By Anatole Kaletsky
July 11 Whenever Alan Greenspan was praised for
delivering a clear message on U.S. monetary policy, he liked to
reply something along the lines of: "If you think that, you have
misunderstood what I said." Ben Bernanke prefers the opposite
On May 22, he triggered one of biggest financial panics
since 2008 by raising the possibility of reducing the Fed's
record-breaking monetary stimulus, while admitting that he had
no idea when to start this process. He spent the subsequent six
weeks trying to clear up the mess that he had created by
explaining in painstaking detail the precise timing and
conditions under which "tapering" might or might not take place.
In the process he created even greater confusion and
financial volatility. It now appears that he would have done
much better for the world economy, and for his own reputation,
by saving his breath and imitating Greenspan's obfuscation.
The Fed minutes published on Wednesday revealed so many
divergent opinions on the conditions, timing and even direction
of any change in monetary policy, that all the recent speeches
and press conferences on tapering could reasonably be described
as white noise.
This raises the question of why investors reacted so
strongly to all this confusion. Recent market behavior around
the world suggests an explanation: while Fed tapering was not in
itself a very important issue, Bernanke's comments acted as a
financial alarm bell, drawing attention to risks in the world
economy that were forgotten or ignored. When we hear a fire
alarm we naturally ask ourselves three questions: Is it a false
alarm? Is it a fire drill? Or is it a real fire - and if so,
Similar questions may shed some light on the tapering scare.
For the U.S. stock market, Bernanke's May comments were clearly
a false alarm, since the Fed was nowhere near a decision to
tighten monetary policy, as we now know officially from the
minutes. It is not surprising, therefore, that U.S. equity
prices have rebounded to their pre-Bernanke record highs. But
looking beyond the U.S. stock market, tapering speculation seems
more like a fire drill than a false alarm.
Long-term interest rates have risen sharply as the world has
been reminded that central banks will not continue buying
government bonds forever. Following this reminder, investors who
tie up their money for ten years or more in long-term government
bonds are now demanding a premium of 2.5 to 3 percentage points
above Fed funds.
Such steepening of the term premium is a perfectly natural
and healthy development as economic conditions normalize, as
they seem to be doing in the U.S. But the natural rise in
long-term U.S. interest rates is a problem if it happens too
suddenly or goes too far which is why Bernanke may have done the
U.S. a favor by testing the vulnerability of the housing market
and Wall Street to higher long-term rates.
Meanwhile in weaker economies, such as continental Europe,
Japan and Britain, local central banks have been put on notice
by the Fed that they will have to resist a steepening of
long-term yield curves for which their economies may be less
ready than the U.S. This is exactly what the European Central
Bank and the Bank of England have started to do in response to
Bernanke's fire drill.
Unfortunately the fire drill analogy looks too complacent
once we shift attention from the U.S. and Europe to the emerging
markets, where currencies, equities and bonds have all been
collapsing, along with consumer and business confidence, since
Bernanke first spoke. Perhaps, then, the financial alarms of the
past two months really did warn of danger, not in the U.S. or
Europe but in emerging markets and specifically in China.
The biggest worry suddenly preoccupying investors and global
businesses is the possibility that the Chinese authorities, in
trying to gain control of their unregulated shadow banking
system, will squeeze too hard. The result could either be a
Lehman-style financial implosion or a disastrous credit crunch
among the private sector consumer-oriented companies which China
must rely on for its next phase of growth. These risks raise a
host of characteristically Chinese paradoxes.
China's private companies are supposed to take up the
economic slack left by the decline of exports and heavy
industry. But these companies rely largely on the shadow banking
system, since they tend to be denied credit by the big
government-dominated banks. Thus China's efforts to control its
informal banking system, while necessary for financial
stability, could stifle the very businesses on which the economy
now depends for future growth.
The government may try to overcome this problem by forcing
the state-owned banks to redirect their lending from
infrastructure, property and exports to the consumption-oriented
private sector. But there is an obvious paradox in imposing
tighter central planning on the financial system to encourage
growth of a private market economy. Such paradoxes suggest the
alarming possibility that China's model of communist-controlled
capitalism may be approaching its limits.
China has successfully resolved many such paradoxes in its
30 years of reforms and the chances are high that it can do so
again. However, the risk that something may go fundamentally
wrong with the Chinese economic model as it tries to navigate
the transition from investment-led growth dominated by
state-owned enterprises and banks to consumer-led growth
dominated by the private sector is probably the greatest risk
now facing the world economy. Like the breakup of the euro, this
is a risk with low probability but potentially huge impact. By
comparison, whatever the Fed may or may not decide about U.S.
monetary policy is a sideshow. Judging by recent market
behavior, investors are coming to this conclusion.