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What is Ben Bernanke thinking?

By David M. Smick, Special to CNN
  • David Smick: Ben Bernanke's policy of "quantitative easing" is stirring opposition from left, right
  • He says Fed is flooding market with cash, but it may not be stimulating economic growth
  • If economy takes off, there are huge risks of escalating interest rates and inflation, he says
  • Smick: Bernanke may be hoping policy will juice stock markets, encouraging wealthy to spend

Editor's note: David M. Smick is chairman and CEO of the Washington macroeconomic advisory firm Johnson Smick International, founder and editor of the International Economy magazine and the author of "The World Is Curved: Hidden Dangers to the Global Economy."

Washington (CNN) -- Question: What do Joe Stiglitz and Paul Volcker on the left and Martin Feldstein and John Taylor on the right all have in common?

Answer: They admire Federal Reserve Chairman Ben Bernanke as a brilliant monetary theorist but are skeptical of his quantitative easing, the new effort by our central bank to stimulate our economy by purchasing massive quantities of U.S. Treasury securities.

So how could someone so brilliant venture into a policy territory so controversial? One counterintuitive theory is that the Fed chairman realizes that the policy has little chance of dramatic success. The U.S. economy suffers from excess capacity, Bernanke argues, a situation that is unlikely to correct itself any time soon given consistently high levels of unemployment.

To be sure, a dramatically successful policy would carry enormous risk. Indeed, if you are a Wall Street risk manager, the nightmare scenario with quantitative easing is that the U.S. economy confounds conventional wisdom, animal spirits kick in, and the economy begins to perform significantly better than expected.

How could someone so brilliant venture into a policy territory so controversial?
--David Smick

Loan demand recovers, and Treasury interest rates soar. Suddenly, today's $3 trillion to $4 trillion of privately held bond market Treasury securities, a lot of it drawn into the market by the Fed's generous policies, have an exit problem.

The value of those bonds drops sharply since they pay very low rates of interest. Bond holders try to sell simultaneously. The economy's better-than-expected performance, ironically, produces a bond market nightmare, which feeds chaos into the stock market. The theory is that Ben Bernanke, aware of this danger, is pushing quantitative easing anyway precisely because he believes that the policy, at best, will succeed only modestly.

Which leads to an important question: What's the real reason Bernanke is taking the risk of purchasing an additional $600 billion to $900 billion or more in Treasury securities. No one believes the U.S. monetary mechanism is working. Clearly, for some time the Fed, with already more than $1 trillion in excess reserves and near zero percent interest rates, has been "pushing on a string" in trying to stimulate the economy by flooding it with cash.

Moreover, to return to full employment, bringing today's 9.6 percent unemployment back down closer to 5 percent, interest rates, according to many experts, would need to be theoretically "reduced" by at least another 400 basis points (4 percentage points) or more.

With nominal interest rates near zero percent, that's essentially saying the quantitative easing necessary to put Americans back to work theoretically would need to be perhaps more than a whopping $6 trillion, nearly half America's annual Gross Domestic Product. That's not going to happen.

Bernanke's goal instead appears to be more modest and is not dependent on the monetary mechanism working. Indeed, its assumption is that the mechanism won't work. With consumer demand still relatively flat, the Fed's hope is that the quantitative easing exercise produces a stock market rebound in coming months with an accompanying "wealth effect." The policy appears to be geared to more affluent consumers who hold stocks and account for more than half of retail sales. The hope is that with the market rallying, these consumers will start spending again.

The Fed's hope is that the quantitative easing exercise produces a stock market rebound ... with an accompanying 'wealth effect.'
--David Smick

A secondary goal is to keep inflation from dropping too low, which would risk a deflationary threat. One way of raising prices is to cheapen the international value of the dollar, which means that the cost of imports rises.

The sticker price of a Toyota goes up, for example, because the value of the yen has increased against the dollar. And what do GM, Ford and Chrysler do? They raise their prices, as well, to keep pace. This phenomenon raises all auto prices.

Incidentally, this threat of dollar weakening has infuriated the Chinese. Why? Chinese officials regularly manipulate their currency to keep it cheap against the dollar, to support their powerful export market. Bernanke's quantitative easing policy suddenly makes China's job of currency manipulation a lot more expensive. For the Chinese to keep their currency from rising against the dollar, they now have to buy up all those new dollars Bernanke's quantitative easing is pumping into the global economy.

With the Obama administration's fiscal stimulus plan a clunker, quantitative easing policy is also the Federal Reserve's kind of "we can't sit here and do nothing" response to the threat of a double-dip recession. In a sense, the Fed for now is on an S&P Stock Index standard. It's not a pretty picture, but a double-dip scenario with the Fed doing nothing in response could well destroy the central bank's political independence in the thinking of many Fed policymakers.

Critics rightly argue that the further bloating of the Fed's balance sheet threatens to raise inflationary expectations. The fear is that the Fed will eventually monetize its mountain of debt, which means they'll reduce the debt's value through higher inflation. The critics are right to be concerned about inflation, not to mention that the risk of a crowding out of the private sector in the credit markets as a result of quantitative easing could get out of hand. There is no denying that the risks associated with quantitative easing are enormous and uncertain.

There is no denying that the risks associated with quantitative easing are enormous and uncertain.
--David Smick

In the end, for instance, what does it mean if, between now and late summer, the Fed follows its quantitative easing to full completion, spending the full $900 billion to buy Treasury bonds? It means the Fed incredibly will probably have absorbed all net new issues of Treasuries.

Is having the Fed the only buyer of America's Treasury debt an inflationary or contractionary development? The truth is, nobody knows.

A similar scenario in Japan in the 1990s failed to produce an inflationary effect. Perhaps today, the threat of a U.S. bond market exit problem may itself serve as a contractionary brake on inflation expectations.

Yet the more globalized U.S. economy may be different. Witness today's soaring worldwide commodity prices. Inflationary expectations have a history of building with initially no clear tell-tale signs in the interest rate markets. The 1970s are known as the decade of high interest rates and soaring inflation.

Yet in July 1977, the 30-year Treasury yield was the same as it was in July 1970. It seemed as if inflation was nowhere in sight. Yet within several months, interest rates arrived at some hidden tipping point and began to climb. They eventually soared, along with inflation.

The opinions expressed in this commentary are solely those of David Smick.