Posted on 01/13/2006 1:17:20 PM PST by Travis McGee
The economy that Alan Greenspan is about to hand over is in a much less healthy state than is popularly assumed
DESPITE his rather appealing personal humility, the tributes lavished upon Alan Greenspan, the chairman of the Federal Reserve, become more exuberant by the day. Ahead of his retirement on January 31st, he has been widely and extravagantly acclaimed by economic commentators, politicians and investors. After all, during much of his 18½ years in office America enjoyed rapid growth with low inflation, and he successfully steered the economy around a series of financial hazards. In his final days of glory, it may therefore seem churlish to question his record. However, Mr Greenspan's departure could well mark a high point for America's economy, with a period of sluggish growth ahead. This is not so much because he is leaving, but because of what he is leaving behind: the biggest economic imbalances in American history.
One should not exaggerate Mr Greenspan's influence—both good and bad—over the economy. Like all central bankers he is constrained by huge uncertainties about how the economy works, and by the limits of what monetary policy can do (it can affect inflation, but it cannot increase the long-term rate of growth). He controls only short-term interest rates, not bond yields, taxes or regulation. Yet for all these constraints, Mr Greenspan has long been the world's most important economic policy maker—and during an exceptional period when globalisation and information technology have been transforming the world economy. His reign has coincided with the opening up to trade and global capital flows of China, India, the former Soviet Union and many other previously closed economies. And Mr Greenspan's policies have helped to support globalisation: the robust American demand and huge appetite for imports that he facilitated made it easier for these economies to emerge and embrace open markets. The benefits to poorer nations have been huge.
Advertisement So far as the American economy is concerned, however, the Fed's policies of the past decade look like having painful long-term costs. It is true that the economy has shown amazing resilience in the face of the bursting in 2000-01 of the biggest stockmarket bubble in history, of terrorist attacks and of a tripling of oil prices. Mr Greenspan's admirers attribute this to the Fed's enhanced credibility under his charge. Others point to flexible wages and prices, rapid immigration, a sounder banking system and globalisation as factors that have made the economy more resilient to shocks.
The economy's greater flexibility may indeed provide a shock-absorber. A spurt in productivity has also boosted growth. But the main reason why America's growth has remained strong in recent years has been a massive monetary stimulus. The Fed held real interest rates negative for several years, and even today real rates remain low. Thanks to globalisation, new technology and that vaunted flexibility, which have all helped to reduce the prices of many goods, cheap money has not spilled into traditional inflation, but into rising asset prices instead—first equities and now housing. The Economist has long criticised Mr Greenspan for not trying to restrain the stockmarket bubble in the late 1990s, and then, after it burst, for inflating a housing bubble by holding interest rates low for so long (see article). The problem is not the rising asset prices themselves but rather their effect on the economy. By borrowing against capital gains on their homes, households have been able to consume more than they earn. Robust consumer spending has boosted GDP growth, but at the cost of a negative personal saving rate, a growing burden of household debt and a huge current-account deficit.
Burning the furniture Ben Bernanke, Mr Greenspan's successor, likes to explain America's current-account deficit as the inevitable consequence of a saving glut in the rest of the world. Yet a large part of the blame lies with the Fed's own policies, which have allowed growth in domestic demand to outstrip supply for no less than ten years on the trot. Part of America's current prosperity is based not on genuine gains in income, nor on high productivity growth, but on borrowing from the future. The words of Ludwig von Mises, an Austrian economist of the early 20th century, nicely sum up the illusion: “It may sometimes be expedient for a man to heat the stove with his furniture. But he should not delude himself by believing that he has discovered a wonderful new method of heating his premises.”
As a result of weaker job creation than usual and sluggish real wage growth, American incomes have increased much more slowly than in previous recoveries. According to Morgan Stanley, over the past four years total private-sector labour compensation has risen by only 12% in real terms, compared with an average gain of 20% over the comparable period of the previous five expansions. Without strong gains in incomes, the growth in consumer spending has to a large extent been based on increases in house prices and credit. In recent months Mr Greenspan himself has given warnings that house prices may fall, and that this in turn could cause consumer spending to slow. In addition, he suggests that foreigners will eventually become less eager to finance the current-account deficit. Central banks in Asia and oil-producing countries have so far been happy to buy dollar assets in order to hold down their own currencies. However, there is a limit to their willingness to keep accumulating dollar reserves. Chinese officials last week offered hints that they are looking eventually to diversify China's foreign-exchange reserves. Over the next couple of years the dollar is likely to fall and bond yields rise as investors demand higher compensation for risk.
When house-price rises flatten off, and therefore the room for further equity withdrawal dries up, consumer spending will stumble. Given that consumer spending and residential construction have accounted for 90% of GDP growth in recent years, it is hard to see how this can occur without a sharp slowdown in the economy.
Handovers to a new Fed chairman are always tricky moments. They have often been followed by some sort of financial turmoil, such as the 1987 stockmarket crash, only two months after Mr Greenspan took over. This handover takes place with the economy in an unusually vulnerable state, thanks to its imbalances. The interest rates that Mr Bernanke will inherit will be close to neutral, neither restraining nor stimulating the economy. But America's domestic demand needs to grow more slowly in order to bring the saving rate and the current-account deficit back to sustainable levels. If demand fails to slow, he will need to push rates higher. This will be risky, given households' heavy debts. After 13 increases in interest rates, the tide of easy money is now flowing out, and many American households are going to be shockingly exposed. In the words of Warren Buffett, “It's only when the tide goes out that you can see who's swimming naked.”
How should Mr Bernanke respond to falling house prices and a sharp economic slowdown when they come? While he is even more opposed than Mr Greenspan to the idea of restraining asset-price bubbles, he seems just as keen to slash interest rates when bubbles burst to prevent a downturn. He is likely to continue the current asymmetric policy of never raising interest rates to curb rising asset prices, but always cutting rates after prices fall. This is dangerous as it encourages excessive risk taking and allows the imbalances to grow ever larger, making the eventual correction even worse. If the imbalances are to unwind, America needs to accept a period in which domestic demand grows more slowly than output.
The big question is whether the rest of the world will slow too. The good news is that growth is becoming more broadly based, as demand in the euro area and Japan has been picking up, and fears about an imminent hard landing in China have faded. America kept the world going during troubled times. But now it is time for others to take the lead.
Then we were a creditor nation. Now we are a debtor name.
Then we produced things. Now we consume them.
And so on.
So true. We used to produce things now we are paper shufflers. I worked in my dad's sheet metal factory. May God bless him. Thanks Dad!
Thank you.
I am still at work and the thought of Little Miss Chrissy Hissyfit defending Alito is giving me cold chills. Must be awesome to watch the Fabric of The Universe Tear.
You have to be kidding. The FRN has lost 96% of its value in the last 90 years.
but the value storage medum has changed from gold to GDP
Stores of value have many necessary characteristics. They must be easily traded. They must represent a means of comparing the relative values of two items. And so on.
How do you trade GDP with someone? How do you represent the value of a commodity, say your car, in terms of GDP?
If we printed more currency than our GDP would allow, we would experience inflation
Which we are. Our fiat currency has inflated by nearly 10,000% over the last 80 years.
To tabilize prices. THAT IS THE ROLE OF THE CENTRAL BANK, IN THIS COUNTRY AS WELL AS OTHERS
Well, they are failing miserably, just like they have failed miserably in every other country and in every other time. We were doing just fine without the Federal Reserve, as prices were stable for 150 years before that monstrosity was illegally established.
All currencies are leveraged and debased these days. If we are pathetic many of our rivals are worse. At least we have that going for ourselves
* Trust in God and family*
I hope this is a rethorical question. They're a bit less looney left wing than, say, UK's Guardian (communist propaganda outfit). Occasionally they talk about socialist economics, and most of the time they bitch about US.
"Read my lips" cost GHWBush the presidency.
That and the New World Order crap.
"If recession should threaten serious consequences for business (as is not indicated at present) there is little doubt that the Federal Reserve System would take steps to ease the money market and so check the movement."
--Harvard Economic Society, October 19, 1929
If the hubris and conceit was thick among the MS intelligentsia in 1929, it's even worse today. An eerie parallel is Bernanke, the ultimate Ivy Leaguer, taking over the Fed in a few weeks.
Interesting comment. What financial publication would you consider "respectable."
Wall Street Journal, Harward Business Review, Investor's Business Daily
Fair enough.
The ones that don't dabble into politics. Economist had a front page cover "Embattled President"... 'nuff said. They should stick with their socialist economic reporting.
The Economist economics/finance is very middle of the road conservative. They tend to lean slightly left on social issues. The politics is a case by case deal.
Most people have know idea we're about to go over the cliff in so many ways (monetary system, diminishing natural resources, debt, China ramping up, illegal immigration, etc.)
It's like 1938. See nothing. Hear nothing.
bump
Well first of all, I didn't say anything about a great power prospering by printing fiat money, so I don't know where that came from. All I was saying is that I have heard constantly for 40 years how we are on the verge of collapse, and yet in the real world all around us prosperity continues to increase. Peoples lives in our country are significantly longer, healthier, easier and filled with more disposable income and leisure than they were a generation or two ago. There were plenty of people around in the sixties who claimed we were on the verge of economic collapse -- I remember ads in National Review when I was a kid for a book called "How You Can Profit From The Coming Depression." At some point I suppose the sky actually does fall, but so far the people who keep predicting it have a pretty lousy track record.
You're welcome.
1914 + 1929 + 1938 = 2006?
I hope you're right, history says we're in for a big fall, soon. For example, there has never been a debt to GDP ratio even close to what we have today, it's much worse than even 1929.
Seriously, can you look at the blue gold/DOW ratio chart I posted in the first 50 replies, and just shrug?
That tinfoil or Mayan numerical prophecy? Screwy Louie math; perhaps?
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