Seven Questions: What Awaits Ben Bernanke

FOREIGN POLICY: What is your reaction to the nomination of Ben Bernanke to be Chairman of the Fed?

Steven Roach: He was my second favorite choice. Hes a very solid financial economist. It just remains to be seen as to whether or not hes going to be able to successfully navigate what I think are going to be very turbulent waters in 2006, still dominated by current account adjustment issues and potential dollar risk. We know hes an inflation targetter at heart, but in practice thats another thing all together, especially as the chairman of the Fed.

FP: How do you think Wall Street and other global markets will react to the announcement?

SR: I think initially the knee-jerk reaction will be positive, because hes a solid guy. But I think that history tells us that even solid guys get tested early in their tenures as Fed chairman. Paul Volcker was tested, Alan Greenspan was tested, and I dont think Bernanke will be given special dispensation, especially since there are so many issues that America faces with respect to its deficits.

FP: In an FP article you wrote earlier this year, you pointed to the shortcomings of Federal Reserve Chairman Alan Greenspans policies. Have you seen anything in the last nine months that addresses some of those shortcomings?

SR: No. What weve seen, though, is a remarkable reversal of his own opinion on many of the issues that I raised. About three weeks ago, he released a very rare research paperonly the second research paper hes written in the 10 years of his chairmanship. It deals with measuring equity extraction from homes. He lays out the metrics and says how significant the housing bubble has been and the consumers willingness to extract purchasing power from their overvalued homes to support the economy. Thats a huge reversal of his belief that the housing bubble is not such a big deal.

Then he gave a couple of speeches that same week on economic flexibility where he admitted that low, nominal interest rates, which the Fed controls, have left the economy with a [greater] bias toward experiencing asset bubbles than might otherwise have been the case. This is a real shift.

FP: If you had to give the current U.S. economy a grade, what would it be?

SR: Id give it a gentlemans C. On the surface, GDP is good, inflation is low, and so is the unemployment rate. Beneath the surface, we have unprecedented imbalances in terms of low national savings. Two of the three pieces of national savingsthe consumer piece and the government pieceare in the red. We have a record balance-of-payments deficit. We have record levels of household-sector indebtedness, and [a record number] of consumers living beyond their means. Superficially, it looks OK. Beneath the surface, it looks disconcerting.

FP: Whats the likelihood of a U.S. recession?

SR: I put a 40 percent chance on a recession next year, which is high.

[Rising energy prices] are a big concern because they are hitting a consumer that has been stretched in an unprecedented fashion. The consumer savings rate right now is negative 1 percent, the lowest its been since 1933, which was not a terrific year. [During] the last 3 energy shocksmid 70s, late 70s and early 90sthe same savings rate averaged 8 percent. We had a cushion that we could use to fund higher energy expenses. There is no cushion today. Consumption is going to get hit hard unless theres immediate relief on energy product prices such as natural gas and gasoline, and home heating oil.

FP: What economic policy change, in your view, is most urgent for theWhiteHouse right now?

SR: The most urgent thing is for the White House to focus on boosting national savings. There are two pieces to that: bringing the deficit down and putting in place policies that will stimulate private-sector savings, especially for households.

FP: The United States has spent $357 billion fighting the war on terror. What impact is that having on the economy?

SR: To commit to massive military expenditures with record lows in our private savings rate means that were passing the bill off to othersnamely, our foreign creditors. The amazing thing so far is that they are paying the bill without demanding concessions on the terms of their payment in the form of a weaker dollar and/or higher interest rates in the United States. I think thats coming, so the American public will have to pay in one way or another. As long as the Bush administration refuses to raise taxes to foot the bill, then most likely the bill will come in the form of higher interest rates….

We have a long, patriotic history of fighting wars and raising the revenue base to fund it. [Now] were fighting wars and were just raising the balance-of-payments deficit to fund it and asking foreigners to do that. That is not the American way. If were going to continue to broaden our reach as a nationmilitarily, with disaster relief post-Katrina, and broadening the safety net because Americas negligence of the underclass has been exposedand cut taxes, which is what these supply-siders want to do, were asking for a fiscal train wreck.

Stephen S. Roach is chief economist at Morgan Stanley.