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November 28, 2008

After General Bernanke Destroys The Deflationary Threat
by Brady Willett

"...we will not stand down until we have achieved our goals of repairing and reforming our financial system, and thereby restoring prosperity to our economy."Ben Bernanke.

In a Wall Street Journal op-ed last month Federal Reserve Chairman, Ben Bernanke, optimistically chanted the word 'restore' 6-times and concluded that the "tools are in place to respond effectively and with force" to the financial crisis. Earlier this week Citigroup was bailed out and the Fed unveiled two new bailout programs that carry a potentially massive price tag of $800 billion. Apparently with market confidence and functionality still in a state of crisis the only thing being restored on a regular basis is Bernanke's pledge to take radical steps to combat deflation. And while Mr. Bernanke will likely be successful in this blitzkrieg, you can not help but wonder at what cost.

Restore: To bring back into existence or use; reestablish.

To begin with, there is little in the U.S. financial system worth 'restoring', much less saddling U.S. taxpayers with for generations to come. Regardless of how many times suspect pieces of paper change hands, bad debts will eventually be exposed as bad. That the Fed is opening its balance sheet up to more and more toxicity is a sign of desperation and will not engender the type of market confidence Bernanke hopes to resurrect.

Along with the bad asset shifts from the insolvent to the U.S. taxpayer, there are the issues of recapitalizing financial institutions and thawing frozen credit markets. The recapitalization efforts to date are, in fact, necessary if you conclude that financial institutions are so connected that any large failure threatens the entire financial system. However, as policy makers implore institutions to lend more freely there are contradictory policy goals afoot. To be sure, on the one Bernanke and company want to slap the wrists of the hooligans that allowed subprime to proliferate and ensure that more bad loans are not made during today's bad times, while on the other they hope that banks undertake super aggressive lending regimes to help boost the fledging U.S. economy. With this in mind, the question begs: are banks really 'hoarding' capital or are they simply reverting to rational policies after many years of 'reckless' lending? This is a question few policy makers dare ask.

At the risk of belaboring the point, liken today's credit market situation to giving away free football tickets for a few years and then one day abruptly restoring normal prices: The crowd inside the stadium declines as ticket prices increase but that doesn't necessarily mean that there are fewer fans of the game. In other words, the U.S. credit markets still contain many participants that want to lend and plenty of others that want to borrow, but many fans of borrowing can not afford the new price of admission (in the case of mortgages this new price is a steady income, a large down payment, and quality credit score.)

In short, if Bernanke's bailout efforts are geared at restoring the unprecedented U.S. credit mania he will most certainly fail - the day of reckoning for many Americans has arrived. However, if Bernanke is attempting to translate his theoretical anti-deflation play book into reality there is the possibility for victory.

Deflationary Tactics and The Risk of Collateral Damage

Falling/crashing stock market and real estate prices - not to mention a return to 'old school' lending - have created the conditions wherein deflationary forces have the potential to take root. Under a deflationary scenario Fed rate cuts are rendered useless and alternative policy instruments must be unleashed. Japan utilized such alternatives under its 'quantitative easing' program enacted nearly eight years ago, and Bernanke has discussed using similar alternatives in the past. It can also be said that the reason why the Fed wants to push an additional $800 billion in shaky assets onto its increasingly shaky balance sheet has everything to do with stifling the threat of deflation.

One of the problems with fighting deflation is that while troops can easily be amassed they can not always be effectively deployed. For example, one of the most immediate anti-deflation tactics in the U.S. is to stop home prices from falling and stabilize the negative feedback loop that declining home prices help fuel. To accomplish this feat with inventories near record highs and foreclosures still soaring is easier said than done.

Another timely challenge to containing deflation is that global deleveraging has sent panicky capital flows into the relative safety of U.S. dollars. Bernanke and company could break this strengthening dollar dynamic by turning on the printing presses, but unless such an undertaking is handled delicately the act of devaluation itself could create a crisis more ominous than the one it is intended to alleviate.

The Attack Formation Remains Much The Same

The $700 billion TARP program took two nail biting votes to finally get enacted and - thanks to Paulson's indirection and the Treasury's potentially illegal manipulation of Section 382 - has been a matter of constant irritation for politicians and the financial markets. At least with the Fed's new $800 billion lifelines Bernanke and company have learned to not go to Congress looking for more money.

But whether or not Bernanke has really learned how to prevent another Great Depression remains to be seen. Quite frankly, with the December 7, 2008 Flow of Funds report likely to show a record decrease in consumer net worth, the pace of U.S. job losses quickening, and the reckless lending practices of yesterday perhaps on a permanent vacation, it can already be said that the Fed is pushing on string. Furthermore, with panicky flows having shown such a strong preference to be in USD it is unclear if any current/future efforts to depreciate the dollar to help quell deflation can succeed without consequences.

What is clear is that the Fed has moved beyond the point of being able to 'credibly threaten' to increase the number of U.S. dollars in circulation and entered the realm of 'show me the money'. And with other central banks also threatening to enter print mode as interest rate cuts lose their teeth, deciphering which direction the FX troops will march to next is a difficult proposition. Perhaps all that can be assured amidst this buildup of uncertainty is that the only global currency that doesn't represent the increasing liabilities of governments, gold, will benefit if current trends persist.

President Obama's new chief economic adviser, Lawrence Summers, once coined the term "balance of financial terror". Summers used this provocative term "to refer to a situation where we [The U.S.] rely on the costs to others of not financing our current account deficit as assurance that financing will continue." It is worthwhile to note that as General Bernanke attempts to close the door on deflation he may only be able to do so by opening the door to and leveraging this 'balance of financial terror' dynamic. Here is hoping that when the inflation (eventually) arrives those panicky investors now favoring USD do not head for the exits all at once; that terror, for lack of a better word, can continue amidst the coming chaos.

Brady Willett
FallStreet.com

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