Fed Chairman Ben Bernanke made an important speech to the ECB’s Central Banking Conference in Frankfurt this morning. Below I present key passages from the speech along with my reaction/interpretation/translation of it. You can read the entire speech (including a series of very interesting graphs) here.
Rebalancing the Global Recovery
“The global economy is now well into its second year of recovery from the deep recession triggered by the most devastating financial crisis since the Great Depression. In the most intense phase of the crisis, as a financial conflagration threatened to engulf the global economy, policymakers in both advanced and emerging market economies found themselves confronting common challenges.
“Amid this shared sense of urgency, national policy responses were forceful, timely and mutually reinforcing. This policy collaboration was essential in averting a much deeper global economic contraction and providing a foundation for renewed stability and growth.
“In recent months, however, that sense of common purpose has waned. Tensions among nations over economic policies have emerged and intensified, potentially threatening our ability to find global solutions to global problems. One source of these tensions has been the bifurcated nature of the global economic recovery: Some economies have fully recouped their losses while others have lagged behind.
“But at a deeper level, the tensions arise from the lack of an agreed-upon framework to ensure that national policies take appropriate account of interdependencies across countries and the interests of the international system as a whole. Accordingly, the essential challenge for policymakers around the world is to work together to achieve a mutually beneficial outcome — namely, a robust global economic expansion that is balanced, sustainable and less prone to crises.”
During the worst of the financial meltdown, global policy makers had their act together and worked together, but that cooperative spirit has broken down as the interests of those who have recovered faster have diverged from those who have lagged behind.
The Two-Speed Global Recovery
“International policy cooperation is especially difficult now because of the two-speed nature of the global recovery. Specifically, as shown in figure 1, since the recovery began, economic growth in the emerging market economies (the dashed blue line) has far outstripped growth in the advanced economies (the solid red line)…
“[G]enerally speaking, output in the advanced economies has not returned to the levels prevailing before the crisis, and real GDP in these economies remains far below the levels implied by pre-crisis trends. In contrast, economic activity in the emerging market economies has not only fully made up the losses induced by the global recession, but is also rapidly approaching its pre-crisis trend.”
Growth is fully back on track in the emerging markets.
“In the United States, the recession officially ended in mid-2009, and…real GDP growth was reasonably strong in the fourth quarter of 2009 and the first quarter of this year. However, much of that growth appears to have stemmed from transitory factors, including inventory adjustments and fiscal stimulus. Since the second quarter of this year, GDP growth has moderated to around 2 percent at an annual rate, less than the Federal Reserve’s estimates of U.S. potential growth and insufficient to meaningfully reduce unemployment…
“[O]f some 8.4 million U.S. jobs lost between the peak of the expansion and the end of 2009, only about 900,000 have been restored thus far. Of course, the jobs gap is presumably even larger if one takes into account the natural increase in the size of the working age population over the past three years.”
Growth has turned positive in the U.S. but is still anemic. Much of the growth we have seen was due to fiscal stimulus, and fiscal policy is about to turn sharply concretionary (not only in the U.S. but in other developed economies as well). The waning of fiscal stimulus has already slowed growth.
“Of particular concern is the substantial increase in the share of unemployed workers who have been without work for six months or more.
“Low rates of resource utilization in the United States are creating disinflationary pressures.”
In the U.S. and most developed economies, inflation is not a problem, unemployment — especially long-term unemployment — is.
Monetary Policy in the United States
“…Most advanced economies still need accommodative policies to continue to lay the groundwork for a strong, durable recovery. Insufficiently supportive policies in the advanced economies could undermine the recovery not only in those economies, but for the world as a whole. In contrast, emerging market economies increasingly face the challenge of maintaining robust growth while avoiding overheating, which may in some cases involve the measured withdrawal of policy stimulus.”
Emerging economies are having problems with inflation, and need to cool down, but not to the point their economies crash.
“…The U.S. unemployment rate is high and, given the slow pace of economic growth, likely to remain so for some time. Indeed, although I expect that growth will pick up and unemployment will decline somewhat next year, we cannot rule out the possibility that unemployment might rise further in the near term, creating added risks for the recovery. Inflation has declined noticeably since the business cycle peak, and further disinflation could hinder the recovery.
“In particular, with shorter-term nominal interest rates close to zero, declines in actual and expected inflation imply both higher realized and expected real interest rates, creating further drags on growth. In light of the significant risks to the economic recovery, to the health of the labor market, and to price stability, the FOMC decided that additional policy support was warranted.”
The Fed is supposed to (by law) foster full employment and stable prices. With inflation low, and unemployment high, it has no real choice but to use more stimulus if it is going to fulfill its legal mandate. Since short-term rates are already at zero, the only effective policy is to conduct open market operations further out on the yield curve. Falling inflation raises real interest rates and further slows the economy.
“Importantly, the Committee remains unwaveringly committed to price stability and does not seek inflation above the level of 2 percent or a bit less that most FOMC participants see as consistent with the Federal Reserve’s mandate. In that regard, it bears emphasizing that the Federal Reserve has worked hard to ensure that it will not have any problems exiting from this program at the appropriate time.
“The Fed’s power to pay interest on banks’ reserves held at the Federal Reserve will allow it to manage short-term interest rates effectively and thus to tighten policy when needed, even if bank reserves remain high. Moreover, the Fed has invested considerable effort in developing tools that will allow it to drain or immobilize bank reserves as needed to facilitate the smooth withdrawal of policy accommodation when conditions warrant. If necessary, the Committee could also tighten policy by redeeming or selling securities.”
The Fed does not want (core) inflation to rise over 2.0% and has the tools it needs to prevent that from happening.
“In sum, on its current economic trajectory, the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable. Monetary policy is working in support of both economic recovery and price stability, but there are limits to what can be achieved by the central bank alone.
“The Federal Reserve is nonpartisan and does not make recommendations regarding specific tax and spending programs. However, in general terms, a fiscal program that combines near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve.”
I put that in bold because it is a key point. We need more fiscal stimulus — aka higher budget deficits now — but a plan to bring them under control in the medium to long term. Monetary stimulus will help a bit, but it desperately needs help from the fiscal side, not the fiscal side actively working to slow the U.S. economy.
And Bernanke is right: a U.S. economy that limps along for years, throwing millions of its people into poverty is simply not an acceptable outcome. While I fully agree with what he is saying (and part of me would like to see him scream it from the roof tops), it is dangerous ground for him to be treading on.
As a rule, the Fed Chairman should not be commenting on the specifics of fiscal policy. That rule has been broken in the past, most notably by Alan Greenspan, who turned himself into a political hack by disastrously endorsing the Bush tax cuts.
Global Policy Challenges and Tensions
“The two-speed nature of the global recovery implies that different policy stances are appropriate for different groups of countries. As I have noted, advanced economies generally need accommodative policies to sustain economic growth. In the emerging market economies, by contrast, strong growth and incipient concerns about inflation have led to somewhat tighter policies.
Different circumstances call for different policies. The circumstances of the emerging economies, most notably China, are very different from those of the developed economies.
“Unfortunately, the differences in the cyclical positions and policy stances of the advanced and emerging market economies have intensified the challenges for policymakers around the globe. Notably, in recent months, some officials in emerging market economies and elsewhere have argued that accommodative monetary policies in the advanced economies, especially the United States, have been producing negative spillover effects on their economies.
“In particular, they are concerned that advanced economy policies are inducing excessive capital inflows to the emerging market economies, inflows that in turn put unwelcome upward pressure on emerging market currencies and threaten to create asset price bubbles…
“To a large degree, these capital flows have been driven by perceived return differentials that favor emerging markets…
“The exchange rate adjustment is incomplete, in part, because the authorities in some emerging market economies have intervened in foreign exchange markets to prevent or slow the appreciation of their currencies…”
What is good for the U.S. might not be good for emerging economies, as it could intensify inflation there, unless they let their exchange rates rise. Much of the emerging economy growth has been at the expense of the U.S., as the U.S. buys all their goods. That is not sustainable.
The solution is for those countries to let their currencies rise. Bernanke is, after all, the head of the United States central bank, and as such he should be more concerned about the U.S. economy than the economy of China or Brazil. To the extent growth in China or Brazil is driven by domestic strength in those countries, strong economies there are good for the U.S., but not if the growth is coming at the expense of the U.S. in the form of their having big trade surpluses while we run massive and unsustainable trade deficits.
Given the higher growth rates and interest rates, emerging markets are a better place to invest than in developed economies. On that point I fully agree.
“It is striking that, amid all the concerns about renewed private capital inflows to the emerging market economies, total capital, on net, is still flowing from relatively labor-abundant emerging market economies to capital-abundant advanced economies. In particular, the current account deficit of the United States implies that it experienced net capital inflows exceeding 3 percent of GDP in the first half of this year.
“A key driver of this ‘uphill’ flow of capital is official reserve accumulation in the emerging market economies that exceeds private capital inflows to these economies. The total holdings of foreign exchange reserves by selected major emerging market economies…have risen sharply since the crisis and now surpass $5 trillion — about six times their level a decade ago. China holds about half of the total reserves of these selected economies, slightly more than $2.6 trillion…”
It is downright warped that capital is, on balance, flowing from poor emerging economies into the U.S. This is not a natural development, but is a function of direct intervention by emerging market governments. If they stopped, their currencies would strengthen, their inflation would fall, and their trade surpluses would diminish. If QE2 is a “currency war,” the U.S. didn’t start it.
“That said, in the short term, rebalancing economic growth between the advanced and emerging market economies should remain a common objective, as a two-speed global recovery may not be sustainable… Unfortunately, so long as exchange rate adjustment is incomplete and global growth prospects are markedly uneven, the problem of excessively strong capital inflows to emerging markets may persist.
“Getting the world economy back into better balance would be in everyone’s long-term best interest, but the short-term interests of high growth, trade surplus countries are very different than those of low growth, trade deficit countries.”
Conclusion
“As currently constituted, the international monetary system has a structural flaw: It lacks a mechanism, market-based or otherwise, to induce needed adjustments by surplus countries, which can result in persistent imbalances. This problem is not new.
“For example, in the somewhat different context of the gold standard in the period prior to the Great Depression, the United States and France ran large current account surpluses, accompanied by large inflows of gold. However, in defiance of the so-called rules of the game of the international gold standard, neither country allowed the higher gold reserves to feed through to their domestic money supplies and price levels, with the result that the real exchange rate in each country remained persistently undervalued.
“These policies created deflationary pressures in deficit countries that were losing gold, which helped bring on the Great Depression. The gold standard was meant to ensure economic and financial stability, but failures of international coordination undermined these very goals. Although the parallels are certainly far from perfect, and I am certainly not predicting a new Depression, some of the lessons from that grim period are applicable today.
“In particular, for large, systemically important countries with persistent current account surpluses, the pursuit of export-led growth cannot ultimately succeed if the implications of that strategy for global growth and stability are not taken into account.
“Thus, it would be desirable for the global community, over time, to devise an international monetary system that more consistently aligns the interests of individual countries with the interests of the global economy as a whole.
“In particular, such a system would provide more effective checks on the tendency for countries to run large and persistent external imbalances, whether surpluses or deficits. Changes to accomplish these goals will take considerable time, effort, and coordination to implement.
“In the meantime, without such a system in place, the countries of the world must recognize their collective responsibility for bringing about the rebalancing required to preserve global economic stability and prosperity. I hope that policymakers in all countries can work together cooperatively to achieve a stronger, more sustainable, and more balanced global economy.”
The current system is an echo of what happened leading up to the Great Depression. We need to get the system back in balance — thus enhancing global economic stability — if we don’t want to repeat those mistakes.
There was much more to the speech, and I would urge people to read it. Although Bernanke suffers from the Central Banker disease of impenetrable prose, most of what he is saying is right on target. In the U.S. monetary stimulus will help, but we need more fiscal stimulus. Emerging economies need to be moving in the other direction, with tighter monetary (and to a smaller extent, fiscal) policies.
The value of emerging market currencies needs to rise (and the value of the dollar needs to fall) to ensure sustainable long-term global economic growth. Despite their diverging short-term interests, the world’s policy makers will need to work together.
Zacks Investment Research
