By Dr. Hans Black
InterInvest Review & Outlook
After 18 years at the helm of the U.S. Federal Reserve, Alan Greenspan retires in January, 2006. His successor was recently picked by President Bush from his Council of Economic Advisors, but unlike some other presidential appointees, Dr. Ben Bernanke appears eminently qualified for the job. Dr. Hans Black and Alex Black match Dr. Bernanke's economic thinking and pronouncements with the challenges that will face him.
President George W. Bush anoounces his nomination of Ben Bernanke, right,
to replace Alan Greenspan, left, as Chairman of the Federal Reserve.
– White House photo by Paul Morse.
Dr. Ben Bernanke is set to become the next chairman of the US Federal Reserve. Largely held to have been the favorite for the position, he is often referred to in the investment community as a 'known commodity' and thus a safe bet - although judging by current volatility in commodity prices this may not be saying much. His views are believed to be closely in line with Alan Greenspan's, fostering the perception of continuity in the Fed's actions. However, for all the talk of being cut in the chairman's mould, Greenspan will be a hard act to follow and it is hard to imagine any successor being more hawkish on inflation than the outgoing chairman. Some analysts even go as far as bruiting that Dr. Bernanke may be dovish, based upon his public concerns with deflationary pressures on the economy around 2003.
Dr. Bernanke has been outspoken in his desire for the Fed to be as transparent as possible, even to the point of issuing specific inflation targets. This commitment arises from his understanding of the impact of inflation expectations on the market. According to some studies, the anticipation of future Fed actions is as significant a contributor to treasury yields as is the current Fed funds rate. Investors consequently expend a great deal of effort trying to anticipate future Fed actions, with varying degrees of success. Reducing this uncertainty is thus a key prerogative of a central banker. The informational asymmetries that exist between market participants and the central bank create an adaptive feedback mechanism in which the market must 'learn' to work according to the behavior of the Fed. This process affects not just the markets, but also the economy as a whole and can result in economic behavior that is radically different from the optimal equilibrium predicted by rational expectations.
In Dr. Bernanke's view, maintaining public confidence in the Fed's inflation-curbing actions becomes just as important, if not more important, than actually containing core inflation. To see the mechanism at work from another viewpoint, we need look no further than the impact confidence in the Fed's inflation-fighting commitment has had on the supply-side inflationary pressures of 2004 and 2005. The promise of low inflation has theoretically been beneficial in restraining the second-tier effects of higher energy prices (and other commodities). Higher prices at the pump (first-tier effects) might induce producers to attempt to pass on their higher energy costs to consumers (second-tier effects), thus leading to inflation. However, with the public confident in the Fed's inflation-fighting resolve and inflation expectations low, producers have not had much latitude in passing on higher energy prices. The promise of keeping inflation in check has helped to keep inflation lower than it might otherwise have been during this period.
"The central bank's optimal policy involves exerting a tighter control on inflation than it might otherwise exert, to avoid the possibility that inflation expectations will drift randomly higher (or lower)." Such thoughts by Dr. Bernanke's on Fed openness and the importance of effective communication lead one to believe that fears of a dovish chairman are rather spurious. Conversely, the success of the Greenspan tenure, characterized by the chairman's comment along the lines of "if you think you understood what I just said, I must not have made myself clear," does make one wonder whether a certain mystique is valuable in so public a position as the Fed chairman. Mr. Greenspan, in particular, has proven quite crafty in negotiating public criticism and no doubt his image as an austere, 'central banker of old' has been instrumental in this. Time will tell what some storms await Dr. Bernanke and how he will deal with them. In the short run there is some concern that he remains closely tied to the White House due to his position as chairman on the Council of Economic Advisors, but ultimately we believe these fears of possible political pandering to be unfounded.
We shall now turn to Dr. Bernanke's thoughts on productivity. After trailing Europe and much of Asia for most of the latter half of the 20th century, productivity growth in the US over the last 10 years has been outstanding, picking up post-2001 despite the fall in equity prices. A major reason for this is the Information Communication Technology (ICT) revolution that began in earnest in the 1980s with computers, cell-phones, and then the Internet taking their place in our daily lives. There often exists a significant lag between when investments are made in a given technology and when productivity gains begin to accrue to those who invest in it; this lag is what led to Robert Solow's famous quip in the late 1980s, "computers are everywhere but in the productivity statistics." Dr. Bernanke believes that significant intangible capital investments, which are usually counted as an expense and not as an investment, may be part of the explanation. Technology alone does not necessarily increase productivity, but technology that is properly integrated does have a large impact. For instance, to take advantage of the productivity benefits associated with ICT, it may be necessary to reorganize management systems, the workforce, production lines, suppliers, etc. Europe has been quick to experience productivity gains in its ICT sector but has been much slower in spreading those gains to other sectors, presumably on account of a heavier regulatory burden, larger government involvement in business, and higher costs of displacing workers between jobs, all of which amount to higher costs for intangible capital investments. The US did make these investments and built up productivity gains in most sectors of its economy as a result. This not only accounts for a significant part of the delay in recognizing the full gains in productivity but also suggests that intangible capital investments matched traditional capital investments in the US in the late 1990s. This has led to aggregate savings and investment being significantly understated in the US. As for the future, Dr. Bernanke will keep a close watch on productivity numbers: "If productivity growth appears poised to decelerate, but (for whatever reason) aggregate private spending does not slow materially in response, then inflation risks would rise, but employment would not be adversely affected. The appropriate response in this case would be a tightening of monetary policy... On the other hand, if slower productivity growth were accompanied by a sufficiently large slowdown in aggregate demand and economic activity, then easier monetary policy might be called for."
Every Fed Chairman will at some point be called on to comment on the current account deficit. On this issue Dr. Bernanke takes a rather unconventional view. Rather than focus on trade flows, he looks at movements in international capital markets to explain the rapid build up of the deficit. One of the consequences of this build-up is that American investment far outpaces American savings, which have declined steadily since the 1980s to where they now stand at just under 14 percent of GDP. While the incentives to save have not changed significantly in the US over the last 10 years, what has changed are asset prices (first equities, then housing prices), which have risen steeply. Dr. Bernanke believes external influences play a significant role in explaining the growth in the current account deficit. In short, it is foreign creditors' willingness to invest in the US that has helped lead to the appreciation in assets.
Following the period of financial crises over the last 10 or more years (Mexico - '94, East Asia - '97, Russia - '98, Brazil - '99, Argentina - '02), developing countries have built up 'war chests' of foreign capital reserves in order to prevent such financial crises from ever happening again. China is the most notable example of this but many other countries, even in Africa and the Middle East, followed suit. Obviously, high oil prices have contributed to a large amount of the current account surplus in oil-rich countries over the last few years. Developing countries have gone from borrowing roughly $90 billion on the international capital markets in 1996 to lending out $326 billion by 2004 (among developing countries, only in Mexico is still net borrowing). Some developed countries have also been piling on the current account surpluses, mainly Japan and Germany as well as even Switzerland and Canada. All these countries are creating a "global savings glut," but where did all the money go? Mostly into the US current account deficit which raged from $120 billion in 1996 to over $670 billion by the end of 2004, but also to some extent into the UK, Spain, Australia and even France.
Dr. Bernanke does not place great weight on the federal budget deficit as a sufficient explanation of the current account situation - a position that no doubt endears him to the White House. Germany and Japan have current account surpluses despite running federal deficits comparable to that of the US, though they are obviously not economic exemplars. One estimate has it that for every dollar saved off the federal budget only 20 cents would come off the current account. Clearly, Dr. Bernanke thinks reducing the federal deficit would be a step in the right direction but he does not see it as a stand-alone solution. More importantly, the US ought to "encourage developing countries to re-enter international capital markets in their more natural role as borrowers." Promoting financial liberalization is obviously the big tool but generally this suggests the need for a pro-active foreign policy.
As for domestic implications, Dr. Bernanke has stated, "Of course, increased rates of homeownership and household consumption are both good things. However, in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be." The situation is somewhat worse for other developed countries such as the UK, France and Spain. These European countries have populations that are aging significantly faster than in the US, meaning that they have a stronger incentive to save more in preparation. In the long run, we can expect a slow reversal of international capital flow to take place, as the allocation of resources will tend to revert back over time to a more geographically risk-neutral distribution, but ultimately we believe Dr. Bernanke will not be overly concerned about the current account deficit.
In short, our research into Dr. Bernanke leads us to believe he is eminently qualified for the job and may well be a very successful Fed chairman. However, it is the times in which we live and the challenges facing the globally economy that will ultimately test the new Fed chairman's ability to maintain a steady course for the US economy, and will turn color the perceptions of his stewardship of the nation's top economic post.
Editor's Note: Dr. Hans Black is editor of Interinvest Review & Outlook. P.O. Box 51462, Boston, MA 02205, 1 year, 12 issues, $125. Interinvest is a global money management firm. Visit the web site at www.interinvest.com.
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