Danger Time for America

The Economist ^ | Jan 12, 2006

[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.

[nopardons]

You could at least try to read what I post. or else you could get someone else to explain what I've written means. *sigh*

You want the exact time periods? Okay, I'll get them for you. Far be it from me, that I tell you X hours and it's actually Y. LOL

Oh yes, in the midst of a melt down, you absolutely, positively, must, must, MUST divest yourself of your holding? Did you do that on 9/11; did you even try to?

Gold, in 1963 was worth $35 dollars an ounce. Even adjusted for dollars then V dollars now, no, gold is NOT worth the same amount of money at all!

Good grief! You have no idea what you're posting! LOL

Take a stock that was around in 1963 and is still listed today and look at the history of it. Then, get back to me. You are better off just reading fiction and posts by people who give you tingles... you ignore facts, don't know any history, and should educate yourself about things that you are involved in. Nothing I post will help you "get it"; I see that now.

Here's the short answer...you can sell your stock, AFTER the stop has been taken off. Since you didn't ask me, I wont tell you how that would end up. LOL

[Lurker]

In 1963 a decent suit cost around $35.00, same as an ounce of gold. Today a decent suit costs around 500 bucks, just about the same as an ounce of gold. Therefore in around 40 years gold has neither gained nor lost any purchasing power. That's what I meant by 'worth'.

The difference between the long term prospects of gold is that it will still be here long after Acme Widgets has expired and its stock become worthless.

Now since you insist on not doing the one thing I asked you to do (answer my rather simple question) and continued to do the one thing I asked you not to do (POST TO ME IN ALL CAPS AND THEN BOLD THEM LIKE YOU'RE SCREAMING AT AN 8 YEAR OLD) I'm becoming convinced that you're unable to do either of them.

I'm not stupid sir or ma'am, and to tell you the truth I really don't have a dog in this fight. 95% of my investment dollars are in the market right now, and I have maybe a couple of thousand put back in precious metals just because I like having some 'real money' around the house.

Since it's apparent that you don't actually know how these 'triggers' and 'cooling off' periods work or how long they last you are obviously an unreliable source of information on these subjects.

That makes me wonder why I should put any 'stock' (forgive the pun) in what you have to say. If you can't tell me how they work or how long they last or what the effect on my holdings would be, then why the he** should I care what you have to say on the subject?

HAVE A REALLY NICE NIGHT-I'M OUTTA THIS THREAD!!

L

[Toddsterpatriot]

In 1963 a decent suit cost around $35.00, same as an ounce of gold. Today a decent suit costs around 500 bucks, just about the same as an ounce of gold. Therefore in around 40 years gold has neither gained nor lost any purchasing power. That's what I meant by 'worth'.

Brilliant!! If all you buy are suits, gold is a perfect store of value.

If you buy anything else, let's say a house, then gold isn't as good. In 1980 the median house was about $71,000 (about 90 ounces of gold) in 2005 the median house was about $253,000 (about 500 ounces of gold). But you're right, gold is the only real money. Hasn't gained or lost any purchasing power.

Sorry if I made you cry. Capiche?

[verity]

"You are my friend so keep your eye on US debt and keep your eye on gold."

I appreciate being called your friend and for the advice.

[verity]

Thank you for letting me know where we can easily access gold if we need it.

[expat_panama]

We were doing just fine without the Federal Reserve, as prices were stable for 150 years before that monstrosity was illegally established.

While I grant that you certainly have a right to your own opinion, please remember that you have no right to force on us your own Bizarro parallel universe.

OK, please forgive my coming on with an exasperated tone, but it doesn't matter that how many times gold bugs say that we had no inflation before the FRB, saying it will never make it true.   The worst inflation we ever had was back then and it was even over 20% --for years.   What made it even worse was that it would never stay there --without warning it would plummet to double digit deflation --and then back up again.

We're not talking just numbers here.   That kind of market environment was pure hell.  People starved and died.

We've posted historic inflation data several times on these threads, and often some goldbug will say (again without looking it up) that the wild price fluctuations were only during times of crisis --Civil War, WW I, etc..  That's when we bring out a comparison of the inflation records of the past two decades superimposed on the last 20 years before WW I.   Again, before the FRB prices were all over the place then and today's inflation looks well, boring.

Probably whenever a bunch of gold bugs get together it's easy to make up numbers without fear of anyone's scientific honesty getting in the way, but out here in the real world the rest of us are forced to actually look these things up.  We need to feed our selves without asking others to pay our bills, and we can't afford to get it wrong.

[dennisw]

Yeah right. I'll bet at least 10% of expat's net worth is in gold

[alrea]

90% of what the writer says depends on home equity drying up, which it isn't. But even if it did, the effect is not what is asserted. The article is B.S.

The magazine should be called the Socialist Economist. The growth engine in the U.S. is small companies. Lower taxes cause growth, job creation and wealth creation.

Bureaucracies have a harder time tracking small companies and thus they are not discussed in the Economic textbooks. Greenspan is celebrated as a great bureaucrat. His greatness was driven by the technology boom Reagan tax cuts lit a fire under.

[expat_panama]

"I'll bet at least 10% of expat's net worth is in gold..."

You caught me flat-footed --the honest truth is that I have been doing quite well (thank you) with gold mining stocks.  These past few years gold has been terrific --not for owning of course, but for selling to gold bugs.   Then again, if you really believe that "gold is real money" and paper isn't, then let me know when you're throwing away all your paper money.   I'm willing to come by and pick it up for "recycling".

You don't need to thank me, that's just the kind of guy I am.

[dennisw]

Good for you Señor gold bug. Gold has done good by you. Stop being cynical.Thou doth protest too much. Gold is real money


I certainly understand that gold fluctuates greatly since it's commodity traded on exchanges same as sugar crude pork bellies S&P

[alrea]

Sorry but don't be sucked in by "The Economist". Great cover, great puns for captions, it looks slick but it's free traitor all the way. Brit arrogance, don't bet on what they print

Absolutely. Why does their great republic have double digit unemployment?

[alrea]

The Economist is "leftist?"

We have a tough time defining leftest sometimes, but the Economist is usually seeking to verify the Keynesian European Socialist State that competes with the U.S. slightly freerer Keynesian economic model. Those European states with their grand double digit unemployment and free healthscare.

Leftist should mean any further growth of government in the U.S. since such a high percentage of income(revenue streams, cash flow) are sent to the Government(including legal related costs and payments).

[Mulder]

Trading is halted if the exchanges go up or down too much in a day. (It doesn't seem like a free market, when the "powers that be" can dictate when you can and cannot trade.)

The stops were put in place after the mini-crash of 1987, where the market lost 25% in a single day. Interestingly, however, the markets recovered and were up slightly for that particular year.

Now that "controlled trading" is in place, you get to lose 60% of your money in 3 years (2000-2002) instead of 25% in a single day.

[television is just wrong]

we aren't. It is just periods of adjustment.

[Mulder]

And yes, it has outpaced the value of gold

According to Travis's chart of the 100-year Dow vs. gold, the market hasn't outperformed gold over the last 100 years, except for a few time periods where equities were in a bull market.

Also, the "dow" in his graph is sort of cheating, since the same stocks in 2005 aren't the same ones in 1900. As companies go under, or new technoglies emerge and replace older ones, the composition of the Dow Jones average changes. What would be really interesting is to see a plot of the original Dow stocks in 1900 plotted against gold. (Do any of those companies still even exist??)

[Mulder]

In 1980 the median house was about $71,000 (about 90 ounces of gold) in 2005 the median house was about $253,000 (about 500 ounces of gold).

Why are you using the peak of the gold bull market in 1980, and then the peak of the housing (credit) bubble in 2005 as your points for comparison?

A 100-year chart of gold vs. housing would be more instructive.

[agrarianlady]

Consumer spending is not fueled by home equity loans. Have you taken out a home equity loan to buy things like plasma TVs?

Do a little research and get back to us. Consumer spending has absolutely been fueled by home equity loans.

[Mulder]

no inflation before the FRB, saying it will never make it true. The worst inflation we ever had was back then and it was even over 20% --for years. What made it even worse was that it would never stay there --without warning it would plummet to double digit deflation --and then back up again.

Looking at your graph, it appears that high inflation rates corresponded to times of war. 1812. War between the States. WWI (or more accurately, JP Morgans war). Then you had deflation after the wars. So things averaged out close to zero.

Compare that to today, where we have inflation during times of war. And then we have more inflation during times of peace!

We're not talking just numbers here. That kind of market environment was pure hell. People starved and died.

More people starved and died because technology (agricultural and medicinal) wasn't what it is today.

wild price fluctuations were only during times of crisis

From your chart, there were price flutctuations. But keep in mind our nation was rapidly expanding during the 1800s. Perhaps those fluctuations were simply a function of that, not unlike how a small growing business has more volatility than a large establised corporation. But the important thing, is that despite these fluctuations, if you held dollars over the long term, you maintained wealth. We had "honest money" back then.

Again, before the FRB prices were all over the place then and today's inflation looks well, boring

Inflation is running about 6-10% today, depending on who's numbers you believe. That isn't "boring", it's "criminal".

We need to feed our selves without asking others to pay our bills, and we can't afford to get it wrong

So if you had to choose between leaving 500 one-dollar bills, or one ounce of gold to your great-grandchildren for 100 years into the future, for them to "feed themselves", which would you choose?

[vrwc0915]

You can lead sheep to water but you can't make them drink :)

Everything is great why I will always have a paycheck and access to easy credit. China is our friend and most favored trading partner. Venezuela and Iran would never disrupt our oil supply and if so we could take them out in 24 hours with "smart bombs" Islam is a religion of peace. Those undocumented workers are just here to take the jobs that lazy Americans wont do. And paper money and stocks could never just become worthless paper. I am going to go refinance with an interest only loan take the equity out and buy a plasma TV, trade in my paid off cars for some 60k SUV's and start providing some undocumented workers employment by mowing my lawn and taking care of tasks that I am able to do but are beneath me. I think I will invest all my money in mutual funds as those bankers surely have my interests at heart. And hey socialist security will always be there for me. And why worry about supply disruptions if there is no food on the shelves why FEMA will deliver hot meals to my home. Well since everything is so great I better log off and find the most expensive cable package so I can see what I have been missing out on

If anyone did not get that this was sarcasm please seek medical attention

[TexanToTheCore]

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.

Good to see another ex-reader of The Economist checking in...