The problem with Ben Bernanke

The Senate voted on Thursday 70-30 to reconfirm Ben Bernanke as Chairman of the Federal Reserve. It was the closest vote ever for a Fed chairman, and reflects a growing unease in the country about the state of our monetary affairs.

The concern makes a lot of sense. Somewhere deep in their bones, the American people know something is wrong. But they still can’t put their finger on the problem.

The basic crisis runs to the philosophy of the Fed and its monetary policy. Almost every economist or investor you can find will declare without question that low interest rates spur economic growth and that high interest rates slow the economy. Even beyond Wall Street, most Americans unthinkingly accept this notion. What most people don’t realize is that it runs contrary to both classic economic theory and recent examples in other countries.

Classic economic theory says that if a country wants to encourage investment, it needs high interest rates to attract capital. This doctrine was widely embraced in the 19th and early 20th centuries, during which several financial crises resulted from interest rates being too low in the U.S. relative to other countries. For instance, the Panic of 1907 partially resulted from the Bank of England raising interest rates, which drew gold away from New York and threatened to cause a run on the banks.

World War I changed everything because the U.S. accumulated so much gold from exporting war materiel that it was no longer needed foreign capital. As a result Americans have forgotten this basic principle of capital flows.

However, the rule still applied elsewhere: Asia’s emerging markets in the 1990s, for example, used high interest rates to attract large amounts of foreign capital in the 1990s. A similar pattern appeared in China as recently as 2007, when foreigners smuggled money into the mainland to earn higher rates of return. These so-called “hot money” flows increased the credit available in the Chinese economy and were considered a source of inflationary pressures. That’s right: High rates caused inflation.

Low rates can also have the opposite effect. Reacting to its own financial crisis in the early 1990s, Japan has maintained a policy of interest rates close to 0% for more than a decade. The Japanese citizenry has responded by shipping trillions of yen to countries such as Australia and New Zealand, where they could make more money. The result has been a completely stagnant domestic economy, worsening employment and all the related social problems, such as rising suicide rates and plunging fertility.

As I said, the U.S. stopped relying on foreign capital during WWI. That situation largely continued until the 1990s, when Asian countries starting earning billions of dollars exporting electronics, shoes and automobiles to the U.S. This left them flush with dollars, which they used first to buy first Treasury bonds, then Fannie Mae and Freddie Mac securities and finally corporate bonds and private-label mortgage-backed securities — also known as subprime debt.

The numbers speak for themselves: Foreign money accounted for less than 20% of U.S. borrowing every year between 1952 and 1986. It first broke above 30% in 1992, above 40% the next year and then spiked over 50% in 1996. By the 2000s, the U.S. was routinely getting about half its money from other countries. (All of these numbers are derived from Tables F.1 and F.107 of the Fed’s quarterly Flow of Funds report.)

While reality changed, economic theory stood still. The country has returned to financial system that more resembles the 19th century than the 20th century, yet most economists still cling to a paradigm that died more than a decade ago. There is perhaps no greater bastion of the old religion than the Federal Reserve under Ben Bernanke.

These numbers might sound abstract, but they have real-world consequences. The most important point is that capital is both mobile and dynamic. If it isn’t treated well in one country, it will leave or even die.

Imagine you had a brokerage account at a company like Charles Schwab or Merrill Lynch. Imagine they told you: You have to be invested in stocks all the time, and you will be charged 5% every time you hold cash in the safety of a money-market fund. Would you ever put any funds in brokerage account like that, knowing that you had to be invested all the time? Deprived of safety, most people wouldn’t risk investing at all.

Yet, this is precisely what the Fed’s, or the Bank of Japan’s, low interest rates are doing: causing capital flight and making money stream out of the country. That’s a big reason why countries like Brazil and China saw their stock markets soar 500-1000% last decade while the U.S. lost value. It’s also why companies have focused on overseas growth, and why everyone is buying gold. All of these developments show money is leaving the U.S. financial system, where it gets no respect.

Another way to think about it is to imagine a rabbit that lives underground, and emerges everyday to hunt for food. The rabbit can survive challenges like long periods of hunger and outrun predators. However, it still must return to the safety of its hole. Take away its secure place to rest, and the animal will soon die. Even worse, it will fail to raise its young and the species will go extinct.

Your bank account is like the rabbit’s hole in the ground. The best way to rebuild a base of capital is to raise interest rates, which encourages people to accumulate money. At a certain point, those savings will be put to use building businesses and driving investment, just as baby rabbits one day emerge after reaching the necessary size and strength underground.

Money, like nature, is dynamic. Unfortunately most economists and policymakers still embrace a zero-sum view of human behavior.

That’s why they doubted Reagan’s tax cuts. Despite all their degrees and textbooks, they didn’t understand that lower tax rates would stimulate economic activity and give the government even more money. The Gipper, along with advisers like Art Laffer and Larry Kudlow, understood that if the government punishes prosperity with high taxes, it will destroy wealth.

Likewise, Americans need to realize now that if the Fed punishes savings with low interest rates, it will destroy capital.

The example of Japan is staring us in the face like a red and yellow flashing neon sign, warning us that low interest rates spell economic atrophy and death. Will we heed the example, or will ignore reality, as the liberals do?

Yes, some people argue that high rates will hurt the banks. I’ll address that issue in another posting soon.

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