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Sorry, Fed and People's Bank of China: You Can't Have It Both Ways (March 15, 2011) My thoughts are with those trying to contain the nuclear reactor crisis in Japan, and with their families, who are justifiably worried about the health consequences their loved ones risk as they work long hours in hazardous and difficult conditions. You can't have it both ways, but that isn't stopping the Fed and the PBOC from continuing their doomed policies. The Federal Reserve and the People's Bank of China are each trying to have it both ways: they want rapid growth in money supply, lending and the economy but no troublesome jumps in the price of essentials. Yet the rapid expansion of money supply and credit feeds volatile price increases and politically disruptive income inequality. While the world watches and hopes the reactor containment structures in Japan hold, whatever the aftermath of this deepening nuclear crisis, we will be living in a world defined by the financial policies of the Federal Reserve and the People's Bank of China. Frequent contributor Harun I. neatly summarized the problem with Fed Chairman Ben Bernanke's explanation for why the Fed's policies had nothing to do with skyrocketing global commodity prices:
What I find troubling about Bernanke these days is his overt dissembling. Before congress he says that the recovery, not money printing is causing a rather destabilizing spike in commodity prices. Looking for evidence in nominal price charts, there is none to be found. What he is trying to make us believe that from 1982 to 1998 (the great equity bull market) there was not enough demand to drive crude oil prices where they are today. Hmm. Thank you, Harun. The Fed is being disingenuous in claiming it is blameless for global inflation: the Fed's zero-interest rate policy and quantitative easing are both unleashing "hot money" that is seeking higher returns anywhere they can be found in the global economy. In a larger sense, the Fed is attempting to repeal the business cycle. In the normal course of capitalism, low rates and easy credit lead to increased borrowing, which leads to rising consumption and investment in production to feed that increased consumption. This leads to higher profits, which feed more investment and debt. At some point, the cycle hits a brick wall: borrowers can't afford to pay more interest, so debt stops rising, and consumption and demand slump as borrowing levels off. In the rush to mint profits, production capacity exceeds demand, and as a result prices and profits both fall. As the boom progressed, investors sought out riskier, more marginal investments. As new debt and demand fall, then these riskier investments lose money and are either shuttered or sold for a loss. As profits decline, workers are laid off and commercial borrowers find their income streams aren't sufficient to meet their obligations. The credit cycle turns from expansion to contraction, as marginal borrowers go bankrupt and insolvent businesses and loans are liquidated or written down. This purging of bad debt, speculative excess and misallocated resources sets the foundation for another cycle of renewed growth. But the Fed has attempted to repeal the credit cycle. Rather than allow credit to fall sharply and interest rates to rise as bad debt is purged from the financial system, the Fed has pursued a policy of making credit even cheaper in the hopes that financial-sector borrowers will be able to borrow more since rates are near-zero. But since consumers and enterprises are still burdened with mountains of existing debt, few are willing or qualified to borrow more. As I recently wrote here, consumer debt in the U.S. has declined a paltry 2.7% in the Great Recession. The Fed's quantitative easing ends up flowing not to households or productive enterprises but to the “too big to fail” banks and Wall Street firms, which then seek higher returns in assets such as stocks and commodities. The Fed's intention was to push money into productive enterprises, but instead it has fed pools of speculative money chasing high returns in global commodities. This is helping to fuel inflation in food and other commodities, not just in the U.S. but globally. Now the Fed has backed itself into a corner: if it keeps interest rates low and continues pouring hundreds of billions of dollars into “hot money” hands, then it will adding to the destabilizing consequences of rising commodity inflation. If it stops its quantitative easing stimulus to help cool global inflation, it threatens to derail the stock market run-up. Without QE2 to hold down rates, interest rates will rise, pushing marginal borrowers out of the market and increasing borrowing costs for everyone from new home buyers to those buying new vehicles. By attempting to repeal the business cycle and refusing to allow a necessary credit cleansing (writing off of bad debt) and repricing of risk, the Fed has created an inescapable double-bind for itself: either continue to pursue easy-money policies and help destabilize the global economy with rising commodity inflation, or allow interest rates to rise and destabilize speculative markets and marginal borrowers. China is also trying to have it both ways. China's leadership is on the horns of a dilemma: if it continues pumping up rapid growth, it will inevitably feed inflation, while if it raises interest rates and curbs lending to limit inflation, that policy will restrain overall growth. Though profits and gross domestic product (GDP) have been surging over the past decade as China's productivity improved, these gains have not trickled down to the workers' paychecks. According to the National Development and Reform Commission, incomes only kept pace with profits and GDP in three of China's 27 provinces. In other words, the "rapid growth" is flowing only to the top tranch of China's households, while food and energy inflation's impact is felt mostly by lower-income wage earners. In effect, China's economy and political structure is creating a nation of Haves and Have-Nots. (Sound familiar? Just substitute "America" for "China" and the statement is equally true.) Victor Shih, an Associate Professor of Political Science at Northwestern University, sees the government's tight control over yields on savings accounts and lending rates as a primary cause of rising inequality: as inflation accelerates, China's savers are losing money, as the return on savings is lower than the rate of inflation. Negative returns on savings act as a stealth tax on China's households and a subsidy to the government-owned banks. The banks then turn around and loan money to politically connected real estate developers and government-owned enterprises at interest rates that are near zero in inflation-adjusted terms. "The Chinese financial system channels wealth from ordinary households to a small handful of connected insiders and state-owned firms," writes Shih. Insiders and top managers take home substantial income in cash that goes unreported in regular channels—so-called "grey income." This is another source of wealth inequality: average workers don't receive these large cash payments, which are considered commissions and bonuses in China. A Credit Suisse survey of urban households in China found $1.5 trillion in grey income unreported in the official household income numbers. About 60 percent of this grey income flowed to the top 10 % of households. According to Shih, while income of normal households rose 8%, the top 10% of households saw their income leap by 25% The net result of these structural imbalances, in Shih's view, is a China that is "increasingly splitting into a small upper class that spends freely on luxury goods, and a remaining population whose earnings and savings are eroded by inflation and state confiscation." So both the Fed and the PBOC are creating two equally destructive and pernicious financial forces: runaway commodity prices fueled by asset bubbles and heavily goosed speculation, and rapidly increasing wealth/income inequality as the gains from speculative excess flow to the top while the price increases and low yield on savings stripmines purchasing power from those least able to afford it.
You can't have it both ways, and that's something neither the Fed nor the PBOC
is willing to admit--yet.
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