Bernanke’s knows deficits are a problem and unsustainable as well. He is even warning Congress about them. Bernanke also knows that the Fed is going to have to unwind the garbage on its balance sheet.

Bernanke sees the problems, yet he is still willing to add to those problems. This is clearly a case of Monkey See Monkey Don’t.

Let’s investigate the situation starting with Treasuries Rise as Bernanke Warns on Deficits, Fed Buys Debt.

Treasuries rose for a second day after Federal Reserve Chairman Ben S. Bernanke said large budget deficits threaten financial stability and the central bank purchased $7.5 billion of U.S. government securities.

Yields on 10-year notes declined as the Fed chief said deficit concerns are already influencing the prices of long-term Treasuries after yields climbed to the highest since November last week. The central bank plans to purchase U.S. debt again tomorrow as part of its $300 billion, six-month effort to cap lending rates.

The U.S. can’t continue to borrow at the current rate to finance the budget deficit, Bernanke said in testimony to the House Budget Committee today.

“Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth,” Bernanke said. “Maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance.”

Bill Gross, founder of Pacific Investment Management Co., said Treasury Secretary Timothy Geithner’s plan to bring the budget back into balance won’t be successful as consumers shrink spending and the U.S. growth rate slows. The budget deficit will be narrowed to “roughly” 3 percent of GDP from a projected 12.9 percent this year, Geithner said June 1.

‘Balanced Rabbit’

“I think he’ll fail at pulling a balanced rabbit out of a hat,” Gross said in a Bloomberg Radio interview today from Pimco’s headquarters in Newport Beach, California. “They are talking about — once the economy in the U.S. renormalizes –the move back toward balance or much less of a deficit. I suspect that will be hard to do.”

Gross advised holders of U.S. dollars to diversify before central banks and sovereign wealth funds ultimately do the same amid concern about surging deficits.

Dearth of Rabbits

I suspect Gross is talking his book and the dollar may be poised for a rally as noted in Speculative Bets Against The Dollar Highest Since July 15 2008.

However, I happen to agree with the idea that there is a dearth of rabbits available to pull out of hats.

It’s your problem, Bernanke tells Congress

The question of the day is: Who is going to shut off the spigot? Clearly it’s not the Fed, at least not Bernanke, as noted above. Indeed, Bernanke tells Congress, It’s your problem.

Congress and the people who elected it must decide how much government they want to afford, Bernanke said. Stating the obvious, he went on to say: “Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run.”

Unfortunately, Congress and the people have seldom gotten the balance right. We want the benefits of a large government without paying the costs, just as we wanted a loftier personal living standard than our income could support.

For its part, the Fed also faces having to make some tough choices. The U.S. central bank has lowered interest rates substantially and has expanded its balance sheet by about $1.2 trillion, effectively flooding the banking system with cash to keep the economy from collapse.

Everyone knows this and accepts it in principle — but in practice, it will come down to knowing when to let go. It will require a deft hand and a dollop of good luck to keep the economy from crashing back to the ground or, conversely, from soaring like Icarus and burning up with inflation.

Sadly, the Fed’s near-impossible task is child’s play compared with the problem faced by the Obama administration, the Congress and the people.

Tough Decisions For The Fed

Inquiring minds are reading An Economy at Risk: The Tough Decisions Ahead by Thomas Hoenig, President, Federal Reserve bank of Kansas City. Here are a few quotes.

“In the long run we are all dead but our children will be left to pick up the tab”.

“In our efforts to fix the oversight process for our financial system, we should not misdiagnose the patient. Unfortunately, I’m afraid we are witnessing some regulatory malpractice now. The emphasis on reform at the moment is to change the structure of the regulatory system rather than address the fundamental weakness of that system.”

“Capitalism is a process of success, failure and renewal, and for it to work properly, institutions must be allowed to fail, no matter their size or political influence.”

“Over the past two decades, The US has created for itself a set of economic imbalances that, in my judgment, have significantly increased uncertainty and placed economic growth at risk for future generations of Americans”.

“Starting from where we are today, it is clear that interest rates must rise.”

“I suspect there will be considerable pressure on the central bank to ‘help out’ in easing this adjustment process by keeping interest rates low for an extended period. This happens because people often confuse the establishment of low interest rates – and therefore the creation of money – with the creation of wealth”.

Fed’s Hoenig Is A Monkey See Monkey Don’t Policy Advocate

The first quote above is Hoenig quoting Keynes, and one of the few things Keynes said that makes much sense. Most of the rest seem to come from the Austrian economic handbook.

I especially like “In our efforts to fix the oversight process for our financial system, we should not misdiagnose the patient. Unfortunately, I’m afraid we are witnessing some regulatory malpractice now. The emphasis on reform at the moment is to change the structure of the regulatory system rather than address the fundamental weakness of that system.

Yes indeed, it is the Fed and Fractional Reserve Lending that are the “fundamental weakness of that system” and no amount of regulation can possibly fix that problem. Please see Case Against the Fed and Fractional Reserve Lending for details.

Yet, for all Hoenig’s talk, where is the action? Where are the dissenting votes? More so than Bernanke, Hoenig seems to understand at least a few basic principles including the extremely important distinction between rising prices with rising wealth.

However, actions (or lack of them) speak louder than words. I hope Hoenig can prove me wrong, but as of right now Hoenig appears to be a willing participant of Bernanke’s Monkey See Monkey Don’t Policy.

No Rabbits For Obama Or Congress Either

The magic hats are empty. There are no rabbits to be found.

Monkeys are large and in charge, everywhere one looks. Meanwhile, rabbits are hiding in Wonderland with Bernanke chasing them down the zero interest rate hole. Unfortunately, even the monkeys who see problems and know what to do about them are unwilling to make the tough choices necessary.

It’s a sad case of Monkey See Monkey Don’t.

Mike “Mish” Shedlock
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