable, market-set rates to small and medium-sized business, retarding economic growth in those crucial segments of the diversified U. S. economy. The dollar strengthened to $615/oz. after the funds rate hikes were stopped. The FOMC eventually discontinued injecting net new liquidity in 2007, a second positive change by the Bernanke-led FOMC. But the long-inverted yield curve had already misallocated excessive liquidity to the long end of the curve. This policy error resulted in many private misjudgments in credit markets.
Lenders with access to funds at long rates pressed to put those funds into hands of borrowers at higher rates. With small and medium-size business growth shut down, much of the action went into sub-prime housing at low front-end adjustable rates. Easy-credit money also went to hedge funds and speculative investors. When those bad judgments began affecting confidence in commercial paper in mid-2007, FOMC’s bad monetary policy was felt in new ways by different players.
Misallocations of credit during the period of inverted yield curve and extreme excess liquidity caused stresses that threatened significant financial institutions. The FOMC reversed its field on the funds rate and moved towards a normalized yield curve. In August, 2007, the FOMC began historically sharp reductions in the overnight rate for inter-bank lending of reserves, reaching 3% in January, 2008. In addition, the Fed renewed about $50 billion in temporary funds during the second half of 2007 and began auctioning credit secured by permitted types of troubled collateral. The central bank’s responses did not restore confidence in its policy or in credit markets. The dollar fell to its lowest value in history during February, 2008, above $965/oz gold. The pitifully weak dollar speaks to failed U. S. monetary policy, and this failed policy overhangs the U. S. economy and financial markets in 2008.
Worsening U. S. Fiscal Policy
Since 2005, good U. S. fiscal policy (the Bush 2003 tax cuts) has been overrun by bad U. S. monetary policy. No matter how positive fiscal policy is, the Federal Reserve has tools and discretion to bring the economy to its knees, and has done so again. In its recent funds rate cuts, the Fed did not rescue the economy or contribute beneficially. The Fed simply reduced the harm it had been and is doing. The yield curve remains inverted, meaning that bank credit is priced above reasonable market value to much of U. S. main street.
The major difference in 2008 is that U. S. fiscal policy is measurably worse and set to get much worse than recent years. Congress just made the federal budget deficit $155 billion worse for no better reason than paying “walking around money” just prior to the November elections. Most deplorably, the $155 billion spent will be cited eventually as excuse enough to refuse further extension of current income tax rates.
U. S. GDP has grown almost 40% with current tax rates in place. That growth path is likely to be retraced if the economy is placed under the 2002 tax rates again. The 2008 elections get closer and extension of current tax rates appears less likely with each passing day. Financial markets fear that outcome, so 2008 will be volatile watching the threat of a sharp downside.
A Volcker 1980 Redux?
U. S. monetary policy is no better friend to financial markets than is fiscal policy, even during the Fed’s current rate-cutting mode. Chairman Bernanke’s FOMC may repeat Paul Volcker’s performance of 1980-1981. Recall those fabulous years when Carter-appointed chairman Volcker first poured liquidity into the economy in 1980 during President Carter’s re-election effort. Then, after President Reagan’s election became a foregone conclusion, Volcker turned to draining liquidity. The economy crashed into deflationary recession. That mindset seems still in place at the Fed. Already those who buy into the Fed’s mercantilist manipulation of interest rates and the dollar prescribe high rate hikes ahead, even while FOMC likely will move closer to a normal yield curve in the near term.
Combined with sun-setting of the Bush tax rates, this is not a pretty scenario. The year 2008 has worse macro-economic influences than any since 2002 and threatens to rival 1980.
Time for Policy Change
U. S. monetary policy has inflicted damage on Americans and other global economies for 37 years. Those with low income – sub-prime borrowers, laborers, the young, the old, working people of all levels – are hurt worst. How much more must they (and we) bear before this chaotic leap into mercantilist trade war via currency manipulation is ended? There is no “soft landing” able to cushion losses imposed on earning power by manipulated currencies. That earning power is being transferred daily to the captains of chaos who know how to profit from advance knowledge of central banking practices.
Inflation reality is this. The dollar has been devalued by about 65% during the past five years (worse than FDR’s devaluation in 1934, but with no announcement). Most of today’s devaluation remains to be reflected in U. S. and world prices. The Fed will soon have to face the price rises it calls inflation. Unless the Fed reforms policy, rising prices foretell manipulation of the funds rate higher, a significant recession and tumbling financial markets.
What the Fed should do is float the funds rate so the cost of bank credit can decline to market levels and economic growth can become robust again. This would create greater demand for dollars to invest in production, pulling down the price of gold as dollars become more valuable. Concurrently, the Fed should monitor liquidity, draining or adding by selling or buying Treasury securities to move the dollar’s value back to an announced target in the range of $450/oz to $500/oz of gold.
Please note this does NOT recommend the Fed manipulate the cost of bank credit higher to induce recession. So long as the dollar’s value relative to gold is moved to a proper and stable level, monetary inflation will not be a problem. Neither will the U. S. dollar’s status as the international reserve currency.