10.31.2010 0

The Fed’s Growing Malaise

  • On: 11/24/2010 10:30:05
  • In: Monetary Policy
  • By Bill Wilson

    On November 3rd, the Federal Reserve lowered its outlook for the U.S. economy in 2011, projecting lower growth and higher unemployment than it had in its June estimates, based on the now-released minutes of that meeting.

    In June, growth had been predicted to be from 3.5 to 4.2 percent, but now the Federal Open Market Committee (FOMC) has downgraded that to 3.0 to 3.6 percent. Unemployment was originally projected at 8.3 to 8.7 percent, but now that projection has risen to 8.9 to 9.1 percent.

    The worsening attitude comes at a time when Fed Chairman Ben Bernanke is still assuring the world that the economy “is now well into its second year of recovery from the deep recession,” as he did as recently as November 19th.

    Tell that to the 26.1 million either jobless or underemployed. The fact is, unemployment has been at or above 9.4 percent for 18 consecutive months, the longest period of sustained high joblessness since the Great Depression.

    Nonetheless, the Fed’s revised outlook is slightly improved from the current situation, where currently growth is stuck at 2 percent and unemployment hovers at 9.6 percent. The change in projections, however, indicates a souring economic outlook amongst the nation’s top central bankers as expectations for a robust recovery have dampened.

    In February, Barack Obama had claimed that government policy had “rescued this economy from the worst of this crisis”, even as the recovery was slowing down and unemployment was still rising. Back then, the Fed had been projecting 3.4 to 4.5 percent growth for 2011, and unemployment at 8.2 to 8.5 percent.

    Now, the Fed is admitting that the nation will not even come close to those rosy projections in 2011.

    All of which highlights the obvious failure of government “stimulus”, which has totaled over $3 trillion since the crisis began in the second half of 2007. That included $150 billion in fiscal “stimulus” in 2008, $816 billion in 2009, plus Fed purchases of $300 billion of treasuries in 2009, $1.25 trillion of mortgage-backed securities, $150 billion of agency debt, and now, the most recently announced Fed purchases $600 billion of treasuries.

    So, what has changed? The sovereign debt crisis. After Obama’s February 2010 proclamation that the worst was behind us, the worsening financial positions of Greece, Ireland, Portugal, Spain, and others came to the fore. Also, since then, Congress has passed the $2.5 trillion ObamaCare and the Dodd-Frank financial takeover bill.

    Overall, as more and more investors have questioned the ability of governments to service their gargantuan debts, the prospects for global economic recovery have dimmed. New York Times columnist David Brooks recently underscored the failure of the “stimulus” in a recent column, writing, “Ethan Ilzetzki of the London School of Economics and Enrique G. Mendoza and Carlos A. Vegh of the University of Maryland examined stimulus efforts in 44 countries. In a recent National Bureau of Economic Research paper, they argued that fiscal stimulus can be quite effective in low-debt countries with fixed exchange rates and closed.”

    Brooks continued, “Stimulus measures are generally not as effective, on the other hand, in countries like the U.S. with high debt and floating exchange rates.” So, the reason the $3 trillion monetary and fiscal “stimulus” has failed is because of the vast national debt and the uncontrolled growth of the fiat currency. Moreover, much of the “stimulus” has leaked overseas into emerging markets.

    Fortunately, as the breadth of the forest comes into full view, so does the way out. There is now an even stronger need for fiscal authorities like Congress to rein in spending as the reality dawns on policymakers that we are facing not just a typical recession, but a debt crisis.

    In the next few years, the nation’s $13.7 trillion national debt will grow to be larger than the entire economy. The Fed will become the top lender to the government in the world, more than China or Japan. And if nothing is done, the U.S. will have its credit rating downgraded by Moody’s in 2018, if not sooner.

    What will it take turn the Ship of State around? Aggressive spending cuts and a balanced budget. But the immediate prospects for spending reductions are not good when Congress cannot even bring itself to defund things we do not even need, like National Public Radio (NPR). A vote on November 18th in the House to defund NPR failed on a party-line vote.

    This indicates that while House Republicans may be eager to begin cutting unnecessary spending in 2011, congressional Democrats are not. At least, not yet. If anything is to be done to reduce the deficit, to say nothing of reducing the debt, House Republicans may have to resort to attaching spending cuts to increases in the national debt ceiling.

    But spending cuts alone may only be part of the solution. The Fed’s ability to paper over the debt with its printing press undermines any incentive Congress has to rein in spending. After all, why cut spending when the government can just print more money? Currently, with the floating exchange rate versus other currencies, there is no limiting effect on monetary expansion. Instead, the monetary base expands at will.

    The U.S. should consider moving back to a fixed exchange rate with gold or a combination of metals. This would automatically have a limiting effect on monetary expansion. The Fed would not be able to paper over the debt. Congress would not be able to spend in excess. Credit bubbles such as the housing bubble that devastated the U.S. economy would not be possible. Prices would be cheaper and remain stable.

    That combination, a strong dollar and fiscal restraint, would help the U.S. get its economic house back in order. The transition would be very painful, make no mistake. It would mean more government layoffs and an end to federal subsidies of industry. It likely would bring the nation back into recession temporarily. But it would work.

    In the early 1980’s, President Ronald Reagan and Fed Chairman Paul Volcker slayed the inflation beast with higher interest rates. Many economists now speculate that helped cause the recession of the first Reagan term. But it laid the groundwork for 20 years of nearly uninterrupted economic expansion. It was a painful pill to swallow, but Reagan believed in a strong dollar. The American electorate and a robust recovery vindicated him.

    Today, the situation may be even direr. We cannot afford to wait for inflation to go to double digits before acting to save the dollar. We cannot afford to wait for a credit downgrade to begin balancing the budget and paying off the debt. As the sovereign debt crisis both at home and abroad takes its toll on the global economy, it is time for the government to live within its means.

    Bill Wilson is the President of Americans for Limited Government.

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