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July 19, 2006

Bernankes More Difficult Dilemma Is Not the One He Stated Today
by Econotech

The more difficult dilemma facing Fed Chairman Bernanke is not the one he just posed in his July 19 Humphrey-Hawkins appearance today, the same one the financial markets continue to be obsessed with, i.e. how to walk the fine line between tightening just enough to control inflation expectations without slowing the U.S. economy too much.

Asset, Nor Product or Wage, Inflation Has Been Rampant in Global Economy

Rather, it is how to deal with the after-effects of the massive asset inflation created by essentially free money provided by various central banks for several years prior to the current tightening cycle.

Bernanke noted today that even though inflation might not be much of a threat in labor markets, since unstated by him over the past six years American workers have had very little power to share in the gains from rising productivity, it can still come through the product markets, as businesses pass through energy and other input price increases to protect record profit margins, cash flows and hence equity prices, again unstated.

The actual or "headline" inflation rate is unacceptably high and negatively impacting Americans' living standards. But imho the financial markets' ongoing obsession over each tenth of a percent increase in the "core" inflation rates obscures the even more basic problem.

Almost never publicly addressed by Bernanke, the mainstream media, etc (it is sometimes discussed in obscure central banker speeches and academic studies) is that inflation mainly has been in asset markets, most especially in this cycle in global real estate, commodities, and a wide range of financial securities, and that the most glaring manifestation of this asset inflation is in the unprecedented U.S. current account deficit, exacerbated by home equity extraction and consumer "wealth" effects, and associated global economic imbalances to fund it, a deficit that continues to be swept under the rug by the global financial speculators.

Global Speculators Hope Bernanke is Done and Their Party Will Continue

Global speculators hope that as Bernanke feels he is able to bring "core" inflation back under control, as the Fed currently forecasts, mainly due to slowing economic growth, the continuation of non-existent real wage growth, and a flattening of energy price increases (presumably helped by other factors, including geopolitical), then he will stop tightening.

This then would happen without having corrected in any meaningful way the huge excesses from the previous run-up in real estate prices, which are now far higher than they were four years ago even though mortgage rates are back to the level then and real wages have not grown over that period (consumers no doubt benefited from refinancing their mortgages at much lower rates, but then someone else somewhere had to lose on those mortgages).

In this "Goldilocks" scenario, then what, the nearly four-year bull market from Oct 2002 continues unabated? (See my 6/15 "Bernanke Talks Down Risky Assets" link and 6/2 "Did May's Sharp Sell-Off Signal a Major Trend Change" link--I will update the global financial market trends discussed in these in another article.)

With continued rampant speculation, since despite ongoing central bank tightening, the global economy is still awash in liquidity, global money is still not tight (one indication being the easy financing of very large amount of M&A deals), and global growth has been high (e.g. China's second quarter GDP growth of 11.3% was the highest in a decade)?

That is what the emerging markets and financial stock indexes seem to be saying every time speculators feel they get the slightest hint that Bernanke will stop tightening, e.g. today and on June 29 right after the last FOMC meeting. The EEM emerging market ETF jumped 6.2% today, XBD broker-dealer stock index 4.1% and the BKX bank stock index 3.0%.

I still strongly question whether the world's central banks, especially in Japan (which is loaded with Japanese and U.S. government debt which would lose value with rising rates), will take away the proverbial punch bowl in a significant way.

Nor would U.S. voters tolerate it, something Bernanke must be aware of, since they have become so dependent on real estate speculation to maintain their living standards, making real estate prices more "sticky" to the downside, the modern-day equivalent of labor unions protecting their wages and benefits long ago, except that was based on real income from real production, not speculation. (See my 2/14 article, "Mommy, Where Do McMansions Come From?" link.)

Improving U.S. Current Account Deficit Would Help Restore Economic Rationality

Imho, perhaps the most important thing to help restore more economic rationality is if the U.S. somehow begins to take its current account deficit more seriously, the way every other nation in the world must. Not having to do so is what I have labeled the "curse of the dollar" because it allows the U.S. to avoid dealing with the negative consequences of its super-easy monetary and fiscal policies. I still see virtually no likelihood of this changing soon.

If by chance it did, then the U.S. would have to re-orient its economy outward toward satisfying global demand for real high-tech sustainable solutions for energy, water, housing, transportation, medical care, etc., for global economic development in the rapidly growing emerging markets (not mainly for media/entertainment that Silicon Valley has focused on since the TMT equity bubble burst. See my 2/27 article, "The New, Old Thing" link).

The world might then once again start feeling that the U.S. is earning more of its very high living standard, rather than overly relying on what Bernanke mistakenly calls the global savings glut, which is really a gross misallocation of global capital toward U.S. consumption, and on massive financial speculation, just shown once again in the quarterly results of the U.S. corporations that dominate the economy, the largest commercial and investment banks.

The Political/Social/Moral Benefits of Reducing the U.S. Current Account Deficit

Such an economic re-orientation would also have other profound implications. Politically, I believe it may be the only thing that perhaps might meaningfully be able to shift the U.S. from its current focus on unilateral military solutions to the so-called "war on terror," which is now entering a new and potentially even more dangerous phase in Lebanon.

Until that happens, support for U.S. military policies might continue to do very poorly in world public opinion polls, to its ultimate detriment, both economically and in terms of its national security. Unfortunately, as indicated by recent developments in Israel-Palestine-Lebanon, Iraq, Iran, India, N. Korea, etc., the negative geopolitical situation at the moment seems to have escalated.

(Btw, the "liberal" vs "conservative" Democrat vs Republican debate over foreign policy and other issues seems increasingly sterile to me. Liberal Democrats, including their leaders and media pundits, are probably more heavily reliant on real estate speculation in the coastal "blue" states than conservative Republicans, which I believe makes it very difficult for both sides to grasp the core problems they profess concern about. Of the huge number of commentaries and books on current events from many viewpoints that I read, I have never seen a single one that even mentions this liberal dependency on real estate speculation. See my 2/12 article "The Home-Equty ATM of Blue-State Liberals" link.)

Hopefully over time, a U.S. shift toward once again earning more of its way in the global economy, as indicated by a much more responsible current account deficit, would begin to re-inject more of a positive reality orientation to U.S. political, social and moral culture. Many in the U.S. population would re-learn the now lost lesson that simply bidding up the prices of already existing homes does not in any way create actual real economic wealth, but rather transfers it.

Very Well-Meaning but Limited Mainstream Efforts to Address Global Development

As hugely generous and important as Buffett's enormous recent gift to the Gates' foundation was, private philanthropy is not going to solve the problems of the more than four billion people who live in deep poverty, nor probably significantly change the image of the U.S. in the eyes of most of the world's population.

There are also some very minor changes at the margins to get corporations more oriented in the direction of sustainable economic development. E.g. see such books as "Capitalism at the Crossroads" and "The Fortune at the Bottom of the Pyramid" by two very well-meaning and leading b-school professors.

But such efforts seem very limited to me because only global capital markets can incentivize corporations to allocate the massive resources necessary to have a meaningful impact on global economic development. (I may take up at another time the debate in development economics circles over policy, e.g. between economists Easterly and Sachs.)

So-called "Endogenous" Factors are now Endemic to Hyper-Speculative Globalization

And right now those global capital markets have been seriously distorted toward supporting massive speculation by U.S. major financial institutions, including hedge and private equity funds (which usually don't focus on innovative new solutions to critical global needs, the recent venture capital focus on ethanol notwithstanding, but rather on rentier arbitrage and expropriation, often through M&A deals, which has ballooned again in the past couple of years, as corporations have limited their spending of record cash flow on new product and job creation which might negatively impact margins, returns and security values, mainly for the benefit of their CEO's and the super-wealthy at the top of the wealth pyramid.

Until global capital markets change, and as I've said there is absolutely no sign that it will, regardless of any political changes, none of the world's geopolitical and development problems will probably meaningfully change.

The huge and critical exceptions, of course, are those countries such as China and India which are rapidly developing themselves mainly due to their own efforts at taking advantage of integrating themselves into the global economy, not to any international help.

But they are doing so in an overall global environment in which the political leaders of the still most powerful nation, the U.S., are focused on other things, i.e. the so-called "war on terror," and the financial system has long since morphed into one dominated by speculators for their benefit.

I believe that the risk to the U.S., and to financial markets, is that if the U.S. continues along this path, the current unipolar world will at some point become a more multipolar one less to its liking, and perhaps more dangerous to its citizens.

This is not an "exogenous" factor (see my 5/1 article "The Silent Dollar Crash" link), rather it is endemic to the current hyper-speculative version of globalization, since with U.S. labor long since defeated and docile, the inevitable social-political tensions from a very unequal economic/financial system has mainly shifted into the geopolitical arena.

Imho, one of the big dilemmas of world history for the past two hundred years is that progressive industrial capitalism seems to morph into hyper-speculative financial versions in various leading countries at different times, the U.S. being the current example.

Neither that nor the much more unviable so-called alternatives are good solutions, but the elite present them as if they are the only two available choices, when a progressive, pro-development, high-tech oriented market economy minimizing financial speculation would seemningly work much better. Will the world stumble onto that?

Econotech

Visit Econotechs Blog at http://econotech.blogspot.com/.

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