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

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.]

News and Related Story Links:

• Merchant Banker Alert:
  Official Website.
• Money Morning Special Investment Research:
  QE2: How New Quantitative Easing Will Launch Emerging-Market Stocks.
• National Bureau of Economic Research (NBER):
  Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression.
• Wikipedia:
  Smoot-Hawley Tariff Act.
• U.S. History.com:
  Panic of 1837.
• Wikipedia:
  Milton Friedman.
• Money Morning Special Report:
  QE2: How New Quantitative Easing Will Launch Emerging-Market Stocks.
• Money Morning News Archive:
  Double-Dip Recession Stories.
• WhiteHouse.gov:
  Herbert Hoover.
• Wikipedia:
  1931 Davis-Bacon Act.
• EconomicHistory.net:
  Reconstruction Finance Corp.
• Reuters:
  Analysis: Commodities poised to ride central bank cash higher.
• MarketWatch.com:
  Gold falls after jobs data, Trichet sap rally.