Fed chairman's assessment sunny, but quite unrealistic

Ben Bernanke continues to reject the idea that the stalling recovery could morph into a long-lasting downturn, despite evidence to the contrary, writes Adrian Pabst.

The US Federal Reserve chairman Ben Bernanke. Reed Saxon / AP Photo

Amid signs of a "double-dip" recession or Japan-style stagnation for years to come, Ben Bernanke, the chairman of the US Federal Reserve, continues to reject the idea that the stalling recovery could morph into a long-lasting downturn.

In an eagerly anticipated speech on Friday to an annual gathering of central bankers and economists at Jackson Hole, Wyoming, he acknowledged short-term setbacks to America's economy but held out the prospect of long-term growth and prosperity.

The trouble with his upbeat assessment is that it is increasingly at odds with reality. Indeed, the stop-start economic recovery in the US and Europe is already the weakest since the Second World War, despite an unprecedented monetary and fiscal stimulus.

Mr Bernanke's intervention came on the day when the estimates for US second-quarter economic growth were slashed to just 1 per cent a year, down from 1.3 per cent.

The world economy may grow by as much as 3 per cent this year, but there is growing evidence that the US and Europe are close to recession.

With output down and inflation up, business and consumer confidence has taken a major hit. Since peaking in May, almost 20 per cent has been wiped off the value of global shares. Economists at Credit Suisse said there was a one-in-two chance of a worldwide slump.

In this context, Mr Bernanke was at least right not to announce a third round of quantitative easing, or QE. In March 2009 and November last year when the Fed began to implement two vast programmes of purchasing assets, stock markets went up for a while. But in each case, shares stopped rising about the same time QE ended.

Crucially, higher share prices did not translate into lasting investment and consumption that would sustain the recovery and reduce unemployment.

Instead, central bank monetary assistance has created a lot of "hot money" that is flowing in and out of shares and commodities.

That has led to some spectacular speculative gains for global hedge funds, major investment banks and commodity trading companies. Little wonder that stock markets were clamouring for yet another "fix" of cash injections.

But investors' addiction to the drug administered by Mr Bernanke is not just distorting financial markets around the world by exacerbating volatility.

Worse still, QE has fuelled real inflation and thereby depressed the disposable income of ordinary households in the US and Europe that are deleveraging.

Without more private spending, businesses simply won't invest.

In short, the real economy has hardly benefited from two rounds of monetary stimulus. That, coupled with a poorly designed programme of fiscal expansion, has failed to boost growth and create jobs.

So what will? Mr Bernanke reiterated the Fed's commitment to hold down interest rates for the next two years, which will help.

But despite the lowest rates on record, both the public and the private sector across western economies is focusing too much on debt and too little on investment.

That is why he belatedly warned US (and possibly European) politicians not to sacrifice the fragile recovery on the altar of sovereign debt.

Mr Bernanke implicitly urged the Obama administration to design fiscal policies that promote a more productive economy.

In one of the more interesting sections of his speech, he said that "our nation's tax and spending policies should increase incentives to work and to save, encourage investments in the skills of our workforce, stimulate private capital formation, promote research and development, and provide necessary public infrastructure".

The fact that US banks and corporations sit on funds worth about US$2 trillion (Dh7.34tn) adds to the urgency of channelling finance into productive activities.

As such, the chairman of the world's most powerful central bank sought to deflect the spotlight from the Fed back to Congress and the White House. The focus of markets and commentators will now shift to President Barack Obama's major economic policy speech on September 5.

But the political stalemate in Washington leaves little room for fiscal manoeuvre.

Radicalised by the Tea Party, Republicans seem determined to enact some measure of short-term fiscal tightening that will hurt the recovery. Any further shock, and the US could find itself in a recession come winter.

For now, the Fed thinks the US will pull through the choppy waters of the global recovery. But if the jobs package and other stimulus measures planned by the embattled Obama administration fail to boost confidence in the weeks and months ahead, the Fed stands ready to act - if necessary by launching a third round of QE.

Thus, Mr Bernanke's speech confirms that the Fed will do just enough to avert a 1930s-style deflation. But the as yet unanswered question is how monetary policy can help reconnect finance to the real economy.

Adrian Pabst is lecturer in politics at the University of Kent, UK, and visiting professor at the Institut d'Etudes Politiques de Lille, France