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Blame Bernanke and Bush for the market mayhem
Huge sums of money are flowing out of the US dollar into the euro and the pound, writes Anatole Kaletsky
May 20, 2006
WHAT'S rattling the financial markets? The US dollar appears to be collapsing, the gold price has soared to its highest levels since the great inflation of the 1980s and stock markets all over the world are in a swoon.

For once, this question is fairly easy to answer. Two things are worrying investors and both are "made in America".

But no, they are not the dreaded "twin deficits" - the $US800 billion ($1.053 trillion) US trade deficit and the $US600 billion government deficit. The US national debt is smaller, relative to national income, than any other leading economy's apart from Britain's, so government borrowing has nothing to do with the weak US dollar.

Neither does the US trade deficit. It has been consistently denounced as "unsustainable" since 1980, yet it has been sustained without any trouble and without impeding the world-beating economic performance of the US or diminishing the US dollar's long-term value at all.

What, then, is the real trouble? The answer can be reduced to just two names: Ben Bernanke and George W Bush.

President Bush's diplomatic incompetence and his myopic energy policies have hugely boosted oil prices, enriching and empowering anti-US regimes in Iran, Venezuela, Bolivia and Peru. As a result huge sums of money are flowing out of the US dollar into the euro and the British pound - and this process will probably continue until Mr Bush leaves the scene or the value of the US dollar falls so far that it becomes an irresistible bargain to other investors.

I suspect this point is not far away, but it will depend on my second scapegoat - Bernanke, the new chairman of the US Federal Reserve.

Mr Bernanke, one of the world's most prominent academic economists, is a worthy successor to Alan Greenspan, the truly irreplaceable Fed chairman, who steered the US economy throughout the two glorious decades from 1987 to 2006.

But Bernanke turns out to have had a character flaw that should probably have been expected in such a brilliant academic: he is not just clever; he is too clever by half.

Soon after taking the helm at the Fed three months ago, Bernanke decided he would improve on Greenspan's notoriously convoluted and Delphic statements on monetary policy - a verbal technique epitomised by Greenspan's celebrated response to a politician who thanked him for being so clear in explaining the economic outlook: "If that was your impression, Senator, then I'm afraid you must have misunderstood me."

Bernanke has tried to dispense with such obfuscation and offer clear guidance on the future direction of interest rates.

He started off by emphasising his strong belief in the Fed's dual mandate: to maintain price stability and achieve the highest possible rate of economic growth.

He then promised to call a halt to monetary tightening and do everything to keep the economy growing, even if inflation continued to accelerate "temporarily". When currency and bond investors, whose wealth is decimated by inflation, took umbrage and started selling their US dollar holdings, Bernanke changed his tune and started presenting himself as an inflation fighter.

He then "clarified" this apparently hawkish message by repeating that he might call a "pause" in the Fed's rate hikes if that was what the economic statistics dictated. The revelation that future monetary decisions would depend on economic data should have come as no great shock, since this is what the Fed has always done.

But by making his intentions so explicit, Bernanke thought he could simultaneously please inflation vigilantes on Wall Street and Washington politicians demanding faster growth and more jobs. The culmination of this Jan us-faced approach came last Wednesday in the carefully crafted communique after the Fed's monthly meeting.

By adding the single word "yet" to the previous communique - "some further tightening may yet be needed" - Bernanke seemed to think he could convey the dual message that the Fed would pause in its rate rises to avoid any danger of an economic slowdown, but would also do what was needed to keep inflation under control.

This approach achieved exactly the opposite result - undermining confidence in the US dollar and US financial markets, while intensifying the political pressure on the Fed to refrain from any further interest rate rises. The trouble is, such ambiguity could deliver the worst of both worlds: an economic slowdown and an inflation scare.

US inflation is now at its highest level for a generation and is creeping upwards, while gold prices are soaring, bond prices are falling and the US dollar is weakening against every other currency in the world.

In other words, investors seem to be losing faith in the Fed's willingness to maintain the value of the US dollar. If Bernanke decides to stop tightening while inflation is still moving upwards, financial markets may decide to test the new Fed chairman's mettle - just as they tested Greenspan with the 1987 stock market crash and Paul Volcker with the 1981 US dollar collapse and explosion of gold prices.

I am convinced the Fed will eventually pass this test, that any US inflation scare will turn out to be a minor hiccup and that the US dollar will, in time, re-establish itself as the most trusted currency in the world. A year from now the US dollar will almost certainly be stronger than it is today against the euro and the pound and gold will be valued again for its usefulness in dental fillings, rather than its monetary magic.

But first, investors will have to be persuaded of the Fed's ability to control US inflation - and of Bernanke's ability to control his words.

The Times