Big shoes to fill

The nomination of Bernanke is seen as a move to effect a smooth transition from Greenspan’s leadership. Still, Bernanke has a few ideas of his own.

Prior to his nomination in June 2005 as chairman of the U.S. President’s Council of Economic Advisers, Bernanke served as a member of the Board of Governors of the Federal Reserve, a role he will hold until Jan. 31, 2020. However, he is probably better known as a distinguished academic than as a policymaker. He was a professor of economics at Stanford University from 1979 to 1985. He then moved to Princeton where he was chairman of the department of economics between 1996 and 2002. During his academic career, Bernanke has published numerous research papers in the most prestigious journals of economics.

As an academic and policymaker, Bernanke addressed a wide variety of economic topics. He also had occasion to publicly discuss his views on the role the FED should play regarding various issues.

ON THE ROLE OF CENTRAL BANKS
Bernanke is a firm believer that the FED has what it takes to ensure financial stability and guard against economic collapse. According to him, the Great Depression could have been avoided if appropriate policies had been put in place. In the case of the Great Depression, Bernanke contends that raising interest rates to protect the dollar contributed to soaring unemployment and severe price deflation. He believes that policymakers worsened the situation by failing to counter the collapse of the country’s banking system.

Bernanke also believes that Japan’s decade-long recession could have been avoided through proper monetary policy. According to him, an example of a greatly orchestrated FED intervention is the stock market crash of 1987 where Chairman Alan Greenspan persuaded banks to rescue struggling brokerage houses and cut interest rates to restore macroeconomic stability.

ON INFLATION TARGETING
Bernanke is known as an ardent proponent of inflation targeting. This position is often cited as his main point of dissension with Alan Greenspan. He does admit, however, that the FED is already practicing something close to de facto inflation targeting. According to Bernanke, the next step should be to implement an explicit inflation target. This would increase the coherence of monetary policy by providing a precise definition of price stability.

Bernanke believes that inflation targeting could be beneficial by anchoring the public’s inflation expectations. This could lead to a reduction in the volatility of output and help financial market participants to more accurately price longterm assets. Moreover, inflation targeting could act as an additional measure of accountability for the FED. Bernanke adds that the inflation target should not include zero so as to leave a bit of buffer for the nominal interest rate to remain sufficiently above zero.

ON THE PERILS OF DEFLATION
Bernanke made a famous speech on deflation in November 2002. He concluded that “sustained deflation can be highly destructive to a modern economy and should be strongly resisted.” The main peril of deflation is that it can lead to a zero nominal interest rate(the zero bound). With persistent deflation and a nominal rate of zero, the real interest rate becomes equal to the expected rate of deflation. In a period of severe deflation, real cost of borrowing could become prohibitive, therefore reducing capital investment and spending and worsening the economic downturn. The zero bound also poses a challenge in that it places limitations on conventional monetary policy.

ON THE FEDERAL DEFICIT
With U.S. federal deficit reaching worrying levels over the last few years, some wonder what stance the FED should take on the issue. When questioned about this, in a December 2005 interview with The Region, a U.S. banking and policy issues magazine, Bernanke said that “the central bank has the responsibility to be a nonpartisan advisor on general matters of macroeconomic and financial stability.” As such, the Federal Reserve can provide sound advice and counsel to fiscal authorities, but ultimately the determination of fiscal debt and deficits is the responsibility of the president and Congress.

Bernanke agrees that the hypothetical implementation of rules or caps regarding federal deficits is a solid idea.

ON ASSET BUBBLES
Regarding asset bubbles, Bernanke first warns that “it’s extraordinarily difficult for the central bank to know in advance or even after the fact whether or not there’s been a bubble in asset price.” Furthermore, even if a bubble is identified, trying to correct it could not necessarily be done without risking violent adjustment in the market and the economy in general.

A far better approach is to use micro-level policies to reduce the incidence of bubbles and to protect the financial system against their effects. Bernanke suggests that central banks should reserve the use of their single macroeconomic instrument—the short-term interest rate—to ensure price and output stability.

Indeed, history shows that previous attempts by the central bank to control asset price movements via interest rate instruments have more often than not led to large declines in both asset prices and the economy.

ON FED TRANSPARENCY
Bernanke sees transparency as a good way to help the market and the public to achieve accurate expectations of future policies and the future state of the economy. Inflation targeting is one example of greater transparency. Bernanke is in favor of having the Federal Open Market Committee(FOMC)release more information, notably the committee’s forecast of its views on the economy, and releasing FOMC minutes which are a detailed discussion by the FOMC board members, earlier. He does, however, think that not all information disclosures are beneficial. For example, he believes that releasing the Greenbook, which is a document written by FOMC staff containing a summary of recent economic information and an economic forecast, would put too much emphasis on the staff’s forecast instead of board members’ views. He also believes that televising FOMC meetings could compromise the FOMC decision-making process.

HIS MOST FAMOUS RECENT SPEECHES
In 2002, Bernanke made a speech about deflation that led his critics to give the nickname “Helicopter Ben.” The topic was deflation, which is defined as a general decline in prices that comes from a collapse of aggregate demand. It was a preoccupation at that time because inflation rates were so low. Typically, deflation arises when a drop in spending is so severe that producers must cut prices in order to find buyers.

Although Bernanke did believe that the chances of significant deflation were extremely small, the possible drawbacks were severe enough to be of concern. Indeed, the economic effects of a deflation include recession, rising unemployment and financial stress. The best way to counter deflation is to stimulate economic activity with lower interest rates.

However, a persistent or severe deflation episode can drive nominal interest to zero or very close to it. Some might conclude that at this point, monetary policy loses its ability to further stimulate aggregate demand and that the FED has run out of ammunition. But not Bernanke. He believes the FED still has plenty of other loaded guns to fight deflation.

Notably, he stated: “the FED should try to preserve a buffer zone for the inflation rate; that is, during normal times, it should not try to push inflation down all the way to zero.” He also added, in numerous academic papers, that the central bank should act more aggressively than usual in cutting rates when inflation is already low and the fundamentals of the economy suddenly deteriorate.

Apart from prevention, Bernanke pointed out that the FED could lower the interest rate further along the Treasury term structure, such as decreasing the rate on government bonds of longer maturity. The FED could also act to lower rates of other public or private security.

Bernanke proposed some other approaches. First, he pointed out that the U.S. government has at its disposal “a technology called a printing press that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services.” The important point is not the printing press but the idea of injecting additional money into the economy.

As other means of reflation, the opposite of deflation, Bernanke said the U.S. could also count on fiscal intervention such as a broad-based tax cut to stimulate consumption and raise general price levels. He then went on to say that combining the two would lead to a moneyfinanced tax cut essentially equivalent to Milton Friedman’s famous “helicopter drop” of money. The nickname “Helicopter Ben” stuck.

THE GLOBAL SAVING GLUT
In a speech given in March of 2005, Bernanke addressed the low level of long-term interest rates and current account deficit. His main hypothesis was that the huge current account deficit and the low level of interest rates(Greenspan’s interest rate conundrum)are spurred by what he terms a “global saving glut:” a significant increase in the global supply of saving.

This glut originates mainly from two sources. The first is the prospect, in some industrial countries, of a dramatic increase in the ratio of retirees to workers. The second is related to the observed reversal in the flows of capital between developing markets and industrial economies.

In 2004, the U.S. current deficit stood at $666 billion, or about 5.75% of the GDP. U.S. overall imports, which greatly surpassed their exports, had to be financed through foreign borrowing. Economic growth, which requires investment in capital, needs to also be financed in some manner.

If a country’s savings are less than what is required to finance domestic investments, then the country must close the gap by relying on foreign borrowing. This is the case in the U.S. where national saving is currently quite low and falls considerably short of U.S. capital needs. The end result is that both U.S. consumption and growth are largely financed by foreigners.

According to Bernanke, the first element responsible for the global savings glut is that some the major industrial countries are faced with an aging population and have strong incentives to save, preparing for the impending increase of the dependency ratio as more retirees exit the workforce and fewer new workers enter. Since some of these economies are faced with dwindling domestic investment opportunities, they are forced to lend abroad, running a current deficit. Japan and Germany are usually singled out as culprits.

The other plausible source of the glut is the recent metamorphosis of the developing world from a net user to a net supplier of funds to international capital markets. The series of financial crises of the last decade— Asian, Russian, and Argentinean—led to rapid capital outflows, currency depreciation, declines in asset prices, weakened banking systems, and recession. The instability of foreign capital flows towards emerging and developing countries gave rise to the build-up of large quantities of foreign-exchange reserves as a buffer against potential capital outflows.

In practice, these countries increased their reserves by issuing debt to their citizens, thereby mobilizing domestic savings, and then using the proceeds to buy U.S. Treasury securities and other assets. Seemingly, that great demand for American treasury security is what pressured interest rates to fall to their actual low level.

An additional factor that contributed to the currentaccount surplus among the developing and emerging markets in the past few years is the sharp rise in oil prices. Indeed, the current account surpluses of oil exporters, notably Middle East countries, Russia, Nigeria, and Venezuela, have risen with the surge in oil revenues.

International trade is of course a zero sum game. If the world has been saving more, that means the U.S. has been spending more. Why has it spent so much, when in fact it should have be saving? According to Bernanke, this behaviour stemmed from a huge appreciation in asset price. From 1996 to 2000, consumption was fuelled by wealth creation through the stock market bubble.

As those investment opportunities waned with the burst of the stock market bubble, low real interest rates rather than high stock prices became a principal cause of lower U.S. saving. Mortgage rates at their historical lows fuelled home sales(Bernanke does not believe there is a current housing bubble)and the effects of rising home prices on wealth(through home equity credit products)resulted in the next phase of American recklessness.

One important point to note is that the U.S. is not alone. Industrial countries such as France, Italy, Spain, Australia, and the United Kingdom’s current accounts have all moved toward deficit positions(notable exceptions being Germany and Japan). Not surprisingly, all these industrial countries also experienced a substantial housing appreciation.

In his conclusion, Bernanke reiterated that “some of the key reasons for the large U.S. current account deficit are external to the United States,” implying that purely inward-looking policies are unlikely to resolve this issue. He then suggested more direct approaches like helping and encouraging developing countries to re-enter international capital markets in their natural role as borrowers, rather than as lenders.

This speech sparked some controversy as it opposes other economists who consider that the trade deficit was mainly due to excessive governmental spending rather than external forces.

THE CURRENT STATE OF THE ECONOMY
On Oct. 20, 2005, four days before his nomination as the next chairman of the FED, Ben Bernanke delivered a speech on the current economic outlook before the Joint Economic Committee.

According to Bernanke, the U.S. has shown great resilience in light of the ordeals it suffered since 2000. Thanks to a flexible labour market, a culture of entrepreneurship, a healthy competitive environment and efficient capital markets, the U.S. pulled out of what came to be known as the most benign recession ever recorded. The soft landing was further helped by Bush’s tax cut and reform as well as an appropriate monetary policy.

In the shorter term, the devastation wrought by the hurricanes left a palpable effect on industrial production, payroll employment, consumer confidence and the country’s energy infrastructure. Still, Bernanke sees the U.S. economy in good shape. Consumer spending remains solid and recovery efforts will help job creation and growth. Energy prices seem to be coming down from their highs, with the notable exception of natural gas, which remains a concern. Moreover, the growing energy efficiency of the United States renders the economy less vulnerable to energy shocks and inflation, and inflation expectations are well-controlled. Speculative activity in the housing market does exist in some parts of the country, but the overall price increase reflects strong economic fundamentals, including robust growth in jobs and income and low mortgage rates.

Bernanke adds that even if a cooling of the housing market occurs, it would not be inconsistent with the continuing growth of the economy. On the international side, the current account deficit does pose some challenges, and reducing it would be desirable. Increasing national saving seems like the best solution.

With his departure, the legendary Alan Greenspan certainly leaves big shoes to fill. The good news is that his successor, Ben Bernanke, seems perfectly suited to fill these shoes. Indeed, the nomination of Bernanke received a broad bipartisan approval when presented before the U.S. Senate Banking Committee.

And the U.S. economy seems to be in good hands with Ben Bernanke at the head of the Federal Reserve. With remarkable challenges ahead, the next chairman will have plenty of occasions to prove himself. The next big day for Bernanke will be on March 28 when he will preside over his first FOMC meeting.

For the Canadian plan sponsor, the million dollar question is: how will U.S. equities fare? The outcome is murky, and the risks however are very present. One of the best indicators of a economic slowdown/recession is an inverted yield curve. As the actual shape of the curve is presently inverted, if the FOMC decides to further increase the inversion, this will bring the possibility of a bear market even closer.

Alexandre Nguyen and Mathieu Roberge are both investment policy research analysts with the Caisse de depôt et placement du Québec. anguyen@lacaisse.com , mroberge@lacaisse.com