Wednesday, December 15, 2010

The Climax is Coming

I have said in the past that this Great Recession is playing out like a slow-motion movie. Every scene takes forever--months even--to occur. Ben Bernanke is our hero/anti-hero, and he has implemented his last tactic: QE2 (a second round of Quantitative Easing, another enormous expansion of the Federal Reserve balance sheet), just as he announced he would.

At least he doesn't mess around. He has put his--oops, our--money where his mouth is.


For Jon Stewart's take on all of this, watch this hilarious clip.

So if everything goes as Bernanke expects (or hopes), inflation, i.e. the general price level, will rise a bit, to around two percent. The banks will remain solvent in spite of the fact that they are still carrying billions of bad loans and that real estate will continue to fall in value. Freddie and Fannie will survive. The unemployed will begin to find jobs. U.S. Bonds will continue to sell at low interest rates and the Treasury will be able to finance the biggest budget in history. The U.S. dollar will retain its reserve status because the Chinese and other U.S. financiers will continue to play the game, in spite of the fact that the dollar will continue to lose purchasing power relative to other store-of-value items (e.g., gold and perhaps other currencies). And all will go well in the world.

On the other hand, if things don't go as he expects, commodities will blow off the charts. Retailers will find themselves forced to pass along costs, and general prices will start to rise even though real estate will continue to tank. U.S. bonds will take a big hit and reveal themselves to have been in bubble territory up until two months ago. Banks will find themselves in the interest-rate squeeze. Foreign trading partners will continue the currency race to the bottom and impose more restrictions. The American workforce will profit from the additional year of benefits the government might hand out, and the unemployment figures will not budge or may get worse. General unrest will rise in parts of the world that depend upon commodity prices remaining stable.

Whatever happens to us, all of Europe is, and will continue to be, in a wrestling match with their unions. Usually this is good for the dollar. However, it is not Europe's troubles that will save the U.S. when Moody's downgrades our bonds. Up to now, whenever Europe trembled, the markets fled to the safety of U.S. bonds. But with this new federal spending bill, the current and upcoming battles between the two parties in Congress, and the insecurity of the next two years, we are in for some mind-bending, rule-bending times.

The big question is: Will the world markets accept U.S. profligacy for another round, or will they demand correction? The answer depends upon factors that are unforeseeable at the moment. Even Bernanke couldn't suppress a tremble of the upper lip during his interview on 60 Minutes. I cringed when he declared "100 percent certainty" of his capacity to reverse gears whenever he chose. I imagined I could feel his fear.

I have grave doubts about any such human capacity, and even about Bernanke's sincerity. He has fallen into the Great Hubris Trap. When Japan was on the hot seat, he was full of bravado and advice. Now he is on the hot seat, and he has to make good on his theory. I suppose he might get lucky; but he also might get what he deserves, i.e. a collapse of the U.S. dollar and pandemonium. The problem is, we don't deserve it.

The Chinese are waiting patiently in the wings. They have taken steps to liberate their yuan on the currency markets, and the results have surprised everyone. Hong Kong is scrambling to handle all the business. It seems doubtful that China's currency will become the next world reserve unit, given their efforts to control everything; but what will the markets decide? That is the real question. The Chinese, as the French say, have forgotten to be dumb ("ils ont oublie d'etre cons").

We may have to be patient as this movie plays itself out, but play itself out it will. And the speed can change unexpectedly.

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