By William Patalon III
Executive Editor
Money Morning/The Money Map Report
I came across an old friend last week.
Back in mid-November, just after another rate reduction by Team Bernanke and the U.S. Federal Reserve, I raised the following question in this very column: Where is Paul Volcker when you need him?
Last week, I got my answer.
On Thursday, the former U.S. Federal Reserve chairman made headlines for the first time in quite awhile, endorsing presidential candidate Barack Obama, the 46-year-old Illinois senator who finds himself locked in a very tough race for the Democratic nomination with New York Sen. Hillary Clinton.
“It is only Barack Obama, in his person, in his ideas, in his ability to understand and to articulate both our needs and our hopes that provide the potential for strong and fresh leadership,” Volcker said in a statement that was e-mailed to Bloomberg News and other media outlets on Thursday.
In true Volcker fashion, the statement assailed “partisan bickering,” ideological extremes and the “narrow” interests of lobbyists that he said have taken over American politics and eroded faith in government.
Challenges such as shoring up Social Security, providing affordable health care and protecting the environment from global warming require “a willingness to break out of the engrained habits of partisan politics,” said Volcker, who headed the U.S. central bank from 1979 to 1987.
“We haven't faced up to the need for coherent budget, tax and other policies that will encourage savings, innovation and investment” and free the U.S. from its “heavy dependence on foreign capital and maintain a stable dollar,” Volcker said.
Injecting himself into the limelight and potentially controversial situation was a gutsy move for the 80-year-old Volcker. But, then, that’s par for the course for this man.
And it’s why I’ve always admired him.
You see, in the last part of the 1970s, Fed Chairman Paul A. Volcker looked at the U.S. economy, and didn’t at all like what he saw. The once-great U.S. market was breaking down under the weight of "stagflation," the nasty one-two punch of high inflation and low [or no] economic growth.
Up to that point, stagflation was believed to be impossible: Economists couldn’t fathom how an economy could simultaneously be afflicted with high inflation and low growth. It was tantamount to having an ice storm in hell – and just as unpleasant, as it turns out.
The mess that Volcker inherited included an inflation rate that was climbing and would peak at 13.5% in 1981: Risking his professional reputation – and perhaps even the nation’s financial future – Volcker raised short-term interest rates up to record levels. Indeed, I can remember market interest rates climbing up above 20%.
The net result of Volcker’s politically unpopular rate-policy machinations: A 16-month recession in 1981 and 1982, which led to a 10.8% unemployment rate in December 1982.
But there was a payoff. And it was fairly quick.
The Consumer Price Index – which had soared to 14.8% in the year that ended in March 1980 – actually dropped to 6.8% two years later, and then fell all the way down to 3.6% in March 1983.
Ultimately, Volcker squeezed inflation out of the U.S. economy, and it never returned.
Until now, that is.
Former Fed Chairman Alan Greenspan – who succeeded Volcker – is today remembered by the masses as the nation’s true economic genius today. But believe me when I tell you that Volcker was "The Real American [Economic] Hero.”
Even Greenspan says so.
Volcker’s gutsy moves in 1979 “rescued our nation's economy from a dangerous path of ever-escalating inflation and instability,” and was a “turning point in our nation's economic history,” Greenspan said in speech that he presented back in October 2004.
There’s no doubt that Volcker is one of the most capable and politically courageous leaders in the Fed's 94-year history, Carnegie Mellon University Economist Allan Meltzer, author of a history of the U.S. Fed, said in an interview with Bloomberg.
“In terms of political courage, [Volcker] stands out,” Meltzer said. Volcker “is the only one, with the possible exception of Greenspan, that really took it seriously what it was to be an independent central bank.”
I find myself repeatedly thinking of Volcker right now precisely because of the moves that current Fed Chairman Ben S. Bernanke is making in the face of a horrid global credit crunch that has grown out of the whole subprime-mortgage debacle that seems to establish new standards for stupidity and malfeasance just about every day.
At the present time, the U.S. economy is between the proverbial rock and a hard place. I blame Greenspan for a lot of the problems it’s now facing.
But with the repeated rate cuts that started in mid-September, I’m not sure that Bernanke is making anything better. It’s almost as if he’s playing to the markets, instead of focusing on the long-term health and viability of the U.S. and global economy.
Team Bernanke clearly wants to avoid a long recession. But economic downturns – and especially recessions – can have a dramatic cleansing effect on an economic system.
In the current environment, boosting interest rates would make the dollar more attractive to foreign investors, lifting its value and squelching the escalating inflationary pressures. It would also accelerate the default rates in the subprime-related debt instruments that are already now teetering.
By slashing rates so aggressively, Fed policymakers are drawing out [lengthening] what otherwise would be this natural cleansing process – in effect, blunting the natural, self-healing functions of a free-market economy: The weak and the ill-equipped companies [read that to mean stupid, greedy or downright delusional] would restructure, get bought out, or just fail. The strong and well-managed companies would survive to thrive.
Free of these problematic players, the U.S. economy could move forward, a much stronger and more-viable entity.
I realize that it takes a lot of intestinal fortitude [guts] to allow a recession to happen – or, in Volcker’s case, to start one on purpose.
Many of these debt defaults are still going to happen, and many of these ailing companies are still going to fail: But they’ve merely been delayed by the central bank rate cuts.
Many of these defaults are going to happen anyway; they’ve merely been delayed by the Fed rate cuts. Better to let those defaults happen now, and let the U.S. economy more quickly work itself back into fighting shape.
That’s what Paul Volcker would have done.
Market Matters
| Market/Index |
Year Close (2007) |
Qtr Close (12/31/07) |
Previous Week |
Current Week |
YTD Change |
| Dow Jones Industrial |
13,264.82 |
13,264.82 |
12,207.17 |
12,743.19 |
-3.93% |
| NASDAQ |
2,652.28 |
2,652.28 |
2,326.20 |
2,413.36 |
-9.01% |
| S&P 500 |
1,468.36 |
1,468.36 |
1,330.61 |
1,395.42 |
-4.97% |
| Russell 2000 |
766.03 |
766.03 |
688.60 |
730.50 |
-4.64% |
| Fed Funds |
4.25% |
4.25% |
3.50% |
3.00% |
-125 bps |
| 10 yr Treasury (Yield) |
4.04% |
4.04% |
3.58% |
3.60% |
-44 bps |
"The committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks."
And true to those words, Federal Chairman Bernanke and policymaking friends at the Federal Open Market Committee (FOMC) cut the Federal Funds Rate for the second time in just one week in an attempt to combat the growing threat of recession. This week brought two pretty active earnings and economic calendars, though Gentle Ben stole the show and gave his people what they wanted. At 3.0%, the benchmark Fed Funds Rate now stands at its lowest level since June 2005.
But was it the right thing to do? That’s another question altogether. And as we articulated above, we’re not so sure.
There’s a school of thought out there that holds that Team Bernanke is letting the stock market dictate his moves. And that’s not the best way to play this game.
In the continuing subprime/credit crisis soap opera, Standard & Poor’s warned that it may downgrade over 8,000 mortgage investments, and financial institutions could incur related losses in excess of $250 billion. On that note, UBS AG (UBS) reported $14 billion of write-downs in the fourth quarter. The FBI is investigating 14 firms involved in subprime lending and investing, focusing its efforts on accounting fraud and insider trading among other illegal activities.
[Once again a day late and several billion dollars short, one has to wonder where the law enforcement agencies, financial regulators and the debt-rating agencies were before this debacle broke. We warned the rating agencies back in the summer than this mess was going to get lots worse before it even thought about getting better].
Countrywide Financial Corp.’s (CFC) Chief Financial Officer Angelo Mozilo seems to be on his way to the unemployment line [don’t let the door hit you on the way out] and may be foregoing about $37 million in total compensation. While Bank of America Corp. (BAC) is still set to be Countrywide’s “white knight,” some analysts are warning that the deal is still a long way from closing and things could get even more shaky for the mortgage giant. [Don’t think the company’s very poor quarterly earnings announcement went unnoticed].
Earnings season moved forward this week [for those investors who still care about such “insignificant” things] with Google Inc. (GOOG) and rival Yahoo Inc. (YHOO) both posting some pretty disappointing results and watching their stock prices plunge accordingly. Apparently, a recession could put a serious damper on ad sales. Microsoft Corp. (MSFT) made yet another attempt to become a force in the hyper-competitive Internet-search sector by offering $44.6 billion to acquire slumping Yahoo [For a detailed story on Microsoft’s surprise bid for Yahoo in today’s issue of Money Morning, please click here].
Bond insurer MBIA Inc. (MBI) announced a $2.3 billion quarterly loss and speculation emerged that a consortium of major banks might be working on a bailout of the troubled bond insurer [For a detailed story on the bond insurers in today’s issue, please click here].
American Express Co. (AXP) reported lower-than-expected profits and began preparing for an extended period of delinquencies as cardholders struggle to pay their debts. Not all the earnings news was negative, however, as Exxon Mobil Corp. (XOM) reported the largest annual profit by a domestic corporation EVER, and Eli Lilly & Co. (LLY), Procter & Gamble Co. (PG), Honda Motor Co. (HMC), Boeing Co (BA), and CVS Caremark Corp. (CVS) were among other firms from a variety of sectors to post stellar results.
Even Mattel Inc. (MAT) overcame some serious toy recalls [thanks, China], and announced strong quarterly profits along with a significant share buyback program.
Investors analyzed – and over-analyzed – the U.S. central bank’s latest rate-cutting move, and the accompanying economic and earnings news, and apparently liked what they saw.
While the domestic and global equity markets struggled early in the week, the rate cut seemed to have had a calming effect, and investors also welcomed the proposed Microsoft and MBIA deals. While the Dow Jones Industrial Average suffered through its worst January in eight years, investor sentiment did not seem quite so bleak as the month came to an end and share prices posted nice gains [For a research report on the “January Barometer Theory,” please click here. The report is free of charge].
U.S. President George W. Bush – always the eternal optimist – kicked off this final “State of the Union” address with a personal assessment of the U.S. economy: “We can all see that growth is slowing…this is a good agreement that will keep our economy growing.”
While the U.S. Senate continued to discuss the merits of the Bush stimulus plan, the data of the week indicated that the economy might indeed be heading toward recession [At least, that was the case before the Fed took its rate action].
Of note, 4th quarter gross domestic product rose by a mere 0.6% [Down from a whopping 4.9% in the 3rd quarter] as the U.S. economy suffered its worst year since 2002. If we define a recession in an official way [two consecutive quarters of negative growth], a recession is not upon us [but may be getting close]. Housing continued to struggle, and home sales plummeted to levels not seen in 12 years. Consumers remained worried as their confidence level plunged in January, as well.
On a bright note, manufacturing may be on the rebound as both durable goods orders and the ISM index depicted surprising strength in the sector. Labor has become a key wildcard. While the non-farm payroll fell in January for the first time in four years, the actual unemployment rate declined a tad and a noteworthy ADP survey showed that the private sector was actually adding workers. That’s lots of data to digest.
Perhaps Paul Volcker can help out...
News and Related Story Links:
- Money Morning News:
White House, Congress Reach Agreement on Economic Stimulus Package. - Money Morning News:
In Another Whipsaw Day on Wall Street, Stocks Reverse Early Losses, Post Gains in Final Day of January. - Wikipedia:
White Knight (Business). - Money Morning News:
Fed Comes Through with Expected 50 Basis Point Cut, But Markets Still Falter. - Money Morning News Analysis:
Fed Fans Optimism and Fears With Surprise Rate Cut. - Money Morning News Analysis:
Sen. Dirksen: Let Me Introduce You to Standard & Poor’s. - Bloomberg News:
Paul Volcker, Former Fed Chairman, Endorses Obama. - Money Morning Economic Analysis:
The Week That Was: Team Bernanke and Interest Rates Have U.S. Economy Headed in the Wrong Direction. - Federal Reserve Bank of New York:
Historical Changes of the Target Federal Funds and Discount Rates (1971 to Present).
About the Author
Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.