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Saturday, April 12, 2008
A blunt former Fed chairman takes on Bernanke. Take heed of what he says
AVNER MANDELMAN
A few days ago an unusual event took place: Paul Volcker, themythical U.S. Federal Reserve Board chairman from the Reagan years,criticized the policy of the current Fed chairman, Ben Bernanke, in aspeech to the Economic Club of New York.
Just so you grasp how extraordinary this was, you should firstunderstand that normally a past Fed chairman scrupulously avoids sayinganything at all about current Fed policy - for the simple reason thatthe current Fed chairman's words are one of his most important tools
hey can sway markets.
This ability does not fade entirely when a Fed chairman leaves.
So when a past Fed chairman speaks, his words can clash with thoseof the present one and make that one's job difficult. Out ofprofessional courtesy, past Fed chairmen therefore keep quiet; Mr.Volcker especially - the man who hiked interest rates to 20 per cent tokill inflation, at the cost of a deep recession. But last week Mr.Volcker spoke his mind bluntly. He said, in effect, that the currentFed is not doing its job.
This would have been unusual enough. But Mr. Volcker went further.Not only is the Fed not doing its job, he said, but it is doing thewrong job: It is defending the economy and the market, instead ofdefending the dollar. And just to stick the knife in, Mr. Volcker addedthat this bad job now will make the real job - defending the greenback- much harder later. It'll cause even greater economic suffering.
In plain words, Mr. Volcker implied that the current Fed is not only incompetent, but that its actions are dangerous.
There is no record of Mr. Bernanke's reaction, nor that of anyoneelse inside the Fed. But there was plenty of buzz in the market becausewhat Mr. Volcker said amounted to a rousing call to raise interestrates. Yes, raise rates, and do it now.
Can you imagine what this would do to the market? I sure can, whichbrings me to the gap between physical economic reality as we witness itevery day in our physical investigations, and the surreal marketchatter we see and hear on TV. This gap has never been wider - but itwill inevitably close as markets catch up to reality - as just forecastby former president Ronald Reagan's Fed chairman. Let me cite threeitems, then go back to Mr. Volcker.
First, commercial real estate. You surely have read about theresidential real estate problems - subprime loans syndicated andresold, causing the implosion of several U.S. financial institutions.The writeoffs and damage here total close to a trillion dollars, saidthe IMF recently. That's about one-seventh of the U.S. gross domesticproduct, or more than three years of growth.
But what of commercial real estate? I heard recently from some savvyprivate real estate investors that although commercial real estate fellby 20 per cent, it should fall by a further 20 to 30 per cent before itprovides a reasonable rate of return. So whatever economic damage wasdone to the economy by residential real estate speculation mayeventually be equalled by commercial real estate. Say another 10th orseventh of GDP erased, or another two-three years of growth gone.
Second, there's also the war in Iraq. Some U.S. economists recentlyestimated it has cost about two trillion dollars to date - anothertwo-sevenths of U.S. GDP. That's five more years of GDP growth gone.
And third, we haven't even begun to tally the private equity blowups that are surely coming.
Taken all together, the economic damage spells a very bad and longrecession. How to fix it? No problem, say the actions of Mr. Bernanke'sFed. Let's print the missing money - and it doesn't matter if it causesinflation and tanks the dollar. Because that's not our job.
Up to now Mr. Volcker kept quiet, but no more. In his speech he justsaid, in effect, that the recession is not the Fed's problem. It's thegovernment's. The Fed's job is to defend the currency and fightinflation - exactly the opposite of what this Fed is doing. Thesolution? Raise interest rates, Mr. Volcker practically said, no matterthe consequences now, because if you don't, you'll have to raise themeven more later, with even more awful consequences.
Will rates indeed rise? I have no doubt they must. Not now, perhaps,but at the end of this year or the beginning of 2009, with a newpresident in the White House. The stock market, which usually looks sixto nine months ahead, already understands this and may soon react. Infact, when Mr. Volcker's words sink in, the markets are likely to sinkas this bear market rally ends.
For surely you understand we are still in a bear market - and onlyin the beginning of it? Yes, we are experiencing a rally, and like mostbear rallies, it is sharp and spiky. But when bear rallies end, theyleave a lot of spiked bulls behind - and this rally should be nodifferent. When it is over - in the next few weeks, methinks - thewaterfall could continue, as the market begins to digest theinevitability of higher inflation and higher interest rates ahead.
Against all protocol, Mr. Volcker just went out on a limb and warned you of this. I urge you to heed his words.
