Friday, September 7, 2012

When Central Bankers Rule the World



Friday's jobs report for August poured a drenching rain -- far more than the actual storms threatening Charlotte -- on the renewed hope-and-change rhetoric coming out of the Democratic convention. But even more than that, the bleak news that the U.S. economy created only 96,000 jobs and unemployment remained at plus-8 percent levels for a record period underscored a critical trend in the major Western economies, one that has important implications for President Obama’s reelection prospects.
The economies of the United States and Europe are locked together in a slow-growth embrace. In America, the utter paralysis of politics in the run-up to a deeply polarized presidential election means that all hope for action now lies in the hands of Federal Reserve Chairman Ben Bernanke. In his speech at the annual Jackson Hole conclave for central bankers last month, Bernanke hinted that the Fed would deliver more “quantitative easing” if unemployment remained high. It has. Get ready for an announcement next Thursday, when the Fed wraps up its regular two-day meeting.
That’s  just about the only relief you will hear about coming from Washington in the foreseeable future, especially considering the red lines that President Obama laid out in his feisty speech accepting the Democratic nomination on Thursday night.
Obama referred to “decisions that will have a huge impact on our lives and our children’s lives for decades to come,” and he said again and again that he would “never” yield to what he considers unreasonable Republican demands on cutting the budget and giving tax breaks to the wealthy, on funding education and energy programs, as well as altering the health care system.
And with the political debate, such as it is, still entirely focused on cutting government, any further fiscal stimulus proposals will be DOA, much as Obama’s jobs plan earlier in the year. If the president is reelected, it’s a safe bet that negotiations over the “fiscal cliff” looming at year’s end will get bogged down in the usual  brinkmanship, and that no one will be talking about boosting unemployment.
Europe is suffering from a different form of political paralysis, but it is at least as intractable. As the euro crisis drags on, and elected leaders in Germany, France, and other major nations put off decisions on a more effective fiscal union, the only person stepping into the breach is Mario Draghi, the head of the European Central Bank. After playing coy for months, Draghi this week made his biggest move yet as the avowed savior of the eurozone when, in defiance of the powerful German Bundesbank, he announced an unlimited bond-purchase program that should help stabilize the debt crisis in countries such as Italy and Spain, at least for now.
What this means, in effect, is that the fate of the major economies—and very possibly Obama’s reelection chances—now rests on the way that two “New Keynesian” economists, Bernanke and Draghi, decide to use their vast balance sheets for more stimulus. It also means that Draghi has probably made himself, and the ECB, as powerful in Europe as Bernanke has done with the Fed in the United States. “Those betting on the demise of the euro may now have to realize that the ECB is as mighty as the Fed,” Holger Schmieding, chief economist at Berenberg Bank in London, told Bloomberg News.
For Bernanke and Draghi, the irony of their enormous influence right now is that this “is probably the most impotent time for monetary policy since the 1930s,” says former Federal Reserve economist Dennis Farley. “They’ve taken the standard [federal funds rate] instrument and driven it to zero, what Keynes called the liquidity trap. Keynes’ solution was fiscal policy, but that’s a nonstarter today. It’s a monster problem. The only thing the Fed can do is cross its fingers. Quantitative easing is a stopgap. It’s to make the public believe they’re on the case and to make sure rates don’t tick up.”
Farley adds: “Draghi may have the tougher problem. He’s kind of hinted that [the ECB] will buy Italian and Spanish bonds, but for what price? What is the proper interest rate to buy them at? The markets are saying 6 or 7 percent. He’s saying the market undervalues them.”
Marshall Auerback, a Denver-based portfolio manager and investment analyst who closely follows the moves of both central banks, says that Bernanke and Draghi both know they are playing with fiscal fire right now. If Bernanke pushes rates into “negative nominal” territory, this could actually have the effect of “a tax” on people’s income and net financial assets. That in turn could reduce their creditworthiness. Thus, paradoxically, with a QE3 Bernanke could actually make more fiscal stimulus necessary. Draghi, for his part, knows that he must tie renewed bond-buying to yet more fiscal austerity from governments, which will only put the troubled countries into a deeper hole than the one he’s trying to buy them out of. “Pick your poison,” says Auerback.
Both Bernanke and Draghi have expressed barely concealed impatience that the politicians they are supposed to be working hand in hand with have failed to resolve their differences. Deploying the usual opaque Fed-speak at Jackson Hole, Bernanke said that fiscal policy had become an “important headwind” holding back the economy. But he also worried that “persistently high levels of unemployment will wreak structural damage on our economy that could last for many years," and he alluded to similar problems that his old colleague Draghi is having across the pond.
What remains unknown is how much these two unelected world figures are coordinating with each other, but speculation is rife. Bernanke and Draghi are not only longtime acquaintances but also considered to be like-minded professionally. Both men got their Ph.D’s in economics at theMassachusetts Institute of Technology and studied under Stanley Fischer, one of the world’s most renowned economists (currently the head of the Bank of Israel). Like Fischer, both come strongly out of the New Keynesian tradition, acknowledging the need for government oversight and occasional intervention in tough times. According to a Fed official I spoke to in 2011, Bernanke and Draghi began consulting regularly after the latter was appointed in June of that year.
Given the limits in what they can do, both men have demonstrated an impressive ability to work themselves out of the policy boxes their respective politicians have left them in. Under Bernanke, the Fed opened new multitrillion-dollar lending windows, slashed its benchmark rate to virtually zero, and began a series of unconventional moves to push long-term interest rates lower. But the moves have not been enough by themselves to stimulate strong growth. Draghi has been just as constrained by politics. The European Central Bank's bias, strongly influenced by Bundesbank thinking, is toward ever-greater austerity and price stability. Draghi must also worry that if he continues to turn the ECB into a Bernanke-esque stimulus machine, investors in European debt could grow scared that the eurozone is no longer the bastion of sound money.
So more growth will be a close-run thing for the U.S. and European economies in the coming months, and a few ticks upward or downward could easily determine the outcome of the presidential election. Says Farley: “I think Ben is going to muddle through, and I don’t think the economy is going to go back into recession. But I think Europe is already in negative territory and they don’t know it."
President Obama, in his speech on Thursday night, seemed to warn his audience of the bad economic news to come. “I never said the journey would be easy,” he said. Tell that to the dynamic duo of Bernanke and Draghi.

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