In a new period of instability, Obama becomes Hoover

October 7, 2010

Yesterday I participated in a “Living in the post-bubble world: What’s next?” event with Nouriel Roubini. The key take-away from the discussion is that the U.S. and global economies are headed into a new period of instability and competitive currency devaluations.

The primary driver of this breakdown in the international consensus around free trade and global markets is the overt policy by the Fed to use quantitative easing or “QE” to devalue the dollar. The final comments by John Makin illustrate this point very nicely.

Now the Fed claims that further QE, which will include the purchase of hundreds of billions in debt issued by the Treasury, will help stimulate the U.S. economy and reverse the secular deflation that is depressing real estate valuations, employment and business investment. But the trouble is that QE is having little positive impact on American households. Without refinancing, there is no reflation of balance sheets or consumer spending.

As I noted in an earlier comment, “Bernanke conundrum is Obama’s problem,” the Fed’s attempts to help American households is being blocked by the largest banks. We wrote about the issue again this week in The Institutional Risk Analyst, “Refinancing, Not Foreclosures, is the Issue.”

While the Fed has been attempting to refloat these same banks — and their bond holders — on a sea of cheap money, the central bank is ignoring the larger, structural problems in the real estate sector. Forget mere valuations losses on ABS and derivatives on same. The real surprise heading for Washington and Wall Street is when everyone realizes that the big risk facing the U.S. economy is not from the foreclosure crisis, but from the actions of the “Big Five” financial monopolies — Fannie Mae, Freddie Mac, Bank of America, Wells Fargo and JP MorganChase – to prevent tens of millions of American homeowners from refinancing performing mortgages.

In public, the Fed is keeping a brave face on its policy moves, but in private current and former Fed officials acknowledge that there is little that the central bank can do to reverse the deflation that seems to be accelerating. There is a 40% probability of a double-dip recession, Nouriel Roubini said during the discussion.

I would argue that such metaphors miss the many differences in the present economic collapse compared with previous “recessions.” Indeed, as Tom Zimmerman of UBS noted very astutely, by easing interest rates in 2001-2002, the Fed avoided a recession then, so now we are going through double the adjustment process.

What is to be done? For starters, American policy makers need to acknowledge that the real intent of the Fed’s resumption of QE is not to stimulate directly domestic economic activity, but instead to drive down the value of the dollar — an adjustment that is long overdue. The monetary ease already injected into the U.S. economy justifies a significant drop in the value of the greenback, an adjustment that America’s creditors and trading partners have long resisted. A cheaper dollar means less export revenue for China and the other mercantilist nations of Asia and a de facto default for America’s foreign creditors.

Second, in concert with QE, the Fed needs to dust off the bully pulpit and start to publicly discuss why the largest U.S. banks are unable or unwilling to refinance the more than 30 million households which have relatively high-cost mortgages. As I have noted previously, the large banks and the housing GSEs, Fannie Mae and Freddie Mac, are using fees and other subterfuges to block refinancing for millions of Americans. This renders Fed interest rate policy largely ineffective.

It also is time for Chairman Bernanke and other Fed governors to publicly own up to the surreptitious transfer of hundreds of billions of dollars per year from American savers to the largest banks, a cowardly strategy that is allowing the Obama Administration and Congress to avoid making tough decisions about restructuring the U.S. financial system. The spectacle of Treasury Secretary Tim Geithner publicly accounting for repayment of TARP while the largest U.S. banks sink into insolvency is a national scandal.

As the Fed starts to get ahead of the curve in terms of the continuing crisis in the banking sector, the economists inside the central bank should start to ponder a new policy approach: QE to devalue the dollar and modestly higher interest rates to restore balance between the continuing needs of the banking industry and American savers.

Retired Americans, working families and corporate treasurers are all being taxed via QE and zero interest rates to subsidize the largest banks. It is time for Fed Chairman Bernanke to reassert the independence of the U.S. central bank and demand that Congress and the Treasury start to do their jobs. If we need to restructure the largest banks, then we should make the cost explicit and conduct the process publicly for all Americans to see.

As I told the AEI audience, the avalanche of mortgage defaults now hitting Bank of America, Wells Fargo and other large lenders could force these banks to seek new government bailouts in 2011, an outcome that will expose the Obama Administration’s incompetence for all to see.

For the economy, the slow process of muddling along championed by Secretary Geithner will ensure that Barack Obama becomes the Herbert Hoover of the Democratic Party. From the Crash of 1929 until the end of his term in 1932, President Hoover repeatedly predicted the end of the crisis. The rest is history.


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