The Federal Reserve fumbles, as Old Europe gets it right
A recent headline item in the Financial Times, led with “Europe and US unite on stronger dollar”. Various unnamed policy makers and officials are now apparently united on the view that the dollar needed strengthening and the Euro some relief from pressure. Apparently, senior officials feel that the weakening dollar is partly to blame for crude petroleum prices forever moving to new heights.
But no less a person than Ben Bernanke, Chairman of the US Federal Reserve, has opined that oil and other commodity prices would soon revert to lower levels. Has not every Fed statement in the past six months paid little heed to inflation risks, except that it needed to be “monitored carefully”, always expecting it to come down soon? In March 2008, what was happening to oil and food prices could perhaps not be ignored any longer, and the statement read that the Fed “expects inflation to moderate in coming quarters, reflecting a projected levelling-out of energy and other commodity prices and an easing of pressures on resource utilization”. Oh, and of course it would be monitored carefully. On April 30, 2008, when the Fed cut rates one more time, there was more of the same.
The much touted US recession is yet to make its appearance. The US economy grew by 0.6 per cent in both the last quarter of 2007 and first quarter of 2008. There is weakness, as anyone would have expected, but no contraction. Job losses also have begun to ease up and the financial markets seem to have made most of its recovery. Now even Henry M. Paulson Jr., US Treasury Secretary and formerly boss of Goldman Sachs, feels the worst is over. “I am feeling better about the markets ….we are closer to the end than the beginning”, he said in a recent interview.
So, remember where you first read about us being at the half-way mark in the crisis: Right here, in this column on March 21, 2008. Amazingly, the Federal Reserve was operating on the premise of “a contraction of real GDP in the first half of 2008 followed by a slow rise in the second half”, according to meeting minutes of March 18, 2008. Hard to believe, but sadly true.
As the markets sensed that the Federal Reserve was out on a limb and unable to continue with its ill-judged strategy of slashing interest rates to stave off a non-existent recession and in complete disregard to the hard reality of high and rising inflation rates, the dollar recovered ground. After dropping to $1.601 to the Euro on April 22, 2008 the greenback strengthened 2.4 per cent in just three days and has moved up a further 1.7 per cent since then.
Crude petroleum is undaunted. The price goes up when the dollar falls, they say. It also goes up when the dollar rises. As long as there is enough tightness in the supply situation, the oil cartel of OPEC and Russia, will do what it takes to keep prices high. The incentives are truly huge. Every increase of $10 per barrel means extra revenues of $13 billion each month and vice versa. Financial investors complement the hard work of producers and Mr. Paulson has gone on record to say that investors were making longer-term asset allocations to commodities, including oil. The media, always on the hunt for bad news, helps by putting out stories that exaggerate dangers of supply disruptions.
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Basically the Fed got it wrong, and badly so. This is not an argument for outsourcing US monetary policy! Nobody, or rather no person knowledgeable about the conduct of monetary policy, could have expected that the Fed would so completely disregard all the lessons that have been so painfully learnt over the decades. By January 2008, big names – Martin Feldstein, Allan H. Meltzer and Ronald McKinnon – aside from others had begun to lace the columns of the Wall Street Journal with increasingly critical essays. Feldstein’s last piece on April 15, 2008, finally abandoned the indirect tone: the column was titled “Enough with the interest rates cuts” and was virtually a lecture on basic macro-economics – perhaps insultingly so.
The Americans have long lost their once comprehensive leadership. First, it was in steel, then cars, then chemicals, then electronics. They lost their fabled military leadership in the Mekong delta, recovering some ground in the first Gulf War. However, what the senior Bush achieved, the son undid. Three decades after Vietnam, and ten years after Operation Desert Storm, it was the turn of its political and diplomatic skill, its credibility and hegemony, to be severely damaged in the misadventure of Iraq.
However, in one area, America yet commanded respect: In matters financial and macro-economic management – particularly monetary policy. Even those Europeans with an inclination to reject solutions that smelt of “Anglo-Saxon” origins would grudgingly concede that the American were good at this. No more. The sub-prime crisis finally revealed American banking to be as naked as the Emperor of fable. The home of financial innovation has turned out to be a dispiriting habitat, marked more by greed, guile, as well as naïveté, with incompetence in much greater abundance than competence. Worst of all, the prevailing atmosphere reeked of that most venal of sins in the world of banking – a lack of prudence, i.e. common sense.
A recent statement of the US Treasury reads: “The United States is the world leader in financial services, so it is from this position of strength that we must constantly work to improve our system”. May be it will remain the world’s leader for some more time, but the best days seem to be behind us.
It must be particularly cruel that in this crisis, conceived, born and raised in America, it was the European Central Bank (ECB) who got it right. The veritable “Old Europe” to use the phrase of Donald Rumsfeld, once US Secretary of Defence, who made other memorable contributions to the vocabulary of the twenty first century: Remember “known unknowns and unknown unknowns”? Old Europe got it right, while the smart brainy whizz kids in Washington and New York badly fumbled and dropped the ball.
So Old Europe is now seeking its dues. ECB President, Jean-Claude Trichet recently spoke in New York University. It was an erudite lecture that reminded the audience of the once American ascendancy by way of references such as to Poole’s work on liquidity, to NASA and also to the Martingale hypothesis that served to remind the audience (in case they had forgotten it) of the European and French roots of America. And it roundly criticised the new banking model of “originate-to-distribute”, and the operating practices of American banking as the “‘shadow banking system’ that rapidly emerged as an excrescence of the formal banking sector”. Excrescence, good heavens! It is indeed the privilege of the victorious to write history.
(The author is Economic Advisor, ICRA)
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Published in Mail Today, Saturday, 10 May 2008