Long-Time Economic Forecaster Sees Sobering Future

Henry Kaufman is worried about inflation. It’s not the first time. During the 1970s the noted economist earned the nickname Dr. Gloom by issuing prescient and constant alarms about soaring interest rates and prices. Today, he isn’t quite so worked up, but then, the outlook is not nearly as grim.Nonetheless, over lunch at the Pierre, Mr. Kaufman delivers a scathing criticism of the Federal Reserve Board. In his view, the Fed is not acting decisively enough to break what he describes as “creeping inflation” that ultimately will begin to take a toll on economic activity.What should the Fed do? “They should give up the “measured response” that they’ve been following for the past three years. The Fed follows an asymmetrical policy. They’re faster to accommodate than to restrain,” says Mr. Kaufman. Moreover, the Fed “hasn’t lived up to one of its mandates – to preserve and protect the sanctity of the financial markets.”This is tough talk, coming from a fellow that serves on the international advisory committee of the New York Fed, and who has had more than a passing acquaintance with every Fed Chairman but Ben Bernanke for the past 50 years.It’s also an admitted reaction to a childhood spent in Germany during a period of devastating inflation. “My grandfather spoke endlessly about escalating prices. He had owned a lot of farmland and there were mortgages on these farms. Farmers used to come to him to pay off the mortgages with bushels of money.”Inflation was not of course what drove the Kaufman family from Germany. “We were the victims of Nazism, and I was also the beneficiary. I ask myself all the time why me and not someone else,” he says. “We lived in a small town near Frankfurt. We were forced to move out in January 1937. There was a torchlight parade in the town and they broke into our house and destroyed everything downstairs. We were upstairs. We fled.”At 79, Henry Kaufman is as engaged as ever in the economic dialogue of our time. His perspective, certainly, has been colored by his long-time involvement with debt markets and stint as research director and executive committee member at Salomon Brothers. Today he serves on numerous boards, including Lehman Brothers and New York University’s Stern School of Business, where he is chairman emeritus, and he also heads an eponymous consulting firm.He’s not too busy, however, to be contemplating his next book. His theme? The growth of enormous financial institutions, and the consequent constraints on government financial policy. Mr. Kaufman has a high regard for the kind of research that discerns big trends ahead of the pack. Such a development, in his view, may well be the increasing consolidation among financial intermediaries. He sees increasing global concentration of financial activity into just a few giant institutions which ultimately will undermine competition, creates conflicts of interest and become almost impossible to manage.Evidence of this process, he thinks, is already well underway. Firms such as Goldman Sachs and Citigroup are active in all corners of the financial markets, and they continue to expand. Further consolidation will mean fewer trading entities, reduced liquidity, and greater volatility. The ultimate outcome? “Financial institutions will have to become utilities; they will be too big to fail, and so will have to be too good to fail.” This outcome, Mr. Kaufman is anxious to add, is 10 years or more in the future. Still, given his reputation for seeing into the economic future, his view is sobering.As someone who enjoys this kind of creative long-term thinking, Mr. Kaufman is disdainful of the Fed’s reliance on econometric modeling. “The models are based on the past, not on anticipation of the future. They can’t anticipate changes in the financial markets, which have become increasingly complex. There has been a lot of growth in the diversity of investments since 2000 which haven’t yet been tested.”“It’s very difficult for supervisory agencies to know the totality of risk taking in our financial system,” he says.He is also skeptical of the Fed’s resolve in breaking the upward creep of prices. “No one wants to rock the boat” he says. “The flow of funds around the world has worked better than expected. Who’s going to push the Fed to get tough? Business? The government? No, the Fed will only change course in periods of stress.”Happily, Mr. Kaufman does not expect a repeat of the raging inflation of the 1970s. His concern is for a gradual escalation of prices, which he says “gets tougher to arrest without draconian measures. Eventually inflation will distort business and household decision making, impacting everything from commodities to hard goods. It’s not good for the dollar, either.”Today, according to Mr. Kaufman, inflation is showing up mainly in the services sector, in the prices charged for rents, restaurant meals, medical services and even education.When will Americans become concerned about this trend? “Probably not until the growth in prices exceeds wage increases, or until there is a threat of a slowdown.”He is not looking for a dramatic slowing in the economy next year, though he does see a moderation in corporate profit growth to around 5% to 6%. He expects the Fed to finally raise interest rates — maybe by as much as 50 basis points — in an effort to slow inflation. “Such a move could cast a shadow on bond markets, where spreads are too narrow. If liquidity starts to dry up, the Fed will become nervous. They are most concerned about heading off a recession caused by a drop off in housing. I doubt that a slowing in housing will pull the economy into recession.”It’s not only U.S. financial policies that Mr. Kaufman finds fault with. “The way to alleviate poverty is to improve education,” says Mr. Kaufman. “The United States has the greatest educational institutions in the world at the college level. But, when you get down to grade school and high school, it is terrible.”Notwithstanding his criticisms, he is an inveterate supporter of his adopted country. “No matter how much I travel, there is absolutely no place like this country. Native born Americans cannot fully appreciate it. We take an awful lot for granted.”Present company excluded.

Long-Time Economic Forecaster Sees Sobering Future

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