OPINION

FEBRUARY 27, 2012

For the Fed, There's No Easy Exit

Rising returns on private loans will raise the central bank's borrowing costs and put pressure on its balance sheet.

By GEORGE MELLOAN



The crash of Zero Mostel's quasi-Ponzi scheme in 1968's "The Producers" left his partner Gene Wilder muttering, "No way out. No way out." Federal Reserve Chairman Ben Bernanke is in a somewhat similar position. Keynesian monetary "stimulus" has failed to revive the housing market, the federal deficit remains at a three-year flood tide, and the recovery is moving at ant-like speed. Americans enjoyed "The Producers." They're not enjoying this.

Presidential candidate Ron Paul's call to scuttle the Fed and return to a gold standard is getting surprising resonance with Republicans, judging from his strong showing in the Maine and Minnesota caucuses. Despite a rising chorus of complaints from seniors, pension funds and frugal savers about scanty returns on investments, the Fed has committed itself to nearly three more years of zero interest rates.




Mr. Bernanke defends that commitment on grounds that low interest rates will continue to make mortgages cheap and help the housing industry recover. But the housing market can't clear until the inventory of distressed housing is worked off. And that process is being inhibited by federal policies to forestall mortgage foreclosures, including a $25 billion shakedown of five big banks as a penalty for alleged foreclosure abuses.




There is no end in sight to the pressure on the Fed's balance sheet. The Fed has acquired over a half trillion dollars (net) of Treasury securities over the last 12 months. Its holdings are up to $1.665 trillion and it is financing some 40% of the deficit—which is now running at a $1.3 trillion annual rate and heading for another collision with the debt ceiling, possibly late this year.




The Fed still holds $836 billion of suspect mortgage-backed securities on its books, bought mainly to bail out Fannie Mae, Freddie Mac and AIG. The Fed lists them at par (the remaining principal value of the underlying mortgages). But sales from the AIG tranche over the last year have shown their market worth to be somewhere around 50 cents on the dollar.

Getty Images

Federal Reserve Chairman Ben Bernanke

The Fed nonetheless booked a surplus of $79.9 billion for 2011, mainly from the interest on its government securities. But by law that goes back to the Treasury. So in effect the Fed earns expenses and little else on its holdings, meanwhile taking a big risk. It is subject to a huge capital loss on its portfolio if interest rates rise and the market price of Treasurys goes down. That gives it one more incentive to hold interest rates as low as possible, despite the rising public clamor for higher returns on investment.



But as the U.S. economy continues its feeble recovery, banks are getting greater demand for more-lucrative industrial and commercial loans, which pay a much higher return than the quarter of a percent the Fed pays banks on its borrowings from the $1.5 trillion in reserves they hold in excess of their legal requirements. It uses those borrowings to buy government debt.
The Fed could use its considerable muscle with the banks to hold on to those reserves, but denying lending to the private sector hardly furthers its professed goal of stimulating the economy.


Nonetheless, the Fed is indeed using its muscle to conscript banks into helping it shoulder the federal deficit. The "Volcker Rule" drafted by the Fed and other agencies that regulate banks is a product of the Dodd-Frank Act intended to prevent depository institutions from trading for their own account. But guess what? There's no restriction on trading in Treasurys. Thus the draft regulation joins Basel II regulations, which gives Treasurys a zero-risk rating in the risk-based capital requirements for banks, in tilting bank lending away from the private sector and toward supporting the federal government.


Former FDIC director Sheila Bair has called the Fed's Volcker Rule draft a 300-page "Rube Goldberg contraption," and even Paul Volcker has criticized it. A recent Journal article reported that foreign central bankers are furious that the U.S. Treasury escapes a ban that will apply to trading in their securities.
Bankers are up in arms as well, none of which helps Mr. Bernanke's relationship with the constituency he once represented before the Fed decided to become the handmaiden of the White House and Congress.


But he has bigger troubles than that. The Treasury will keep rolling out tons of low-interest debt and someone has to buy it. Mr. Bernanke has been lucky that Japan and China continue to buy Treasurys and that European debt has been in bad odor, thus sending investors to U.S. bonds as a haven of last resort.


But how long can that last? Chinese and Japanese demand is slipping and there are at least some signs of light in Europe. All of the available signals point to the likelihood that the Fed will have to turn to more vigorous creation of new money (inflation) at some point—or face the possibility of rising market rates on government securities that sharply raise the Treasury's borrowing costs and devalue the Fed's enormous balance sheet.
No way out. No way out.



Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is the author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).

Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

The State of the World: A Framework

By George Friedman

February 21, 2012






Editor's Note: This is the first installment of a new series on the national strategies of today's global power and other regional powers. This installment establishes a framework for understating the current state of the world.

The evolution of geopolitics is cyclical. Powers rise, fall and shift. Changes occur in every generation in an unending ballet. However, the period between 1989 and 1991 was unique in that a long cycle of human history spanning hundreds of years ended, and with it a shorter cycle also came to a close. The world is still reverberating from the events of that period.
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On Dec. 25, 1991, an epoch ended. On that day the Soviet Union collapsed, and for the first time in almost 500 years no European power was a global power, meaning no European state integrated economic, military and political power on a global scale. What began in 1492 with Europe smashing its way into the world and creating a global imperial system had ended. For five centuries, one European power or another had dominated the world, whether Portugal, Spain, France, England or the Soviet Union. Even the lesser European powers at the time had some degree of global influence.
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After 1991 the only global power left was the United States, which produced about 25 percent of the world's gross domestic product (GDP) each year and dominated the oceans. Never before had the United States been the dominant global power. Prior to World War II, American power had been growing from its place at the margins of the international system, but it was emerging on a multipolar stage. After World War II, it found itself in a bipolar world, facing off with the Soviet Union in a struggle in which American victory was hardly a foregone conclusion.
.. The United States has been the unchallenged global power for 20 years, but its ascendancy has left it off-balance for most of this time, and imbalance has been the fundamental characteristic of the global system in the past generation. Unprepared institutionally or psychologically for its position, the United States has swung from an excessive optimism in the 1990s that held that significant conflict was at an end to the wars against militant Islam after 9/11, wars that the United States could not avoid but also could not integrate into a multilayered global strategy. When the only global power becomes obsessed with a single region, the entire world is unbalanced. Imbalance remains the defining characteristic of the global system today.
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While the collapse of the Soviet Union ended the European epoch, it also was the end of the era that began in 1945, and it was accompanied by a cluster of events that tend to accompany generational shifts. The 1989-1991 period marked the end of the Japanese economic miracle, the first time the world had marveled at an Asian power's sustained growth rate as the same power's financial system crumbled. The end of the Japanese miracle and the economic problem of integrating East and West Germany both changed the way the global economy worked. The 1991 Maastricht Treaty set the stage for Europe's attempt at integration and was the framework for Europe in the post-Cold War world. Tiananmen Square set the course for China in the next 20 years and was the Chinese answer to a collapsing Soviet empire. It created a structure that allowed for economic development but assured the dominance of the Communist Party. Saddam Hussein's invasion of Kuwait was designed to change the balance of power in the Persian Gulf after the Iraq-Iran war and tested the United States' willingness to go to war after the Cold War.
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In 1989-1991 the world changed the way it worked, whether measured in centuries or generations. It was an extraordinary period whose significance is only now emerging. It locked into place a long-term changing of the guard, where North America replaced Europe as the center of the international system. But generations come and go, and we are now in the middle of the first generational shift since the collapse of the European powers, a shift that began in 2008 but is only now working itself out in detail.
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What happened in 2008 was one of the financial panics that the global capitalist system periodically suffers. As is frequently the case, these panics first generate political crises within nations, followed by changes in the relations among nations. Of these changes, three in particular are of importance, two of which are directly linked to the 2008 crisis. The first is the European financial crisis and its transformation into a political crisis. The second is the Chinese export crisis and its consequences. The third, indirectly linked to 2008, is the shift in the balance of power in the Middle East in favor of Iran.

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The European Crisis


The European crisis represents the single most significant event that followed from the financial collapse of 2008. The vision of the European Union was that an institution that would bind France and Germany together would make the wars that had raged in Europe since 1871 impossible. The vision also assumed that economic integration would both join France and Germany together and create the foundations of a prosperous Europe. Within the context of Maastricht as it evolved, the European vision assumed that the European Union would become a way to democratize and integrate the former Communist countries of Eastern Europe into a single framework.

. However, embedded in the idea of the European Union was the idea that Europe could at some point transcend nationalism and emerge as a United States of Europe, a single political federation with a constitution and a unified foreign and domestic policy. It would move from a free trade zone to a unified economic system to a single currency and then to further political integration built around the European Parliament, allowing Europe to emerge as a single country.

Long before this happened, of course, people began to speak of Europe as if it were a single entity. Regardless of the modesty of formal proposals, there was a powerful vision of an integrated European polity. There were two foundations for it. One was the apparent economic and social benefits of a united Europe. The other was that this was the only way that Europe could make its influence felt in the international system.

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Individually, the European states were not global players, but collectively they had the ability to become just that. In the post-Cold War world, where the United States was the sole and unfettered global power, this was an attractive opportunity.
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The European vision was smashed in the aftermath of 2008, when the fundamental instability of the European experiment revealed itself. That vision was built around Germany, the world's second-largest exporter, but Europe's periphery remained too weak to weather the crisis. It was not so much this particular crisis; Europe was not built to withstand any financial crisis. Sooner or later one would come and the unity of Europe would be severely strained as each nation, driven by different economic and social realities, maneuvered in its own interest rather than in the interest of Europe.
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There is no question that the Europe of 2012 operates in a very different way than it did in 2007. There is an expectation in some parts that Europe will, in due course, return to its old post-Cold War state, but that is unlikely. The underlying contradictions of the European enterprise are now revealed, and while some European entity will likely survive, it probably will not resemble the Europe envisioned by Maastricht, let alone the grander visions of a United States of Europe. Thus, the only potential counterweight to the United States will not emerge in this generation.
. China and the Asian Model

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China was similarly struck by the 2008 crisis. Apart from the inevitably cyclical nature of all economies, the Asian model, as seen in Japan and then in 1997 in East and Southeast Asia, provides for prolonged growth followed by profound financial dislocation. Indeed, growth rates do not indicate economic health. Just as it was for Europe, the 2008 financial crisis was the trigger for China.
. China's core problem is that more than a billion people live in households earning less than $6 a day, and the majority of those earn less than $3 a day. Social tensions aside, the economic consequence is that China's large industrial plant outstrips Chinese consumer demand. As a result, China must export. However, the recessions after 2008 cut heavily into China's exports, severely affecting GDP growth and threatening the stability of the political system. China confronted the problem with a massive surge in bank lending, driving new investment and supporting GDP growth but also fueling rampant inflation. Inflation created upward pressure on labor costs until China began to lose its main competitive advantage over other countries.
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For a generation, Chinese growth has been the engine of the global economic system, just as Japan was in the previous generation. China is not collapsing any more than Japan did. However, it is changing its behavior, and with it the behavior of the international system.

. Looking Ahead

. If we look at the international system as having three major economic engines, two of them -- Europe and China -- are changing their behavior to be less assertive and less influential in the international system. The events of 2008 did not create these changes; they merely triggered processes that revealed the underlying weaknesses of these two entities.
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Somewhat outside the main processes of the international system, the Middle East is undergoing a fundamental shift in its balance of power. The driver in this is not the crisis of 2008 but the consequences of the U.S. was in the region and their termination. With the U.S. withdrawal from Iraq, Iran has emerged as the major conventional power in the Persian Gulf and the major influence over Iraq. In addition, with the continued survival of the al Assad regime in Syria through the support of Iran, there is the potential for Iranian influence to stretch from western Afghanistan to the Mediterranean Sea. Even if the al Assad regime fell, Iran would still be well-positioned to assert its claims for primacy in the Persian Gulf.

Just as the processes unleashed in 1989-1991 defined the next 20 years, so, too, will the processes that are being generated now dominate the next generation. Still powerful but acutely off-balance in its domestic and foreign policies, the United States is confronting a changing world without yet having a clear understanding of how to deal with this world or, for that matter, how the shifts in the global system will affect it. For the United States strategically, the fragmentation of Europe, the transformation of global production in the wake of the Chinese economy's climax, and the dramatically increased power of Iran appear as abstract events not directly affecting the United States.

Each of these events will create dangers and opportunities for the United States that it is unprepared to manage. The fragmentation of Europe raises the question of the future of Germany and its relationship with Russia. The movement of production to low-wage countries will create booms in countries hitherto regarded as beyond help (as China was in 1980) and potential zones of instability created by rapid and uneven growth. And, of course, the idea that the Iranian issue can be managed through sanctions is a form of denial rather than a strategy.

Three major areas of the world are in flux: Europe, China and the Persian Gulf. Every country in the world will have to devise a strategy to deal with the new reality, just as 1989-1991 required new strategies. The most important country, the United States, had no strategy after 1991 and has no strategy today. This is the single most important reality of the world. Like the Spaniards, who, in the generation after Columbus' voyage, lacked a clear sense of the reality they had created, Americans have no clear sense of the world they find themselves in. This fact continues to define how the world works.

Therefore, we next turn to American strategy in the next 20 years and consider how it will reshape itself.