Saturday, September 15, 2007


It is perhaps fitting that Fed Chairman Ben Bernanke on the anniversary of 9/11 should be making a speech in Berlin that attempts to clarify why we have run up such a trade deficit—of approximately $1 trillion last year alone.

Chairman Bernanke made the speech on the 9/11 anniversary for several reasons. It is consumer spending and borrowing since 9/11—fueled by record low interest rates—that enabled the huge trade deficit, and the trade deficit in turn has enabled the huge federal budget deficit—up to $8 trillion at this writing.

Those twin deficits are a major headache for Bernanke. They happen at the same time that “the U.S. has already reached the leading edge of major demographic changes that will result in an older population and more slowly growing workforce,” said Bernanke in his speech.

This explains why the Fed has been reluctant to drop consumers’ interest rates as it finally did for its banks last month. It wants to discourage consumer spending and encourage more savings, which would reduce the twin deficits.

There is also a second reason behind the Fed’s reluctance. Too much money in consumers’ pockets tends to cause higher inflation. Bernanke and many other Fed Governors, apparently, believe that part of their mission is to discourage consumers from any inflationary tendencies. I.e., if consumers believe the Fed is hawkish and vigilant concerning any inflation, then consumers might shop more carefully. It is only if consumers believe the Fed is serious about controlling prices, in other words, that consumers will control their spending.

In fact, a famous speech Bernanke made when the Fed’s Vice Chairman in 2001 outlined this philosophy. He claimed it was the Fed’s anti-inflation vigilance in the 1980s that caused a period he called the “Great Moderation”, when inflation was subdued. Inflation began to moderate in the 1980s after such draconian Fed measures as raising their fed funds rate to 19 percent in 1981. This caused 2 recessions within 3 years, needless to say.

However, Bernanke is only giving us part of the story. Consumers are over indebted not only due to the Fed’s very accommodative credit easing, but the federal tax cuts of 2001 and 2003 put a huge amount of money back into consumers’ pockets. This encouraged the borrowing binge, and caused the dollar’s value to fall to a 15 year low. It has also caused the price of imported oil—which is paid in dollars, let us not forget—to rise to $80 per crude barrel of devalued dollars at this writing.

The influx of foreign savings also had a hand in the double-digit housing price rises of the past several years. For it is foreign savings that have been the main cause of lower long-term interest rates (i.e., bonds), at the same time the Fed was raising short-term interest rates. This became a disconnect that could not last. It is the rise of short-term, adjustable rates that has fueled the huge number of defaults, hence the current credit-crunch.

The latest news continues to be mixed. Retail sales are still growing at a 3.9 percent annual clip, but only because of deep discounts on last year’s models in August. Industrial production fell, while the U. of Michigan’s preliminary Sept. survey of sentiment edged up slightly, and inflation expectations declined. That is a good sign. There certainly is not yet a credit squeeze on credit cards or car loans. But there’s the rub, to borrow from Shakespeare. If and when the Fed does begin to drop consumers’ short-term rates, this will encourage more borrowing and spending, not more savings.

Consumers tend to save more when interest rates are higher, in other words—such as in the 1980s. But that hurts economic growth. A much better way to cure the twin deficits is to raise taxes on the wealthiest, those making more than $200,000 per year, as was done during the 1990s. Cutting taxes neither cuts deficits nor helps retirees’ benefits, period.

Copyright © 2007

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