The Fed Is Out of Ammunition

A discredited dollar is a likely outcome of the current crisis.
By CHRISTOPHER WOOD


With an estimated $4 trillion in housing wealth and $9 trillion in stock-market wealth destroyed so far in the United States, there is little doubt that we are witnessing a classic debt-deflation bust at work, characterized by falling prices, frozen credit markets and plummeting asset values.

Those who want to understand the mechanism might ponder Irving Fisher's comment in 1933: When it comes to booms gone bust, "over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money."

The growing risk of falling prices raises a challenge for one of the conventional wisdoms of the modern economics profession, and indeed modern central banking: the belief that it is impossible to have deflation in a fiat paper-money system. Yet U.S. core CPI fell by 0.1% month-on-month in October, the first such decline since December 1982.

The origins of the modern conventional wisdom lies in the simplistic monetarist interpretation of the Great Depression popularized by Milton Friedman and taught to generations of economics students ever since. This argued that the Great Depression could have been avoided if the Federal Reserve had been more proactive about printing money. Yet the Japanese experience of the 1990s -- persistent deflationary malaise unresponsive to near zero-percent interest rates -- shows that it is not so easy to inflate one's way out of a debt bust.

In the U.S., the Fed can only control the supply of money; it cannot control the velocity of money or the rate at which it turns over. The dramatic collapse in securitization over the past 18 months reflects the continuing collapse in velocity as financial engineering goes into reverse.

True, this will change one day. But for now, the issuance of nonagency mortgage-backed securities (MBS) in America has plunged by 98% year-on-year to a monthly average of $0.82 billion in the past four months, down from a peak of $136 billion in June 2006. There has been no new issuance in commercial MBS since July. This collapse in securitization is intensely deflationary.

It is also true that under Chairman Ben Bernanke, the Federal Reserve balance sheet continues to expand at a frantic rate, as do commercial-bank total reserves in an effort to counter credit contraction. Thus, the Federal Reserve banks' total assets have increased by $1.28 trillion since early September to $2.19 trillion on Nov. 19. Likewise, the aggregate reserves of U.S. depository institutions have surged nearly 14-fold in the past two months to $653 billion in the week ended Nov. 19 from $47 billion at the beginning of September.

But the growth of excess reserves also reflects bank disinterest in lending the money. This suggests the banks only want to finance existing positions, such as where they have already made credit-line commitments.

Monetarist Bernanke and others blame Japan's postbubble deflationary downturn on policy errors by the Bank of Japan. But he and others are about to find out that monetary gymnastics are not as effective as they would like to think. So too will the Keynesians who view an aggressive fiscal policy as the best way to counter a deflationary slump. While public-works spending can blunt the downside and provide jobs, it remains the case that FDR's New Deal did not end the Great Depression.

There are no easy policy answers to the current credit convulsion and intensifying financial panic -- not as long as politicians and central bankers are determined not to let financial institutions fail, and so prevent the market from correcting the excesses. This is why this writer has a certain sympathy for Treasury Secretary Henry Paulson, even if nobody else seems to. The securitized nature of this credit cycle, combined with the nightmare levels of leverage embedded in the products dreamt up by the quantitative geeks, means this is a horribly difficult issue to solve.

Virtually everybody blames Mr. Paulson for the decision to let Lehman Brothers go. But this decision should be applauded for precipitating the deflationary unwind that was going to come sooner or later anyway.

The Japanese precedent also remains important because the efforts in the West to prevent the market from disciplining excesses will have, as in Japan, unintended, adverse, long-term consequences. In Japan, one legacy is the continuing existence of a large number of uncompetitive companies which have caused profit margins to fall for their more productive competitors. Another consequence has been a long-term deflationary malaise, which has kept yen interest rates ridiculously low to the detriment of savers.

Meanwhile, the most recent Fed survey of loan officers provides hard evidence of the intensifying credit crunch in America. A net 83.6% of domestic banks reported having tightened lending standards on commercial and industrial loans to large and midsize firms over the past three months, the highest since the data series began in 1990. A net 47% of banks also indicated that they had become less willing to make consumer installment loans over the past three months.

Consumers are also more reluctant to borrow. A net 48% of respondents indicated that they had experienced weaker demand for consumer loans of all types over the past quarter, up from 30% in the July survey. This hints at the Japanese outcome of "pushing on a string" -- i.e., the banks can make credit available but cannot force people to borrow.

What happens next? With a fed-funds rate at 0.5% or lower in coming months, it is fast becoming time for investors to read again Mr. Bernanke's speeches in 2002 and 2003 on the subject of combating falling inflation. In these speeches, the Fed chairman outlined how policy could evolve once short-term interest rates get to near zero. A key focus in such an environment will be to bring down long-term interest rates, which help determine the rates of mortgages and other debt instruments. This would likely involve in practice the Fed buying longer-term Treasury bonds.

It would seem fair to conclude that a Bernanke-led Fed will follow through on such policies in coming months if, as is likely, the U.S. economy continues to suffer and if inflationary pressures continue to collapse. Such actions will not solve the problem but will merely compound it, by adding debt to debt.

In this respect the present crisis in the West will ultimately end up discrediting mechanical monetarism -- and with it the fiat paper-money system in general -- as the U.S. paper-dollar standard, in place since Richard Nixon broke the link with gold in 1971, finally disintegrates.

The catalyst will be foreign creditors fleeing the dollar for gold. That will in turn lead to global recognition of the need for a vastly more disciplined global financial system and one where gold, the "barbarous relic" scorned by most modern central bankers, may well play a part.

Mr. Wood, equity strategist for CLSA Ltd. in Hong Kong, is the author of "The Bubble Economy: Japan's Extraordinary Speculative Boom of the '80s and the Dramatic Bust of the '90s" (Solstice Publishing, 2005).