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 approach.
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, where?
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.
(Anatole Kaletsky is a Reuters columnist but his opinions are his own.)