Not the financial Terminators, we hope
Mr Bernanke's Testimony. In Congressional testimony last week, Federal Reserve Chairman Ben Bernanke tried to put to rest the widespread concerns that the Fed has no "exit strategy" from the unprecedented degree of monetary easing and fiscal stimulus currently underway. Many commentators seem greatly relieved by the Chairman's testimony, which identified many of the monetary tightening mechanisms in the Fed's arsenal. Others were not impressed.
The Fed's Tightening Mechanisms. The Fed's inventory of assets includes short-term Treasury bills, which it can sell in order to soak up excess any excess liquidity in the hands of the public and thereby reduce inflationary pressures. The Fed can also encourage banks to hold excess funds (and not loan them to the public) by raising the interest rate that it offers member banks on overnight deposits. These kinds of tightening mechanisms are well known, and it is remarkable that so many observers seemed to be reassured by the Chairman's testimony.
Near-Term Deflationary Pressures. It is true that there is little apparent risk of inflation in the US in the near term. Deflationary forces are likely to persist for some months, or longer, for many reasons. Levels of debt are very high and money entering the financial system is being used for deleveraging and not for real economic activity. Overseas holders of US Treasuries are interested in supporting their own economies by keeping their currencies low relative to the dollar, so as to encourage exports. Debtors are defaulting in increasing numbers, and levels of economic activity are still declining.
Disciples of Bush asleep at the switch again!
Long-Term Debt Problems. Despite the near-term comfort, there are very real long-term risks. The off-balance sheet obligations of Medicare, Medicaid, Social Security, and other programs are huge and growing. The US shows little political will to prevent the train wreck that will occur when runaway promises threaten to turn into a runaway debt load.
Debt Reduction Problems. To make things worse, the economy may stay weak for years, making it even harder to pay for the financial bailouts, let alone pay for expensive social programs. What if the economy is still weak when the interest load starts to become unbearable for the US? Would the Fed defend the dollar by soaking up excess liquidity and risk sending the US into another depression? A depression is hardly the time to raise interest rates.
The Financial Terminator? California's current budget problems may be a forwarning of things to come for the US as a whole. There are clear imbalances in the state's long-term obligations and its ability to fund them. However, the state's supposed budget "solution" fails to cut costs or raise taxes enough to solve the long-term imbalances already built into the system.
The similarities to the growing budget burdens of the US are worrying for the US dollar. Like an army of financial Terminators, creditors do not treat spendthrift debtors kindly.
