As QE2 Looms, Is the Fed Focusing on the Wrong Things?

[Editor's Note: U.S. Federal Reserve promises of a new round of "quantitative easing" - an unconventional monetary-policy strategy Wall Street refers to as "QE2" - have caused commodities prices to soar 10% since just late August. But Money Morning's Martin Hutchinson fears that the Fed is worrying about the wrong set of problems.]

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U.S. Federal Reserve Chairman Ben S. Bernanke is looking forward to 1932.

That's not a misprint. Actually, Bernanke is looking forward to a point when the challenges facing today's U.S. economy mirror the problems of that particular Great Depression-era year. And he wants that to happen for a very simple reason.

He knows how to solve those problems.

Unfortunately, "1932" isn't likely to arrive. And the preparations the Fed is making in the meantime are likely to deepen the United States' economic woes.

Let me show you what I mean…


A Trip Back in Time

Bernanke's 1983 magnum opus "Non-monetary effects of the Financial Crisis in the propagation of the Great Depression" is universally admired for its expert analysis of how a looser monetary policy could have averted the worst of the 1929-33 downturn. His policy before and since the 2008 financial crisis has been directly derived from what would've worked during the 1930-32 downturn.

If only 1932 would recur, therefore, his policies would almost certainly work.

However, we should all be careful of what Bernanke is wishing for: The truth is that 1932 was about the most unpleasant year economically in U.S. history. Certainly, no other stretch since then – not even the whipsaw years of 2008-2009 – have rivaled its level of despair.

[The only others that even come close, as far as economic pain goes, were 1839 (after the "Panic of 1837" banking collapse), and 1894, which marked the bottom of another grinding, pre-1900 recession.]

Back in 1932, the U.S. unemployment rate was rising towards 25% and the stock market was bottoming out 90% below the record highs set in September 1929. In fact, the Dow Jones Industrial Average had fallen so far that by 1932 the index was actually trading at a level that was below its value when it debuted nearly 40 years before.

Consumer prices were declining sharply, too. Indeed, they were to decline by a quarter between 1929 and their nadir in early 1933. Banks were failing all over the United States – a third of the banking system was to disappear during this downturn – and the failure of all these financial institutions was causing a rapid contraction of the money supply.

As Bernanke rightly said in 1983 – and, as Milton Friedman had said 20 years earlier – the Fed had exacerbated the problem by failing to expand the money supply to counteract the losses from bank failures.

Misguided Miscues

There's no question that a Bernanke-esque solution – of expanding the money supply, jamming interest rates down to zero and keeping them there – would have alleviated the miseries of 1932. But this would probably not have brought about a recovery.

There were other catalysts behind the unhappy economic picture that was 1932. One such catalyst – the collapse of much of Europe's banking system, coupled with the seizing-up of the international capital markets – has no parallel today. Another, the collapse in world trade following the 1930 passage of the Smoot-Hawley Tariff Act, is also not exactly imminent, although protectionism has risen and there is certainly a danger of such a development if we get a global "double-dip" recession.

Both those causes were worldwide in their manifestation, causing a worldwide downturn. However, it's important to note that there were only a few places where the downturn was as severe as it was in the United States.

In Britain, for example, 1932 was a year of modest recovery. That country had gone off the "gold standard" the previous September, and was now beginning to benefit from its newly competitive currency,

In the United States, three developments deepened the downturn. And each merits a look.

First, was the huge "stimulus" program undertaken by U.S. President Herbert Hoover through the Reconstruction Finance Corp., which benefited politically connected industries while increasing the federal budget deficit.

Second was the mass of legislation such as the 1931 Davis-Bacon Act regulating wages on federal contracts that forced employers to keep wages far above market-clearing levels. In a period when prices were declining sharply, this produced massive additional unemployment.

Third, and last, were the tax increases – ranging from increases of 25% to 63% in the top income-tax bracket – that President Hoover introduced in early 1932 to counteract the massive federal deficit that his misguided RFC and other policies had created.

We've yet to repeat the Fed mistakes of 1932 – if only because that economic environment has yet to be replicated. But we've repeated most of the other massive mistakes of the early 1930s.

Federal spending has shot up, we're very likely in line for a tax increase and numerous additional regulations have burdened the U.S. business sector – all of which have no doubt added at least marginally to the unemployment numbers. So even if 1932 were to return, Fed Chairman Bernanke would not get to play the hero with any assurance of success.

Fortunately, the chances of a return of 1932 appear slim. Globally, economic recovery is proceeding quite briskly, with only the United States and a few European countries lagging behind. Unlike in the 1930s, commodities prices have been very strong, so the chances of damaging deflation are not strong. Banks have been bailed out, and the rate of bank failure even among regional banks is not excessive, so the financial system appears fairly solid.

However, if we are not approaching 1932, then Bernanke's 1932 policies are wrong and may indeed be damaging.

The Trouble With Bubbles

By encouraging higher inflation – a stance that was clear in the recent statement of the policymaking Federal Open Market Committee (FOMC) – Bernanke is creating a commodities bubble that is already showing signs of distorting the global market. By keeping interest rates below inflation for years at a time, he is discouraging U.S. saving and encouraging leverage.

That leads to the creation of massive bubbles – such as are currently appearing in the junk bond market, and occurred in dot-com bubble of 1997-2000 and the housing bubble of 2003-06.

In the long run, the losses from those bubbles bursting – combined with the low savings rates – will destroy the U.S. capital base. Once the United States no longer has more available capital than its competitors, it will have less and less ability to create good-paying jobs and preserve U.S. living standards. Thus, unemployment will increase and real wages will decline.

By being so vigilant in protecting us from a reprise of 1932, Bernanke is unnecessarily creating a U.S. economy that is in almost as poor shape as its Great Depression counterpart, but with completely different problems.

But those differences won't matter much to the Americans who are forced to endure the hardships and pain those policies create.

[Editor's Note: If you have any doubts at all about Martin Hutchinson's market call to buy platinum, consider this true story. And keep in mind that gold futures on Wednesday closed at their 14th record high in less than a month, thanks to a weaker dollar and the kind of currency "debasement" that will only be exacerbated by a "QE2" move on the part of the U.S. Federal Reserve.

Gold fell yesterday (Thursday), finishing the day at $1,332.90 an ounce - but not before it set a new all-time high at $1,366. And it's going higher ... there will just be normal, healthy corrections here and there.

Three years ago - late October 2007, to be exact - Hutchinson told Money Morning readers to buy gold. At the time, it was trading at less than $770 an ounce. Gold zoomed up to $1,000 an ounce - creating a nice little profit for readers who heeded the columnist's advice.

But Hutchinson wasn't done.

Just a few months later - it's now April 2008 - with gold having dropped back to the $900 level, he reiterated his call. Those who already owned gold should hold on, or buy more, he said. And those who failed to listen to him the first time around should take this opportunity to remedy their oversight, he urged.

We know where gold is trading at today. Those who listened the first time have a 75% return. Even the latecomers have a 50% gain.

More recently, he's urged investors to buy platinum and (as today's essay reiterates) to take a serious look at emerging-market stocks. This documented story about Hutchinson's market calls on gold should give these more-recent predictions a lot of credibility.

But perhaps you don't want just "one" recommendation. Indeed, smart investors will want an ongoing access to Hutchinson's expertise. If that's the case, then The Merchant Banker Alert, Hutchinson's private advisory service, is worth your consideration.

For more information on The Merchant Banker Alert, please click here.]

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  1. Keith Tatarelli | October 8, 2010

    Martin Hutchinson's otherwise deft article is marred by a popular misconception exemplified by this statement: "Unlike in the 1930s, commodities prices have been very strong, so the chances of damaging deflation are not strong."

    First, I suspect he, like far too many economic commentators, mixes and matches definitions regarding inflation and deflation. If you read his cited statement objectivey, he's asserting that deflation (falling prices per his definition) is bad. So Mr. Hutchinson… do we then need positive inflation (good)?

    Prices falling can be caused by any number of factors (i.e. over-suplly, lack of demand, etc.). A general fall in prices is a natural reaction to a drop in demand caused by high unemployment and credit contraction. It's the way a market clears itself (inventory, etc.) to recalibrate itself.

    One of the MOST pernicious things this Congress has done ihas been to eenact policies designed to artificially prop prices up (Cash for Clunkers, Homebuyers tax credit, favoring the UAW over bondholders in the GM reorganization). These and any continued interferences continue to distort the market and DELAY recovery via allowing the market to clear.

    Much like Congress, Bernake, et.al. are artificially propping up prices vis their "zero interest rate" policy. All to avoid the dreaded Deflation Monster. In Bernake's world (and surprisingly Mr. Hutchinson's) prices are always supposed to go up if not remain stable. In the real world, if prices are falling it's generally for real reasons that, when interefered with, create further gut-wrenching distortions.

  2. fallingman | October 8, 2010

    Quite a good argument for ENDING THE FED.

  3. John Lambert | October 8, 2010

    Right about it not being 1932. But it sure sounds like the British Financial crisis around
    1902. It would be interesting to see what you think. Goggle Books is where I got the
    information.

  4. jj | October 8, 2010

    Govt has grown so large that they can do just about anything they want.The larger govt grows and hurts the economy,the more Americans demand more govt.Not a good future for this country.

  5. Peter Morris | October 9, 2010

    The Natural Process leads to what some think is so great, always, to a decline in worker's pay and an increase in that of the owner's which is happening now at high speed. The end result is, always, a decline in the middle class, mass poverty and revolution, redistribution and its not pretty – just read HISTORY. All Fiat money eventually becomes worthless, always. These truths just don't get talked about, at all. And the rest is just jibberish and manipulation.

    Bernanke is debasing the dollar, the rich are still selling worthless stuff which the taxpayer now has to back with "dollars", the real unemployment rate is more like 20-25%, a billion poor workers are now taking American jobs, and not just manufacturing -high tech, service etc, but unable to buy our products, Americans keep buying foreign made, instead of job producing American Made, there was no recovery of the real problems and won't be until things get so bad that Americans have to start thinking, and demanding fair treatment and intelligent behavior, but we are headed for real trouble whether we print more dollars or not, whether we have more government or not -corporations behavior is no better than government- and having any investment based in dollars and really not smart. This is not something that can be fixed unless one takes a look at the growing distance between the rich and poor and can get the rich to start acting in a caring way. Good Luck

  6. Noel Falconer (MEcon) | October 10, 2010

    Our problem is not inflation/deflation nor the response to this, it is government itself.

  7. Kevin Small | October 10, 2010

    Everyone blames big government ie..{Democrats},well remember prior to Reagen the US was the worlds #1 exporter,#1 creditor, 30 years later the US is the worlds #1borrower and no longer the #1 exporter,regulations were cut and the unions purposefully weakened,but no Reagens Big government has nothing to do with our demise, its them damn liberals, no im afraid supply-side economics is to blame truly

    • Theresa L | November 5, 2010

      Do you know ANYTHING about the Reagan administration? Even how to spell the man's name? He was completely against big government and what the news media of the time pejoritively labeled "trickle down economics" Reagan made work. You are complaining about "them damn liberals" and Reagan was mid-conservative. If you don't know what you are talking about you shouldn't post.

      During his presidency Reagan put in policies that increased employment and stimulated economic growth by helping business. When he was critisized for helping "the rich" he said poor people don't give poor people jobs, businesses do. He strengthened national defense. Hecut tases and government spending and helped the private sector (Yeah, those rich businessmen) so they could give jobs to people. He was a man of integrity who refused to deviate from what he thought was right–defense–even when he was critisized for "star wars". This caused a deficit which he was derided for, but no one messed with us. He also cut taxes and revamped the income tax giving millions of people with low incomes a tax break.
      Even though his presidency was during the Iran-Iraq war, we had oil because he sent navy vessels to guard the tankers. In a sign of "don't tread on me" strength he bombed Libya because their terrorists attacked American soldiers in a West Berlin nightclub. This caused a fuss, but he didn't pussyfoot around and let the terrorists hold us hostage. He took a strong stand and said: "Don't tread on me." We need a little of that now. When he took office people were saying America's best days were over. Reagan said, "No, they aren't" and made his presidency some of the best days. We need someone now who believes America's best days are still before her. Reagan's era marks a time of peace without recession or depression. I wish I could vote for him again.

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