Wednesday, February 01, 2006

Bernanke's conundrum

With his retirement yesterday, former Fed Chairman Alan Greenspan leaves his successor, Ben Bernanke, with a conundrum of his own.

In the last quarter of 2005, the economy slowed dramatically. Greenspan contributed significantly to the artificial economic expansion of the last several years. And now the risks of that artifice will be left for his successor to manage.

Greenspan’s artifice stands on two wobbly legs – tax cuts and cheap money. Greenspan supported the $1.6 trillion in tax cuts – 36.7% of whose benefits went to the top 1% of earners -- pushed by the President. And he lowered interest rates to encourage borrowing.

The economy responded to the artificial stimulus. Housing prices increased 50% and consumer spending – fueled by credit cards and home equity loans -- kept the economy from imploding.

Unfortunately, this artificial expansion has a dark side. The Federal government went from a roughly $200 billion surplus to at least a $400 billion deficit (forecast for this year). The savings rate -- at negative 0.5% -- has not been so low since the Great Depression. Personal bankruptcies are at a record and home foreclosures are spiking.

But this dark side is not a concern for the White House. Its financial supporters – the oil industry and Wall Street – have never had it better. Exxon Mobil just reported a corporate record quarterly profit and Wall Street bonuses have never been higher – despite a flat stock market.

This does not help the 60,000 auto workers whose jobs GM and Ford executives intend to eliminate over the next five years. But they are probably Democratic voters anyway.

With interest rates rising, fewer consumers will be able to afford to keep paying the debt service costs required to keep up with exorbitant housing costs, high heating bills, record gas prices, and spiking health care bills. This could result in decreased demand for many consumer products -- leading corporations to cut staff to preserve their margins.

So Bernanke faces a conundrum: How can the Fed control inflation in a world where consumer prices are rising rapidly without exacerbating an economic slowdown being fueled by Greenspan’s wobbly economic legacy? The answer is of more than academic significance for this former Princeton professor – and for the rest of the world.


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