Fed won't be able to halt this downturn

Is the beast of deflation crouching outside our door? Could this be the real reason behind the Federal Reserve's recent injection of $600 billion into the economy?

Despite the logic of much of the criticism being aimed at the Fed, it may be doing what it has to do to keep the country from spiraling down into a deeper recession. In the midst of what amounts to a virtual economic war with some of our trading partners, it's important for us to understand exactly what is at risk and what the Fed is up to.

First, the risk: Deflation is a chain of events in which consumer spending declines, prices fall, and business activity contracts. When that cycle repeats, it gets worse every time. Goods are cheap, but you're too broke to afford them. Nobody wants what you have to sell, and soon you don't have a job.

Deflation is survivable when wages and prices are free to adjust — e.g., in the absence of minimum wage laws and mandatory health insurance. Even though they're working at lower wages, consumers are not much worse off because prices are lower. But deflation is dangerous when it occurs in a high-debt environment like the one we're living in now. With more income going to debt payments, there is less to spend on other things. This empowers a recession and creates even more deflation. Eventually, the economy collapses under the weight of its own debt.

"Quantitative easing," the Fed's ongoing act of increasing the money supply, may be an attempt to avoid that scenario. But the Fed's seemingly rational response to consumer inflation may have unwittingly played a role in facilitating the financial and economic collapse of September 2008.

Dial back to the middle of 2006, when the U.S. economy appeared to be running strong. That October, prices started to climb. Inflation peaked at 11.69 percent (annualized) by June 2008. The Fed, watching this month-by-month tip into unsustainable inflation, started to reduce its holdings of treasury securities beginning in October 2007. Less than a year later, its ownership of this government debt had fallen from $779 billion to a low of $478 billion. The reduction contributed to an increase in treasury yields beginning in May 2008. There is no other way to put it: This was quantitative tightening.

But the strategy backfired. Economists peg the recession as starting in October 2007, just when the Fed began pulling back. Despite rising prices, the underlying economy was weak at the time: The real estate and mortgage markets were wobbly; the trade imbalance was climbing; interest rates were on the rise. Tightening the money supply was like lighting the fuse to the bomb that led to the collapse of September 2008. What followed was a period of significant deflation, with prices falling by nearly 20 percent (annualized) in the following month. Unemployment began its inevitable rise, soon hitting 10 percent.

It would be misguided to blame the entire collapse on the Fed. This was a unique conflation of problems that had been building up in our financial/economic system for years.

The Fed's current round of quantitative easing may be intended to extinguish another match. Gas, food and other commodity prices are rising, yet the economy is still plagued by double-digit unemployment. If the Fed did not engage in monetary expansion, a very painful deflation in general prices and compensation might occur.

But the Fed will not be able to get us out of this mess all by itself. Our society has begun to expect the government to take care of us by implementing policies that preserve the status quo and enable us to avoid pain. We are also in serious conflict with some of our largest trading partners. Things need to change, and much of it should extend beyond our borders.

Consider the strong disparities in wages and currency value between the U.S. and other countries. As long as it's cheaper to produce goods in places like Mexico and China, we will continue to outsource our production overseas and import their competitively priced goods. Similarly, until we reinvest in our education system, innovation and the high-paying jobs that go with it will not be our calling card. Not only will we not make anything in the U.S., we won't even invent it here.

It's not hard to spot the consequences of the disparity: China has been the beneficiary of billions in direct investment by U.S. and European companies, much of it in the form of technology that the Chinese did not possess. They have taken that technology and used it to compete against us in worldwide markets. U.S. taxpayers bailed out GM, and now we're celebrating its return to Wall Street, but that company is pouring money into its Chinese investments. China's sovereign wealth fund will actually take an ownership position in GM with their purchase of some of the new IPO shares.

China, as well as other "state capitalist" countries like Mexico, Saudi Arabia and Brazil, are pursuing protectionist policies that create the conditions for a global economic cold war. The latest round of quantitative easing can be seen as a shot across the bows of these countries — who also just happen to be some of our key trading partners. We may have to play hardball when it comes to trade negotiations and agreements. In a global economy, they need us as much as we need them.

And that, over the long term, may be the true net effect of the Fed's more direct management of the U.S. economy. If increasing the money supply acts as both a hedge against deflation and a way to balance global trade and create new equity among major currencies, then perhaps we should be cheering on Chairman Bernanke. But if the Fed miscalculates, as it did in 2007-08, Americans may insist on greater accountability. Either way, our best bet is a return to real self-reliance, where bailouts are rare and jobs are about adding value. That's how we can keep the beast from our door.

Steven Isberg is associate professor in the Department of Finance and Economics in the University of Baltimore's Merrick School of Business. His e-mail is sisberg@ubalt.edu.

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