Bernanke’s Financial Accelerator At Work, US Dollar As Lifeblood of Globalization

``There is no sign that underlying need to sell US assets to the Chinese government to finance the US current account deficit is about to go away. China’s government isn’t buying US assets to help finance a period of adjustment that will ultimately reduce the United States dependence on Chinese flows. It is buying US assets as a byproduct of a policy of trying to defer adjustment.”-Brad Setser

One of the main reasons we argue against the supposition of a global depression or even downplay the odds of a world recession in spite of a potential US hard landing is on the assumption that monetary policies from the US will have different impacts to different countries, especially to those whose currency regime remains tied to the US.

In a recent note to a favorite client, I wrote, ``If there is any one-single most important link to globalization, it is not exports, reserves, capital flows or remittances, it is the US dollar standard system. Since most of the trade or capital flows, which shapes trading patterns and cross border flows influences a nation's economic and monetary structure, are conducted still in the US dollar, US policies (fiscal and monetary) will continue to be asymmetrically transmitted to the rest of the world. As to its unintended effects is one matter to reckon with and speculate on.”

Why do we say so? Because the Paper money-Fractional Banking system which underpins the US dollar standard is the major artery network which serves as the lifeblood of today’s global economy. In the words of Friedrich A. Hayek in his “The Paradox of Saving,” (emphasis mine) `` So long as the volume of money in circulation is continually changing, we can not get rid of industrial fluctuations. In particular, every monetary policy which aims at stabilizing the value of money and involves, therefore, an increase of its supply with every increase of production, must bring about those very fluctuations which it is trying to prevent.”

So in effect, the manipulation of money and credit growth brings about distortions and imbalances in the real economy. But since today’s real economy involves the participation of most countries in the globalization phenomenon albeit at varying degrees, then the consequences of such imbalances will be reflected on a global scale but is whose to impact domestic economies would likely be at diverse levels.

Figure 5: Bank of International Settlements: Credit, Asset Prices and Monetary Policies

Figure 5 from the Bank of International Settlements (BIS) shows of the divergent scale and scope of the world’s regions relative to its exposure to credit, real policy interest rates, real property prices and consumer price inflation.

In other words, the chart zooms in on the vulnerability of each region to the risks of an asset busts which could influence their underlying real economies. Thus, we find the Industrial countries (upper left) followed by Central and Eastern Europe (upper right) as the most risk prone relative to the indicators: credit to GDP and property price trends. Notice too that real policy rates (green line) have been drifting on a downtrend to near zero levels for all regions which has underpinned growth in the asset markets (property prices).

Yet, following the emergency US Federal Reserves 75 basis point cut last Tuesday, the single biggest cut since 1982, and the first emergency cut since 2001 (cbsmarketwatch), these real policy rates are likely to plunge to negative levels and could possibly ignite further inflationary pressures in different areas not affected by the credit crisis.

For instance, countries whose monetary regimes that are tied to the US dollar via a currency peg like the oil revenue rich GCCs or China risks more inflation. And the speculative momentum brought about by expectations of a break in the currency regime or a substantial revaluation will likely attract more speculative influx into their assets.

Yes admittedly, GCC bourses have lately been affected by the turmoil in the equity markets pricing in the concerns of a US recession but it is too early to impute on the superiority of the transmission effects of a US slump over negative real rates brought about by the Bernanke Put. Zimbabwe should be a timely reminder of policies gone awry and whose unintended effects are reflected in the currency exchange value and the stock market.

As we always love to quote Ludwig von Mises (highlight mine), ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

To our mind, voluntary abandonment of credit expansion is unlikely the scenario given the existence of Central banks whose implied fundamental task is to inflate the money and credit system.

Further, any additional actions to reduce rates by the US Federal Reserve and other safety nets via fiscal response will give further emphasis to such glaring discrepancies in the global monetary system. This is likely lead to more boom-busts cycles.

Nonetheless, the urgency of action undertaken by the US Federal Reserve has prompted for a debate on Fed Chairman Bernanke’s alleged “undeserving” sensitivity to the predicament of Wall Street and thus being hoodwinked by a 31-year old rogue trader Jérôme Kerviel from Société Générale (newyorktimes), who reportedly burned $7.2 billion of the company’s capital from unauthorized trades, to unduly trigger an emergency response from the Ben Bernanke’s Fed.

Such assertion gives Mr. Kerviel undue credit for being able to force Chairman Bernanke’s hands.

We don’t know about the exact chronology of events but global markets have already been in a steep decline even before Monday’s selling pressure.

Besides, Asian markets opened the week with massive losses even prior to the opening of markets in Europe. Hence, while Société Générale unwinding of Mr. Kerviel’s losing illegitimate positions may have influenced the momentum for further selling, it is unlikely to have been the cause. In fact, the US markets, despite the emergency rate cuts and proposed policy responses over the week by the Fed, President Bush and the Congress combined, fell significantly on Friday.

Third, as discussed in November 12 to 16 edition, [see Bernanke’s Financial Accelerator Principle Suggests For More Rate Cuts], Bernanke’s speech last June 15 on the Financial Accelerator was a dead giveaway on his policy responses.

Again from Mr. Bernanke (highlight ours), ``…financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy. Notably, some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator." Moreover, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission.”

What we wrote then (emphasis mine),

``Mr. Bernanke’s Financial Accelerator principle reveals of the incentives by the FED to support the financial markets. Hence, we are likely to see them slash another 50 basis points, especially if the US equity markets regresses back to its August lows or even activate emergency cuts prior to the meeting if the slump deepens or a crisis turns into full blown turmoil. Goldman Sachs’ Jan Hatzuis warning serves as an implicit signal to the Fed and to Treasury Secretary Henry Paulson (ex-Goldman Sachs CEO) of the need to insure their position. We do not believe this warning will be ignored.”

Oops, looks like a bullsye for us.

From our point of view, Mr. Bernanke would have done the same even without Mr. Kerviel’s tomfoolery. It is thus far the fear over the unquantified degree of losses in the banking system spreading over to the real economy that is weighing on the financial markets, hence markets will respond accordingly.

Besides, if indeed Mr. Kerviel’s misdeeds did mistakenly trigger an undue reaction by the Fed, this should be revealed by the next FOMC meeting at the end of the month. The Federal Reserve is likely to hold rates under such circumstances, albeit we will go by Bernanke’s operating principle as basis for anticipating on his next policy response.