The Federal Reserve Starts the Withdrawal

In 1929, the week before Wall Street’s Black Monday, the great economist Irving Fischer wrote a report in which he assured [people] that the American stock market was in good shape on account of its fundamentals.

Four years later, he published his famous article about debt deflation and his theory of Great Depressions. Fischer recognized his error and analyzed the common traits of depressions. The article offered little in the way of concrete measures to solve the problem of deflation, simply saying that “we have to refloat the market.”

Bernanke is surely the most esteemed monetary economist of his generation, taking the reins at the Federal Reserve in 2008 in order to put his master’s recommendations into practice. Handling the crisis was complicated by globalization and economic innovation; with interest rates at 0 percent and with all traditional methods of recession-busting exhausted, they opted for unorthodox measures such as the direct purchase of bonds. Bernanke studied the Japanese recession in depth and knew that early diagnosis and decisive action are crucial to avoiding debt deflation.

The Fed avoided another Great Depression, but it could not stave off a deep-running recession, the weakest recovery in recent decades, a shrinking job market and the consequent decrease in potential long-term growth of the American economy. Inflation still looks more like deflation than inflationary risk, but — as Nobel Prize winner Robert Shiller has warned — we were starting to see irrational exuberance and the risk of bubbles forming in the markets.

Record highs in the American stock markets were in direct correlation with the Fed’s balance sheet and the number of bonds it was buying. There are record lows in the volatility of the credit bubble and in the return on junk bonds. The price of farmland in the U.S. is rising sharply. Oil prices are at a five-year high, despite new ways of finding it and replacing it, decreased American dependence on it and greater energy efficiency. It was the time for withdrawal and the Federal Reserve has begun weaning us off the medication.

Another economist, William Brainard, recommended that when a climate of uncertainty reigned, the central bank should avoid making sudden moves. The Fed is choosing to gradually remove its support, and it is right to do so. For now, it will still buy bonds but it will invest $10 billion less per month. Bernanke, in addition to his academic prestige, has shown a knack for making decisions in delicate situations. And he has been so kind as to leave his successor and colleague in the Federal Advisory Council, Janet Yellen, a clear path to follow in changing strategy.

Though the Fed has no plans to raise interest rates for the time being, the long-term bonds on the market have been reacting since last spring. Mortgage rates in the United States have gone up to 4.5 percent. The dollar is the international anchor currency; the rest of the world’s interest rates are decided on American rates. As such, the American economy and the world economy are losing one of their main motors for growth with the rolling back of the federal stimulus package. Its loss will affect Spanish growth and our risk premium. In order to compensate for the end of this stimulus package, other measures should be taken in Spain and in Europe to do away with economic fragmentation and the credit crunch.

The experiment has not yet finished; it is still too early to judge Bernanke’s actions. Nonetheless, here in Europe it would have been an absolute blessing to have had economists of such esteem, vision and decisiveness as Bernanke and his team at the head of the European Central Bank and advising our governments.