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We’re all on Easter Island

Brilliant piece, with a great big picture, long-run perspective, from Prudent Bear’s Martin Hutchison:

As long-term U.S. interest rates rise and negative global reactions roll in to the Fed’s Nov. 3 announcement of a further $600 billion round of “quantitative easing” purchases of Treasury bonds, to the inquiring mind one question becomes uppermost: Even though there’s a huge amount of competition for this title, is it indeed possible that this Ben Bernanke masterstroke was the most foolish economic policy move ever?

Even a mere 10 days after its passage, and before significant implementation, it’s clear that Bernanke’s move, in terms of adverse effect compared to the size of the policy move, is well up there. The Fed’s buying program will be concentrated on medium-term Treasury bonds, for two reasons. First, the Fed’s loss of principal if interest rates rise will be less on those. Second, the Fed, when looking at the market’s inflation expectations, looks at the five-year forward rate on five-year Treasury securities—thus buying five-year Treasurys maximizes its impact on its favorite inflation-expectations indicator.

The problem is that the market, being manned by traders and investors rather than academic economists, is more simple-minded. When determining its expectations on future inflation, the market looks at the yield on 30-year Treasurys, possibly comparing it with the yield on 30-year Treasury Inflation-Protected Securities (TIPS).  So the Fed’s Treasury bond-buying program, by raising yields on 30-year bonds (which were more or less excluded from it) increased both long-term yields (and hence home mortgage costs) and the market’s expectations about inflation. The move was directly counterproductive, in other words.

It was also highly counterproductive indirectly. Within days of its announcement, the policy had been denounced by China, Brazil, Germany and various other countries, all of whom accused the U.S. of competitive dollar devaluation—with some reason. The gold price shot though $1,400 and is likely to continue rising as long as the policy is in effect. No less a panjandrum than Robert Zoellick, president of the World Bank, suggested that gold should be reintroduced to the international monetary system. For us long-term gold bugs, this was deeply gratifying, but I’m dang sure it’s not what Bernanke intended.

The final verdict on QE2 will not be given until we have seen its long-term effects. Still, it seems likely that it will eventually rank among history’s classic bungles, at least on the economic front.

The most famous economic policy errors are those that bore much of the responsibility for the Great Depression. However, on close examination, I’m not sure Bernanke doesn’t have them beat, when you consider the information policymakers were working with. The Smoot-Hawley Tariff was certainly damaging, but it represented only a modest increase in duties over the already protective Fordney-McCumber tariff of 1922. The Fed’s failure to print more money after banks started crashing in December 1930 was celebrated by Ben Bernanke himself, but at the time the solution to the nation’s bank failure problem was not obvious—in that pre-Milton Friedman age the mechanics of money supply were poorly understood. Herbert Hoover’s tax increase of 1932, raising the top rate of income tax from 25% to 63%, was perhaps the most stupid policy decision of the Great Depression. But the economy was already close to reaching bottom when it was implemented.

Outside the United States, there are some less debatable instances of foolish policy. British Chancellor of the Exchequer Roy Jenkins, always thought of by his acolytes as a moderate, imposed an income tax rate of 135% on high incomes in 1968. Needless to say, that was great for incentives, and yielded tons of revenue!

Then there’s Mao Zedong’s 1958-61 Great Leap Forward, under which private farming was forbidden and agriculture collectivized. That is estimated to have killed 100 million people, but its motivation was primarily political rather than economic. The same applies to the Soviet collectivization of 30 years earlier. The other notorious famine, the Irish potato famine of 1846-48, was however not political but the result (after the original potato blight) of economic experimentation, in that case the extreme Whig version of free trade. This held that feeding starving Irishmen destroyed their incentive to work—clearly ignoring the idea that a (temporarily) disincentivized peasantry might be preferable to a dead one. The non-Whigs Lord Liverpool 30 years earlier and Lord Salisbury at the India Office 30 years later avoided this economic fanaticism in dealing with famines.

Going further back, one has to include the French Regent Philippe d’Orleans, allowing John Law to take over the French currency in 1718 and giving him a monopoly of paper money issued from his fly-by-night Banque Royale. When the Banque Royale collapsed, unlike in the simultaneous South Sea Bubble crisis in England, the French merchant class had its savings wiped out, making government borrowing very difficult and expensive for the reminder of the century—and leading to the British victories in the Seven Years War and the French Revolution. In mitigation, one can say that the paper money experiment had only been tried on a large scale once before, in Song Dynasty China, where it had worked well until collapsing after the Mongol invasion. No doubt both the Regent and Law were regrettably ignorant of the Chinese experience of half a millennium before.

China gives us another example, this one from 1793, when it was still one of the world’s richest countries, with over 30% of global Gross Domestic Product. The Emperor Qianlong (1736-95), in a letter to George III prompted by the visit of the British delegation under Lord Macartney, grandly opined: “Our Celestial Empire possesses all things in prolific abundance and lacks no product within its own borders. There is therefore no need to import the manufactures of outside barbarians in exchange for our own products.”

It was close to the sentiment that motivated Reed Smoot and motivates today’s protectionist trades union movement, but in the event it proved disastrous—China’s share of world GDP declined to a low of about 4% in 1960. Qianlong’s decision, condemning China to excluding the burgeoning Western machinery and manufactures, was not the only factor in that decline but was key to it.

Finally, to the example of poor economic decision-making that most resembles Ben Bernanke in action, that of 17th century Easter Island. From 1000-1600, the inhabitants of that then-well-forested island had developed a high-level civilization, its religious rituals involving the erection of immense stone moai statues, towed into place on cylindrical tree-trunks. When forestation began to decline, the Easter Islanders seem to have decided that the solution was to erect more moai, devastating the rest of the forests to do so. Needless to say, this was economically a highly foolish decision, causing the island’s relatively sophisticated civilization to collapse. For the next 200 years, the starving remnants of the islanders, doubtless cursing the folly of their ancestors, occupied themselves in pulling down moai one after another, until by the time European colonists took over in 1868 few were left standing.

The Bernanke analogy here is startling. The moai are of course the big banks, which Bernanke believes himself bound to preserve. To establish and nurture big banks requires capital, abundant in the United States until the late 1990s. However, low interest rates, allowing the exponential growth of the moai/banks and their increasing dominance of the U.S. economy, also have the effect of decapitalizing the U.S. economy by suppressing its savings rate and causing repeated capital destruction in crashes. The result of the capital stock thus removed, having been necessary for survival both of the moai/banks and of society as a whole, can only be collapse, this time economic rather than ecological. Bernanke’s second quantitative easing represents the point at which the Easter Islanders realized they had a real problem with deforestation, but decided to redouble their production of moai instead of preserving trees.

At present, therefore, Bernanke’s QE2 policy occupies a leading position in the history of foolish economic decisions, but is not yet at the summit. Should its damage prove only moderate, then Hoover’s income tax increases, the Great Leap Forward and Qianlong’s protectionism are all clearly greater follies, although Bernanke has already moved ahead of Reed Smoot, the 1930-32 Fed, Roy Jenkins and John Law.

There is however a modest probability that Bernanke’s policies will prove to have been the equivalent of Easter Island’s moai obsession, with QE2 being the final stage, ending in decapitalization of the U.S. economy, impoverishment of its people, and a miserable couple of centuries for their descendents tearing down bank buildings. In that case, since the United States is bigger than Easter Island, Bernanke would clearly have proved himself the champion of economic folly.

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