Mitt Romney has now said he would not reappoint Ben Bernanke as chairman of the Fed. What a relief! (Or maybe not; I still reckon Obama has a 50-50 chance of winning in November, and he will now presumably get Bernanke’s help, including a dose of QEIII at either the September or October Fed meetings, whenever Bernanke thinks it will do the most “good”). Still, even if Romney wins and persuades Bernanke (whose term ends in January 2014) to forego a year of lame-duckery, there’s still the question of how we exit from Bernankeism. Four, six or seventeen years of loose money, however you count it, have left a huge number of vulnerabilities in the economy, so exit has the potential to be both painful and destructive.
When you include fiscal policy, there are three separate exits to be considered. There’s the rise in interest rates needed to get short-term and long-term rates safely above the rate of inflation, thus bursting the pervasive global asset and commodity bubbles and restoring positive real returns to savers. There’s the reversal in “quantitative easing” by which the Fed must sell its portfolio of more than $2 trillion of Treasury bonds and Federal Agency securities, thus removing risk from its balance sheet and ceasing to fund the federal deficit. And there’s the fiscal recovery, eliminating the annual $1 trillion deficits, part of which might conceivably be achieved by faster economic growth, but most of which must be achieved by higher taxes and lower spending.
Then, on top of managing these three processes, the exit has to be integrated with the needs of the global economy, avoiding crashing the market in Japanese government debt, now at a highly unstable level of 220% of GDP, while allowing a reasonable exit for the weaker sisters of the eurozone. The U.S. does not have direct responsibility for these problems, but at least needs to tailor its policy so as to avoid making them intolerably worse.
Various policy reversal strategies would be counterproductive. To take the most extreme example, it would be foolish to attempt to reverse “QE” without doing anything about the deficit. That would double up on the strains to the financial market from financing the deficit, making the annual net cash flow drain on the market perhaps $2 trillion rather than $1 trillion. Almost certainly, this would cause a liquidity crunch, producing an economic lurch downward that would both worsen the deficit and bring even more misery to the American working class.
The British strategy under prime minister David Cameron, of making modest back-loaded spending cuts, allowing spending to increase in real terms in the short term, while raising taxes immediately, is also counterproductive. In Britain’s case, the authorities have staved off severe problems by massive doses of quantitative easing, financing a high percentage of the budget deficit through the Bank of England. Needless to say this has resulted in more misery for Britain’s unfortunate savers and a further economic lurch downward, albeit a mild one. It does not offer an attractive path forward.
It thus follows that reversing QE must come late in the Bernanke reversal process; that lowering the deficit must take a top priority and that spending cuts should precede or at least coincide with tax cuts. Passing legislation takes time, so monetary steps should logically precede fiscal ones.
The first step to take is thus to raise interest rates. Given this logic, it would be madness to allow Bernanke to subsist in office until January 2014, surrounded by soft-money Fed governors appointed by President Obama, doing further long-term damage to the U.S. economy for an entire year before he can be removed. A newly elected President Romney should demand his resignation on his first day in office, backed if necessary by a resolution of the U.S. Senate (if the Republicans are lucky enough to control that body.) A replacement should be nominated immediately, preferably someone of unassailable scholarly achievement but massive determination, able to win quick Senate approval, yet tough enough to overcome resistance from Obama appointees within the Federal Open Market Committee. Fortunately, he will have at least a few allies among the regional Fed presidents, some of whom have been calling for a tighter, more disciplined policy for several years now. Of the 2013 FOMC members James Bullard of St. Louis is sound, but alas the indomitable Thomas Hoenig has now been replaced in Kansas City. (Hoenig himself would be an admirable choice as Bernanke’s successor.)
On the first day on which a new Fed chairman is in control, by special FOMC meeting if a regular one is several weeks away, he should increase the Federal Funds target rate to 2%. That’s nowhere near high enough in the long run. However it is sufficient to put all the zero-interest-rate games out of business, and to reduce or eliminate the “gapping” profits from borrowing in the short term market and investing in long-term bonds, which have so egregiously benefited the banking system and eliminated its incentive to lend to small businesses.
The initial interest rate rise probably would not quite eliminate the gap between interest rates and inflation, since even reported inflation by early 2013 is likely to be running around 3% (if reported inflation is higher than that, the initial jump in interest rates must be correspondingly larger.) However by changing the market’s psychology it would begin the prolonged secular rise in long-term interest rates that is needed. At the same time, it would knock out such large speculative entities as the agency mortgage REITs, which today have over $250 billion in assets and will collapse once the current interest rate pattern reverses. Thus the initial rate rise should be held for a lengthy period of perhaps six months before further rises are undertaken, to allow the market to adjust to the reality that there is no more free money. During that period, unexpected bankruptcies will occur, but we can be absolutely certain, with interest rates still below the level of inflation, that those bankruptcies are merely the worst excrescences of the bubble period and contain nothing of any long-term economic value.
During the six month period while the money market is reacting to the first interest rate rise, it will be essential to cut the budget deficit back to size. To achieve this, it will be necessary to make adjustments totaling a minimum of $500 billion in the first full year, or $5 trillion over the next ten years. That’s just about the size of the “fiscal cliff” due to take effect January 1, which according to the Congressional Budget Office reduces spending by $103 billion in the next fiscal year and increases taxes by $399 billion.
Needless to say the “fiscal cliff” balance is wrong – most of the deficit reductions should come in spending, since that is the factor that has soared out of control in the last decade. Furthermore, some of the tax increases, such as the total 61% federal tax on dividends (when President Obama’s healthcare tax is added and corporate tax is included) and a return to 55% tax on estates, would be thoroughly economically damaging, as well as unfair. The fiscal cliff’s spending cuts must thus be roughly trebled, to around $300 billion annually, while the tax increases are limited to perhaps another $250 billion. There will be a fiscal “drag” from tax increases, but not from spending cuts, which will be matched by activity increases in other more productive sectors of the economy.
As well as entitlements (of which more presently) possible targets for spending cuts include education, reversing the 2001 bloating of the Education Department and ideally abolishing it, and agriculture and energy subsidies, both of which should be abolished. It wouldn’t hurt to abolish the Energy Department and to cut back the Environmental Protection Agency drastically, folding its remnants into the Commerce Department, where they will be surrounded by people with a proper regard for the health of the U.S. economy. Naturally Fannie Mae, Freddie Mac and the FHA should go, getting the federal government out of the housing finance business.
On the tax side, rates should be raised only at the margins, perhaps raising the rate on capital gains to 20% from its current 15%, while the estate tax should be cut to a maximum of 15-20% and dividends should be made tax-deductible at the corporate level (and fully taxable at the individual level) thereby eliminating much corporate tax sheltering at a stroke. To raise most of the $250 billion required a massive axe should be taken to tax deductions. The mortgage interest tax deduction, the state and local tax deduction, the health insurance tax deduction and above all (because of its massive structural economic damage) the charitable contribution tax deduction should all be swept away, as should the myriad of smaller deductions that litter the U.S. tax code. That should easily provide sufficient revenue, but if not, a modest increase in gasoline tax would do no harm and might produce some possible environmental benefit.
Finally, entitlements should be tackled. On the social security side, this is easy; the step by step increase in the retirement age, taking it up 2 years in 1-month annual increments from 2004-26, should be extended indefinitely, so the retirement age reaches 68 in 2038, 69 in 2050 and 70 in 2062. Instantly, the long-term social security deficit would disappear. As for Medicare, something like the Ryan plan, converting those under 55 to a premium support system, would have passed political muster if the Romney-Ryan ticket is elected, and should hence be introduced as quickly as possible.
Once this combination of fiscal changes is in place, reducing the federal deficit to $500 billion initially and zero once the economy has recovered properly, the Fed’s quantitative easing should be reversed gradually, by no more than $250 billion annually, to avoid over-burdening the bond market. At the same time, interest rate rises should resume, taking the Federal Funds target above the current inflation rate as quickly as possible, and within 2-3 years to a level perhaps 3% above the then-current inflation rate, thereby allowing U.S. savings to be rebuilt, the economy to be recapitalized and long-term growth to return to its historical robust level.
Internationally, U.S. fiscal and monetary policies should reduce the accumulation of idle balances in central banks and elsewhere, thereby allowing capital to be deployed once more to productive uses. A Romney administration should on no account allow the Fed, the IMF or any other body over which the U.S. has some control to bail out the profligate members of the Eurozone. Instead it should encourage the EU and ECB authorities to allow the market to work properly, detaching the more hopeless Eurozone members such as Greece and Italy and allowing the others to form one, two or more separate currency blocs as they may see fit. Similarly, it should encourage Britain to implement in full its excessively delayed budget cuts, and the Bank of England to raise interest rates in line with U.S. rates and above all to stop buying gilts. Japan should be encouraged to bite the bullet and cut spending properly, getting its fiscal house in order, while China should be encouraged to recognize the gigantic hidden losses in its banking system.
By these means, Bernankeism can be reversed and the U.S. and global economies restored to full health, with only a moderate amount of economic pain being inflicted. Allowing Bernankeism to continue, or being less swift and careful in the steps taken to reverse it, will cause further severe problems in the U.S. economy and doom Romney like his predecessor to electoral defeat after a single term.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)