Looking forward from 2006... "Dangers Facing Bernanke"

Not to toot my own horn here, but I recently ran across a short think piece I threw together in 2006. Look familiar? This is just to point out the fact that though the severity of the current downturn might have been unexpected its occurrence should not have been.

-- The Rational

Monetary Policy:

Dangers Facing Bernanke

Hedge Funds - This market, which is an early-warning system for global credit defaults, has been growing at a 50% annualized rate without the proper infrastructure to ensure against the potential risk of a nasty and disorderly shock. Some think there is the potential for a breakdown approaching the scale of the Long-Term Capital Management hedge fund debacle of 1998.

Housing Market - Investors have been buying houses even though rents will not cover their interest payments, purely in the expectation of large capital gains. The total inventory of new and used homes waiting for buyers is still the largest of all time. The number of investors and speculators dumping their properties on the market is just beginning to swell. In addition to the pure financial losses of a burst in the market, people are much more likely to borrow to buy a house than to buy shares. Not only are new buyers taking out bigger mortgages, but existing owners have increased their mortgages to turn capital gains into cash which they can spend. As a result of such borrowing, housing booms tend to be more dangerous than stock market bubbles, and are often followed by periods of prolonged economic weakness. Additionally, two-fifths of all American jobs created since 2001 have been in housing-related sectors such as construction, real-estate lending and broking. If house prices actually fall, this boost will turn into a substantial drag.

Trade Deficit - A combination of things could prompt at least some deficit-balancing capital to repatriate. Such signs could prompt a “run” which could lead to further dollar weakness and capital withdrawal. This would allow domestic producers to discover the pricing power that has been missing the last several years and be tempted to meet strong consumption at higher prices by bidding up for labor and other resources.

Oil/Energy Price Fluxes – "Rising energy prices pose a risk to both economic activity and inflation," said Bernanke. This one is rather obvious.

Changes brought about by the election – The Democratic victory could have a big impact based on fears that they will roll back capital gains tax cuts. Additionally, there is the fear of a new wave of protectionist tendencies on both sides of the aisle that might lead to lowered levels of global trade.

Low Savings/High Credit Levels - In a recent speech, Bernanke warned Americans to save more and spend less to preserve their standard of living for the long term. In the long term the retirement of baby-boomers poses enormous challenges. Bernanke expressed the urgency of fiscal-policy reform to pave the way for either greater government revenues or lower expenses, but has no control over such policy. The Fed could tighten money supply through “higher interest rates, by imposing stricter lending standards and directly reducing money supply through market intervention” to encourage cuts in consumption and increases in savings. The danger lies in the fact that the US economy is incredibly leveraged and interest-rate-sensitive. Higher interest rates have much more effect today because of consumer preferences toward credit and debt. Additionally, Doug Noland writes that “In today’s credit boom, there is a virtually insatiable demand for trillions of Credit instruments – top-rated and perceived highly liquid. The greater the degree of Credit excess the greater the gulf between the perception of safety and liquidity and the reality of highly risky Credits acutely vulnerable to a reversal in the credit cycle.” A potential solution such as increasing interest rates to force a cut in consumption risks inducing deflation and a depression. Another option with the potential for high levels of inflation is a devaluation of the dollar so that nominal promises can be kept, while purchasing power of benefits erode.