Passing the Baton

Clark Winter, Citigroup Global Wealth Management, Chief Global Investment Strategist, New York, 15 November 2005


With unanticipated swiftness, US President George W Bush last month chose economist Ben Bernanke to succeed Alan Greenspan as chairman of th...

With unanticipated swiftness, US President George W Bush last month chose economist Ben Bernanke to succeed Alan Greenspan as chairman of the Board of Governors of the Federal Reserve System - the choice has drawn praise from central bankers around the world.

While few question Bernanke’s credentials and most expect that he will win confirmation, there are some in American political circles who wonder whether the proposed Fed chief may be too close to the Bush administration. Not likely. Good Fed chairmen perform a balancing act, bending and modifying policies in relation to each president’s agenda.

It should be remembered that Greenspan got along as well with former President Bill Clinton as he did with former President Ronald Reagan and as he has with the current president, though each president approached the economy differently. If Bernanke is interested in keeping his job, it is hard to imagine that his approach would be much different.

Indeed, the problem is not with Bernanke but with the economy at this point in the cycle and with the parallels investors draw to a similar period in the 1970s. Interest rates are rising after falling for more than 20 years.

Energy costs are soaring. Iraq looks more and more like the quagmire of Vietnam. Both corporations and government are mired in layers of scandal, breeding distrust among investors and the electorate. Deficits, especially the current account, are almost untenable—unlike in the 1970s, when the US ran a small surplus. Worst of all, neither American incomes nor American investments are keeping pace with previous recoveries.

Since 2001, the US economy has been growing at a healthy clip, to be sure, but that growth largely has been the product of cheap money. Despite 16 months of steady quarter-point interest-rate hikes, real rates remain below 2.0 per cent, which is not enough to discourage borrowing.

It is no surprise that Americans and their government are up to their eyeballs in debt. While Greenspan has been credited with helping to ignite the equity-market boom of the 1990s, he also has been blamed for not reining in fast enough the excesses that led to a bursting bubble. Likewise, he has been accused of failing to act to deflate a real-estate bubble inflated by cheap mortgages.

Meanwhile, central bankers in the UK, Canada and Australia are taking the inflation threat seriously and have begun to raise rates. Where did the world’s central bankers learn such behavior? From the US, of course.

When the Fed mounted a serious assault on inflation in the late 1970s, which was followed by fiscal reform in the early 1990s, the result was prosperity and enormous surpluses by the late 1990s. Other nations have been marching on that same path of reform and have learned the lessons of fiscal probity that the US was teaching a decade ago.

Seen from abroad, Americans seem to have forgotten them. This relates directly back to Bernanke. He has pledged to continue the Fed’s fight against inflation, but what does that mean?

Will he quash inflation and perhaps economic growth, as former Fed chairman Paul Volcker did, or will he be cautious and incremental? Or will he gradually stop raising rates, knowing that the Bush administration wants a robust economy going into the 2006 electoral cycle?

Nobody knows. What is safe to assume is that Bernanke understands the Fed’s mandates to control inflation, maintain growth consistent with full employment and preserve the stability of the financial system.

Significant problems undoubtedly will emerge, and he will be challenged. The second mandate, fostering employment, is perhaps the most urgent priority. Bernanke has the intelligence and independence to rein in inflation. The US economy needs him to use both.

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