**Desperate times: how the Fed plans to save the world

Economic policy
Desperate times: how the Fed plans to save the world
Larry Elliott, economics editor
The Guardian, Thursday 18 December 2008

The unusual measures unveiled this week by the Federal reserve chairman, Ben Bernanke, promise to usher in an era of free money unprecedented in the history of financial markets. They include tools designed to lower long-term interest rates and boost growth in the world's biggest economy. Here we look at what the measures are, what they mean for you, and what will happen if they don't work.
Why has the Fed been forced to take such drastic steps?
After 18 months in which they have cut interest rates sharply, nationalised leading banks and provided tax rebates for consumers, US policymakers are now desperate to halt America's slide into a deep and painful recession. For historical reasons, fear of a slump runs as deep in the US as does fear of inflation in Germany, but all the conventional policy tools have so far failed. Non-farm jobs fell by more than 500,000 in November, the biggest drop since the mid-1970s, and the housing market is in freefall. Ben Bernanke is a former academic who specialised in the lessons of the Great Depression, one of which is that policymakers have to act fast and decisively to prevent a deflationary spiral setting in.
So what is the Fed proposing?
There are various forms of interest rates. Policy, or short-term, rates are set by central banks and affect the cost of money to the financial system. In the UK, the policy, or bank rate, is 2%. In the US, after Tuesday's cut, the Fed has set a target range of 0% to 0.25% - an all-time low. In normal circumstances, ultra-low policy rates make it easier for banks to lend money to their business and personal customers but these are not normal circumstances. The supply of credit has dried up as banks repair the damage to their balance sheets caused by losses on their ill-judged investments during the boom. Real borrowing rates for households and firms have fallen but not nearly so rapidly as have policy rates. The Fed's actions this week are aimed at cutting real borrowing costs.
How does it do this?
The Federal Reserve has already bought up mortgage-backed securities and the debts of Fannie Mae and Freddie Mac, the two giant state-owned mortgage finance companies. This week it said this programme would be stepped up and perhaps extended to purchases of longer-term treasury securities. Buying treasury bonds, the remedy proposed by Keynes in the 1930s and taken up by Franklin Roosevelt, is a radical step and as yet only being "evaluated" by the US central bank. But its aim is to drive down the long-term interest rates, normally set by buying and selling in the financial markets, through large-scale purchases of bonds. The interest rate - or yield - on bonds goes down as the price goes up, and buying bonds makes them more attractive by reducing the supply. Bringing down the interest rate on long-term bonds also brings down all other long-term interest rates, on fixed-rate mortgages, for example. It also gives the banks more money to lend because they exchange their bonds for money from the central bank.
So what's the drawback?
This process, known as quantitative easing, involves a huge expansion of the central bank's balance sheet so it can buy the bonds. It is not "printing money" since it no extra banknotes are churned out, but it gives the commercial banks more capital to lend on to their customers. To be effective, the central bank has to reassure financial markets that it will hold down long-term interest rates for as long as it takes to get credit markets working again. This means expanding the money supply, with the risk of re-igniting inflation once growth picks up. Bond markets are traditionally terrified by inflation and if investors start to believe that the central bank has lost control, a bond market bubble could potentially turn into a bond market bust.
What happens if it doesn't work?
In those circumstances, the next step will be wholesale use of fiscal policy. Keynes said in his General Theory that there might be cases when spirits in the private sector were so low that there would be no desire to borrow at any level of short-term or long-term interest rates. The state would then try to boost activity itself, either by public works or tax cuts. President-elect Barack Obama's plan for a fiscal boost worth 4% of GDP is an acceptance that quantitative easing might not be enough.
Anything else?
The economist Milton Friedman once said it would be theoretically possible for policymakers to end a depression by dumping wads of cash on the populace below from helicopters. This was cited by Bernanke in a paper in 2002, winning him the nickname Helicopter Ben. Other "unconventional" suggestions include providing consumers with time-limited spending vouchers that would force them to spend, or even making people pay banks for holding their money.
What does it mean for the UK?
The Bank of England and the Treasury are looking at whether quantitative easing would be possible in the UK. The upside would be that mortgage rates, overdrafts and business finance costs would fall if long-term interest rates declined. The downside would be if the markets became alarmed at the risks to inflation, turning the recent run on the pound into a full-blown sterling crisis. The pound does not have the dollar's reserve currency status so the UK is more vulnerable than the US.
Is there an alternative?
The other option is to do what the Austrian school of economists suggest: wait for the crisis to blow itself out. What is needed, they argue, is not shoring up a failed system but a period of creative destruction that will lay the foundations for stronger long-term growth. Politicians, who have elections to fight, find the do-nothing option somewhat unattractive.

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http://www.guardian.co.uk/business/2008/dec/18/federal-reserve-measures-ben-bernnake

Helicopter money - a short guide

Helicopter money - a short guide
Ashley Seager
The Guardian, Thursday 18 December 2008

The idea of dropping money from a helicopter sounds great, particularly if you are lucky enough to be standing under one. But surely it would only happen in a banana republic or some weird work of fiction? Well, maybe.
The term "helicopter money" is on everyone's lips thanks to Ben Bernanke, the head of the US central bank, the Federal Reserve. Dubbed "Helicopter Ben" by his critics, he has been associated with the idea since he gave a speech in 1992 quoting legendary economist Milton Friedman as proposing it in extremis should deflation - or continually falling prices - ever grip a modern economy.
There are now fears that exactly that might be about to happen. On Tuesday night the Fed slashed interest rates to nearly zero in a bid to breathe some life into the collapsing US economy. The Bank of England looks about to do the same thing here. But both central banks are worried that cutting rates to zero may not on its own stop the rot so they are considering radical next steps to pump money into the economy to get people and businesses spending again.
The plan is known as "quantitative easing" which in layman's language means increasing the quantity of money in the economy rather than lowering its price by cutting interest rates. At first instance this will involve buying up government bonds, known as gilts, from individuals and pension funds, for an attractive price. As bonds are a form of saving, if you swap them for cash people are more likely to spend it.
If that doesn't work the government could simply give cash handouts. Poor pensioners or working people would be the priority, as they can be relied on to spend it. You can even issue time-limited spending vouchers for shops. You don't, in reality, need helicopters to do that, but it's a nice image.

http://www.guardian.co.uk/business/2008/dec/18/useconomy-economics

**Debt deflation is tightening its grip over the entire global system.

Deflation virus is moving the policy test beyond the 1930s extremes
Debt deflation is tightening its grip over the entire global system. Interest rates are creeping towards zero in Japan, America, and now across most of Europe.

By Ambrose Evans-Pritchard, International Business EditorLast Updated: 5:50AM GMT 09 Dec 2008
Comments 187 Comment on this article

China will not lift us out - they are the most vulnerable of all Photo: AP
We are beyond the extremes of the 1930s. The frontiers of monetary policy are being pushed to limits that may now test viability of paper currencies and modern central banking.
You cannot drop below zero. So what next if the credit markets refuse to thaw? Yes, Japan visited and survived this policy Hell during its lost decade, but that was a local affair in an otherwise booming global economy. It tells us nothing.
This time we are all going down together. There is no deus ex machina to lift us out. Certainly not China, which is the most vulnerable of all.
As the risk grows, officials at the highest level of the British Government have begun to circulate a six-year-old speech by Ben Bernanke – at the time of its writing, a garrulous kid governor at the US Federal Reserve. Entitled Deflation: Making Sure It Doesn’t Happen Here, it is the manual of guerrilla tactics for defeating slumps by monetary means.
“The US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost,” he said.
Critics had great fun with this when Bernanke later became Fed chief. But the speech is best seen as a thought experiment by a Princeton professor thinking aloud during the deflation mini-scare of 2002.
His point was that central banks never run out of ammunition. They have an inexhaustible arsenal. The world’s fate now hangs on whether he was right (which is probable), or wrong (which is possible).
As a scholar of the Great Depression, Bernanke does not think that sliding prices can safely be allowed to run their course. “Sustained deflation can be highly destructive to a modern economy,” he said.
Once the killer virus becomes lodged in the system, it leads to a self-reinforcing debt trap – the real burden of mortgages rises, year after year, house prices falling, year after year. The noose tightens until you choke. Subtly, it shifts wealth from workers to bondholders. It is reactionary poison. Ultimately, it leads to civic revolt. Democracies do not tolerate such social upheaval for long. They change the rules.
Bernanke’s central claim is that the big guns of monetary policy were never properly deployed during the Depression, or during the early years of Japan’s bust, so no wonder the slumps dragged on.
The Fed can create money out of thin air and mop up assets on the open market, like a sovereign sugar daddy. “Sufficient injections of money will ultimately always reverse a deflation.”
Bernanke said the Fed can “expand the menu of assets that it buys”. US Treasury bonds top the list, but it can equally purchase mortgage securities from US agencies such as Fannie, Freddie and Ginnie, or company bonds, or commercial paper. Any asset will do.
The Fed can acquire houses, stocks, or a herd of Texas Longhorn cattle if it wants. It can even scatter $100 bills from helicopters. (Actually, Japan is about to do this with shopping coupons).
All the Fed needs is emergency powers under Article 13 (3) of its code. This “unusual and exigent circumstances” clause was indeed invoked – very quietly – in March to save the US investment bank Bear Stearns.
There has been no looking back since. Last week the Fed began printing money to buy mortgage debt directly. The aim is to drive down the long-term interest rates used for most US home loans. The Bernanke speech is being put into practice, almost to the letter.
No doubt, such reflation a l’outrance can “work”, but what is the exit strategy? The policy leaves behind a liquidity lake. The risk is that this will flood the system once the credit pipes are unblocked. The economy could flip abruptly from deflation to hyper-inflation.
Nobel Laureate Robert Mundell warned last week that America faces disaster unless the Bernanke policy is reversed immediately. This is a minority view, but one held by a disturbingly large number of theorists. History will judge.
Most central bankers suffer from a déformation professionnelle. Those shaped by the 1970s are haunted by ghosts of libertine excess. Those like Bernanke who were shaped by the 1930s live with their Depression poltergeists.
His original claim to fame was work on the “credit channel” causes of slumps. Bank failures can snowball out of control as the “financial accelerator” kicks in. The cardinal error of the 1930s was to let lending contract.
This is why he went nuclear in January, ramming through the most dramatic rates cuts in Fed history. Events have borne him out.
A case can be made that Bernanke’s pre-emptive blitz has greatly reduced the likelihood of a catastrophe. It was no mean feat given that he had to face down a simmering revolt earlier this year from the Fed’s regional banks.
The sooner the Bank of England tears up its rule books and prepares to follow the script in Bernanke’s manual, the more chance we too have of avoiding a crash landing.
Monetary stimulus is a better option than fiscal sprees that leave us saddled with public debt – the path that nearly wrecked Japan.
Yes, I backed the Brown stimulus package – with a clothes-peg over my nose – but only as a one-off emergency. Public spending should be a last resort, as Keynes always argued.
Of course, Bernanke should not be let off the hook too lightly. Let us not forget that he was deeply complicit in creating the disaster we now face. He was cheerleader of Alan Greenspan’s easy-money stupidities from 2003-2006. He egged on debt debauchery.
It was he who provided the theoretical underpinnings of the Greenspan doctrine that one could safely ignore housing and stock bubbles because the Fed could simply “clean up afterwards”. Not so simply, it turns out.
As Bernanke said in his 2002 speech: “the best way to get out of trouble is not to get into it in the first place”. Too late now.

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/3629806/Deflation-virus-is-moving-the-policy-test-beyond-the-1930s-extremes.html

**The growing threat of deflation from a globally synchronised recession

I have been trying to understand deflation. Have I experienced this before in Malaysia? A friend explained this as an environment of falling prices in assets and almost everything, and yet no one is buying. General unemployment is high during the same time and there is falling wages too. He lamented that in this situation one should be brave to snap up cheap and good assets at the opportune time. The immediate income may not be good at the time of buying during the deflationary environment but future potential gains or returns will more than compensate.

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The growing threat of deflation

A widespread drop in prices might seem like a good thing to most consumers, but the Fed and economists see it as another reason to worry.

By Chris Isidore, CNNMoney.com senior writer
Last Updated: December 18, 2008: 10:03 AM ET

AMERICA'S MONEY CRISIS
Hedge fund graveyard: 693 and counting
Fed OKs credit card crackdown
Good news when this bubble pops
Fuel prices drop, but airfares don't
Cheap money: The Fed rate cut and you
When cheap isn't good


NEW YORK (CNNMoney.com) -- Lower prices are probably at the bottom of the list of most Americans' current economic worries. But for a growing number of economists, it's their biggest fear.
A widespread drop in prices is known as deflation. And typically, it's not just the price of consumer goods that fall. Home prices, stock prices and even people's salaries often head lower as well.
The biggest problem with deflation is that when businesses need to continually cut prices to spur sales, they eventually respond by cutting production. That results in growing job losses, and could, in the worst case scenario, even cause a depression.
And several economists say they are far more worried about the threat of deflation now than they have been in the past. The Federal Reserve may also be more concerned about deflation as well.
The central bank cut its key interest rates to near 0% Tuesday. In its statement, the Fed said it expects inflation to "moderate further" but it stopped short of suggesting that inflation would drop "to levels consistent with price stability" as it has in prior statements.
"I think the Fed's statement clearly reflected some alarm that there is a greater risk of not just deflation, but of depression," said Bernard Baumohl, executive director of The Economic Outlook Group, a Princeton, N.J., research firm.
Just a month ago Baumohl put the chance of a deflation at between 10% to 20% sometime in 2009. Now he believes there's a 30% chance of deflation.

Drops in consumer prices
Economists have reason to fear that a deflationary spiral is looming.
On Tuesday, the government reported that its Consumer Price Index -- a key gauge of inflation -- fell a record 1.7% in November. Over the past three months, retail prices have plunged at a 10% annual rate.
While much of that drop was caused by falling gasoline prices, the so-called core CPI, which strips out volatile food and energy prices, declined by 0.1% in November, the first decline in that reading since the severe recession of 1982.
Core consumer prices are now up only 0.4% on an annual basis over the past three months. That is below the 1% to 2% annual range that is generally believed to be the Fed's comfort zone for inflation.
It doesn't take much of a price decline to cause economic pain. During Japan's so-called "lost decade" that started in the 1990s, prices only fell by 1% annually. But those deflationary pressures resulted in a prolonged recession.
So far, few economists believe that a couple of months of price declines is enough evidence to suggest that the U.S. is now going through a period of deflation.
But economists think the Fed should try and nip deflation in the bud and that was probably the reason why the central bank cut interest rates by more than expected.
"They're not dismissing [deflation] the way they did in the past," said David Wyss, chief economist for Standard & Poor's.

Economists debate threat
Wyss said he doesn't believe that deflation is likely to take hold in the next year. But he cautions that if the current recession continues into 2010, "the risk is significant."
Of course, not all economists are voicing increased fears about deflation.
A senior Fed official told reporters on a conference call Tuesday that deflation is not now a major worry, but conceded that the central bank would continue to closely monitor prices to make sure it doesn't become a problem.
Rich Yamarone, director of economic research at Argus Research, said his firm's deflation index is showing less of a deflation threat today than it did in 1998 or 2002-2003, the last time many economists were fearing deflation.
Yamarone said the deflation fears proved overblown in those periods, and he's confident the threat of falling prices won't play out again this time.
"We believe that the market, the Fed and the business press are all going to get it wrong this time around as well," he said. He said the drop in commodity prices, particularly oil, has caused what will prove to be a temporary fall in other prices.

Bernanke's deflation views
Whether or not Yamarone is right may depend on how the Fed continues to respond to this economic crisis.
Fed Chairman Ben Bernanke has spoken frequently in the past about deflation and how he thinks it was a significant factor in the Great Depression, his area of expertise when he was an economics professor at Princeton University.
In November 2002, Bernanke, then a Fed governor, gave a speech about how to combat inflation. That speech may offer some hints as to how the Fed may fight deflation if it becomes more of a threat.
Bernanke became known in some circles as "Helicopter Ben" for his facetious suggestion in that speech that even if the Fed cut interest rates to zero, it could continue to battle deflation by other measures, including dropping large wads of cash from helicopters.
The speech clearly signaled that Bernanke was less scared of cutting rates to zero than he was by the threat of deflation, which he described in terms that appear prescient today.
"Deflation is in almost all cases a side effect of a collapse of aggregate demand -- a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers," he said at that time.
He said deflation would then lead to recession, rising unemployment and financial stress. And he added that while "deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether."
He argued that the Fed and Congress could take steps beyond cutting rates to ward off serious deflation. And he expressed confidence such measures would work, as long as they were taken before deflation took hold.
"Prevention of deflation remains preferable to having to cure it," he said in the speech.
And in his concluding remarks, he added that "the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit...zero."
First Published: December 17, 2008: 2:50 PM ET

http://money.cnn.com/2008/12/17/news/economy/deflation/?postversion=2008121714