US Federal Reserve has a Sophie's Choice by Gaurang Bhatt, MD

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Random Thoughts
US Federal Reserve has a Sophie's Choice
by Gaurang Bhatt, MD

Most people are familiar with the (book and movie Sophie's Choice) Jewish mother’s dilemma when a Nazi officer tells her that one of her two children will be executed and it is for the mother to decide, which one.

The Federal Reserve like all reserve banks, manages the money supply and interest rates to keep the economy growing while keeping inflation in check. It plays a secondary role in maintaining the value of the dollar. The US Treasury has that primary responsibility.

Greenspan was a paid hack of the Republicans and to maintain his job and the adulation of the financial markets and the big institutions, he made decisions that will haunt the nation forever. He was the chief honcho of the commission to put social security on a sound footing. He opted for an increase of the upper limit of the income that was taxable for the pension and disability benefits and raised the rates. If he was in favor of a flat rate, he could have made all earned income taxable for those benefits but he kept the taxable limit well below those of the rich and powerful.

The limits have been rising steadily but only up to about hundred and fifty thousand, so far. Many Americans pay more taxes for social security than for income taxes. Once again the middle class bears a disproportionately larger burden.

He failed to ensure that the social security tax receipts to be kept segregated. The irresponsible Congress and Presidents spent the surpluses in pork barrel projects and defense and left the trust fund with IOUs which the government cannot redeem except by printing more money. The growth of the money supply and the rapidity of its turnover are the factors that fuel inflation. Thus sometime by 2012, the Fed will have to run the money printing presses overtime.

The soaring budget, trade and current account deficits add to the rising interest payment burden of the US government. The fortuitous surpluses of the Clinton era were due to the stock market bubble and scandalous option related enrichment of insiders leading to higher tax receipts and resultant surpluses. These evaporated with the debacle of 2000. In spite of being fully aware of this, Greenspan encouraged Bush to enact massive tax cuts in favor of the rich and threw prudence to the winds. This is what happens when one puts the fox to guard the henhouse.

After 9-11, Greenspan opened up the money spigots to enrich the financial institutions by cutting the lending rate to 1%. Banks could borrow from the Fed at one percent and lend at 5% (home equity loans) to 10% for auto and personal loans and 20% for credit cards. Thus they were ensured windfall profits. The marked increase in money supply barely stabilized the sinking stock market, but led to galloping inflation in home prices and commodities like gold, silver, copper and oil. Whenever home prices rise disproportionately greater than job incomes, houses become less affordable.

Greenspan did not raise Fed margins for buying stocks or interest rates to curb the irrational exuberance of markets. Even as he was aware of the bubble in housing due to his folly of lowering interest rates, he encouraged irresponsible borrowing by touting adjustable rate mortgages and permitting irresponsible lending, like mortgage payments less than even accrued interest, with negative amortization and ballooning principal. These inevitably have led to delinquencies and foreclosures, first in the sub-prime market and the contagion is sure to spread to the prime market as well. The greed of the financial markets led to baiting by mortgagees with low payments, while hiding in small print the future consequences of higher rates leading to unaffordable monthly payments. The Fed’s job as a former chairman said, is to take away the punch bowl when the party (economy) gets going. Greenspan’s dereliction of duty is that he kept spiking the punch after the party got going and served it to those who were ignorant minors in financial matters.

Now the problems have come home to roost. Business cycles are the inevitable curse of capitalism. This expansion is long in tooth and looking tired. The tacit encouragement of the greed of insiders of corporations who finance both the Democrats and Republicans, allowed Clinton and the current boy king junior to hollow out US manufacturing by exporting jobs. This led to a jobless recovery without the expected surge in wages.

The deteriorating public school system in cities and inner suburbs has led to expensive development of exurbia. Middle class families are forced into what a Harvard professor and her daughter call a “Two Income Trap” (title of their book). To afford decent housing in a good school district, husband and wife both need full time jobs just to pay the higher monthly payments. The long commute to jobs in the city increases their commuting expenses due to distance and higher gas prices. Thus the family is teetering on a delicately balanced but potentially unstable seesaw. A minor increase in the financial burden like rising interest rates upsets the apple cart and breaks the camel’s back like the proverbial straw.

The greater problem is not only individual families but even the nation is in dire straits. The national debt is nearly eight trillion dollars and at a 5% interest rate requires 400 billion in annual interest payments to service the debt. The debt is rising at the rate of nearly a trillion dollars a year. Future unfunded liabilities for Medicare including the new Part D drug benefit, wounded veterans’ pensions and healthcare etc. are 40 trillion dollars in current money.

The housing bubble is bursting. The consumer has been using home equity loans as a piggy bank. The US economy is 70% dependent on consumer spending. Consumer spending exceeds personal income and consumers are also overloaded with debt. The housing crash may lead to reduced consumer spending and recession in the economy. Thus the Fed would like to lower interest rates to reduce the nation’s and the consumer’s debt burden.

The problem is that prior unwise Fed policies and Bush’s foolish misadventures in Iraq have doubled oil prices and inflation is chafing at its leash ready to pounce with a roar. This requires raising interest rates, but that would lead to a precipitous fall in house prices and sink the economy. On the other hand, lowering interest rates would unleash inflation and throw the dollar into a precipitous fall. The Fed is like a husband, wife and two kids in a leaky lifeboat. The dilemma is whom to throw overboard. The children are “curbing inflation” and “growing the economy” and the wife is “the dollar”. The man’s name is Bernanke.

We know what Greenspan or Bush did in such circumstances, grinned foolishly. They remind me of a story from the Mahabharata which I have quoted before in my articles about a man who fell into a well to quench his thirst (for oil). He grabbed a branch of an overhanging tree. As he flailed his other arm to get a second support, he noticed that an elephant (China) was trying to uproot the tree itself. He saw that some rats (OPEC Nations) were gnawing at the very branch he was hanging by. He looked down and saw serpents (insurgencies in Iraq, Afghanistan and belligerent Iran) waiting at the bottom of the well to fatally bite him, if he fell down. It started raining (Democrat control of the House and Senate) making his grip on the (executive) branch less secure. His desperately searching left arm upset a beehive and the angry bees (Chavez, Castro, Morales of Bolivia, Correa of Ecuador and Ortega of Nicaragua) stung him. Even his God wondered, why Bush smiled. The reason was that the break up of the hive caused a few drops of honey (sweet taste of executive privilege) to fall in his open panting mouth and his limited synaptic makeup was incapable of a bigger picture and all his neurons could handle only one present and immediate input. Such is the repertoire of a shrub’s brain, capable only of an unexamined life. No wonder Zbigniew Brzezinski in his latest book “Second Chance” gives Bush a grade of “F”.

March 31, 2007

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