August 22, 2007
The Federal Reserve must prolong the party
“Over the past decade a combination of diverse forces has created a significant increase in the global supply of saving – a global saving glut – which helps to explain both the increase in the US current account deficit and the relatively low level of long-term real interest rates in the world today.” Ben Bernanke, chairman of the Federal Reserve.*
Has the Federal Reserve been a serial bubble-blower? Or has it been responding to exceptional macroeconomic conditions? Not surprisingly, the implication of Ben Bernanke’s celebrated speech on the global “savings glut” implies the second view. Yet his self-exculpatory perspective is far from universally shared. So who is right? My answer is both. The Fed can indeed be accused of being a serial bubble-blower. But this is not because it has been managed by incompetents. It is because it has been managed by competent people responding to exceptional circumstances.
The remainder of this column can be read here (FT.com subscription required). Discussion from our guest economists is free.
Tito Boeri: I am bit less optimistic than Martin. First because the legacy of the low interest rate policy followed by the Fed is more serious than hinted by Martin as it changed dramatically incentives of financial intermediaries, induced to extend credit to families and companies with only limited financial strength. There is a need of a strong signal that things are changing. And here it comes my second concern. If I am not wrong, it was precisely Ben Bernanke, who was at that time member of the Board of Governors, to strongly argue in favour of a low interest rate policy fearing a major recession in 2002-3. Last Friday’s communication from the Fed didn’t clarify the intent behind the ½ point decrease in the discount rate. It may just be a prelude to yet another overreaction to the market crisis. I do hope that this is not the case. We do not need new overreaction sowing the seeds of a future crisis today.
Posted by: Tito Boeri | August 22nd, 2007 at 5:18 pm | Report this commentAkio Mikuni: I agree with Martin that today’s credit crisis is telling the world that US consumers will no longer be able to play the role of injecting global demand, and should be replaced by somebody else.
I am tempted to say that Japan might be able, unwittingly, to expand demand.
At the last upper house election, the Democratic Party of Japan (DPJ), the opposition party, won a majority of the upper house for the first time. Needless to say, it has yet to win an election of the lower house in order to organise its cabinet and run the country. DPJ’s success has been generally ascribed to the failures of Abe’s administration in handling properly public outcry associated with missing records of the National Pension Fund, and scandals surrounding his cabinet ministers.
After the dust has settled, it has become somewhat clear that there was another pertinent reason. DPJ’s election campaign promised to give policy priority to higher and better living standards of voters, together with concrete items the DPJ would deliver. This “revolutionary” strategy won the heart of voters, and was identified as a relevant reason for the DPJ victory even by the Liberal-Democratic Party (LDP) and Komeito, its coalition partner.
In past Japanese elections, voters voted for those candidates recommended by employers. LDP is supported by banking and industry. The employees’ entitlement of lifetime employment had been traded for voting for recommended candidates.
The financial crisis forced Japanese corporations to give up such arrangements, and coincided with the end of cross-shareholdings, which was instrumental for management to control shareholders’ voting.
The DPJ exploited these unleashed votes by offering what voters longed for individually and duly won the election.
Probably, Japan’s living standards could be improved by letting the yen to appreciate. However, there are many arguments within and outside Japan to say the appreciation of the yen will drive Japan’s fragile economy back into deflation. But I could argue otherwise.
First, the Bank of Japan could normalise or raise interest rates. If done sufficiently, the BOJ would see hoarded cash or “savings under the tatami” return to bank deposits, recovering reserve deposits of the banking system to the order of 30 trillion yen, which would result in more aggressive lending in the domestic market. Higher interest income accruing from the vast savings of older citizens would be translated into higher consumer spending.
Second, higher interest rates would drive the yen to appreciate. A strong yen would reduce capital export and bring back purchasing power from abroad and reduce import costs substantially, thereby freeing more purchasing power and expanding consumer spending.
Third, reductions in production by export manufacturers would be more than offset by rising domestic service production necessitated by increased consumer spending, provided effective incentives were given.
We should observe more intensely and carefully how Japan’s politics develop in coming months.
Posted by: Akio Mikuni | August 23rd, 2007 at 9:23 am | Report this commentRonald McKinnon: Martin Wolf has provided a masterly summary of US sectoral imbalances. The huge net deficit of the household sector, including residential construction, of the order of 4 per cent of GDP is indeed without historical parallel. With the subprime crisis and new restraints on mortgage lending, coupled with a fall in home prices, the American household’s sector should turn around fairly quickly and become a normal surplus.
Should we worry? Martin certainly does when he puts on his Keynesian hat toward the end of his column and frets about a deficiency in global aggregate demand. However, on the positive side, the long overdue righting of the financial imbalance in American households is both opportune and necessary in the long run to reduce the huge American current account deficit. But how can this be accomplished in the near term without falling into a pit of deficient global aggregate demand?
Instead of nattering about the dollar’s exchange rate, which is the wrong variable to adjust, the US Secretary of the Treasury should now approach his counterpart finance ministers in East Asian countries and possibly Germany to expand aggregate demand jointly. In China, for example, household consumption has been lagging behind the very rapid growth in GDP; and China’s recent success—not fully anticipated—in collecting taxes could be generating an as yet unrecognized fiscal surplus. Similarly, Japan has actually been running public sector surpluses over the past four years. So these governments, and Germany’s, can afford to be fiscally expansive over the next two years or so as part of a world wide countercyclical policy. Apart from international altruism, each of these countries has an individual incentive to expand fiscally because their exports will decline as the American consumer is forced to retrench.
If foreign governments jointly become more expansionary, the U.S. can better avoid another unwise round of unduly easy monetary policy—like that following the collapse of the high-tech bubble in 2001. And further American fiscal expansion is not desirable if the current account deficit is to be reduced. (This does not rule out a balanced-budget expansion such as a substantial increase in the federal gasoline tax to support a much needed rebuilding of roads and bridges.)
But how can US Treasury Secretary Henry Paulson orchestrate with incentives a collective fiscal expansion in Asia and Europe? In April 1995, his illustrious predecessor, Robert Rubin, announced a strong dollar policy and the end of two and a half unhappy decades of Japan bashing to get the yen up and the dollar down, which was severely damaging the Japanese economy. Circumstances are not quite the same in 2007. But today’s China bashing to get the renminbi up has been going on for more han four years, with legislation in Congress threatening high tariffs on Chinese goods unless the renminbi is sharply appreciated. Somewhat surprisingly, Japan bashing also returned earlier this when the incoming Democratic committee chairmen—Levin, Rangel, Frank, and Dingel—wrote toe Secretary Paulson to criticize the weak yen and unduly low interest rates in Japan.
At this critical juncture, with the fall in American consumer spending, the way forward is clear. Secretary Paulson should call a summit of Asian and European finance ministers to work out a joint program of fiscal expansion outside the United States. In return, he would reinstate Rubin’s strong dollar policy by suppressing the bashing of China and Japan to appreciate their currencies. Ideally, he could even promise to reform the notoriously arbitrary US anti-dumping laws and other protectionist legislation.
At the beginning of his term as Secretary of the Treasury, Henry Paulson announced his intention of getting the US to engage China “constructively”. He judged that a smooth economic and political relationship between the two economic giants was key to their mutual prosperity in the new millennium. He was right.
Posted by: Ronald McKinnon | August 24th, 2007 at 9:10 am | Report this commentCatherine L. Mann: Martin Wolf makes an interesting new argument for why the Fed must cut interest rates to ‘keep the party going’. It’s not to provide liquidity to counterbalance years of mis-priced risk that is finally coming home to roost at leveraged financial firms—which is why the financial markets have been begging for a cut.
Rather , Mr. Wolf argues that a Fed interest rate cut would keep “.. US households…spend[ing] more than their incomes.. enough to absorb the economy’s potential output… “If they fail to do so, the economy will plunge into recession unless something else changes elsewhere… [such as] a huge fiscal expansion in the US or a huge reduction in the US current account deficit.” In short, increasing household indebtedness is the key to a sustainable US economy, according to Wolff, and should be aided and abetted by the Federal Reserve.
It seems to me that continued unsustainable increases in household indebtedness should not be the outcome of Federal Reserve policy, no matter how important consumer spending is to the overall performance of the US economy.
Moreover, sluggish business investment of the last five years (noted in the column) has reduced the rate of growth of potential output. At the same time, export growth has been relatively robust which tends to both boost overall economic performance and moderate the current account deficit. Against this background more modest consumer spending is both necessary and appropriate; a Fed cut could even be inflationary.
Finally, if Mr. Wolf’s argument is mostly about the magnitude of global imbalances, and the difficulty of changing the underlying trends, it is even less appropriate for the Federal Reserve to pursue a policy that tends to exacerbate the imbalances. A Fed cut would do just that.
Posted by: Catherine L. Mann | August 24th, 2007 at 4:53 pm | Report this commentRobert Wade: I am alert to the danger of ‘herd thinking’ in a commentariate (having seen what happened in the case of the Washington Consensus about appropriate development policy). So I was pleased to read Ken Fisher’s leaning-against-the-herd argument that the current market volatility is no more than ‘an archtypical market correction’ (23/08/07). He makes a good case. Yet on the very next page Saskia Scholtes and Krishna Gupta report that the recent magnitude of volatility in the price of the safest and most liquid of US securities – T bills – has not been seen since October 1987; which does not sound like a normal correction.
As an outsider to the analysis of financial markets I grab hold of several points which seem to run against Fisher’s argument. (1) Housing market falls have about twice the macro impacts of equity market falls. (2) About 10 million US individuals (at 3-4 individuals per household) will lose ownership of their homes in 2007. (3) The worst is yet to come. The number of foreclosures will rise in 2008 and maybe 2009 because of the built-in tightening of repayment terms in contracts made in 2005 and 2006. (4) In the UK 14,000 homes have been repossessed so far this year (three times the number in 2006), and another 125,000 households are behind on mortgage payments. Personal bankruptcies are running at an all-time record rate. (5) Our knowledge of the impacts of housing market falls is much thinner than of equity market falls. When steep falls in housing prices are involved the greater uncertainty compounds the role of fear in driving investor behavior, and raises the intensity of contagion across asset classes and across countries.
But much of the current commentary, in focusing on the bubble and crash dynamics within the financial/housing sector, has missed the dynamics coming from the link between international financial markets and trade imbalances. This is the point implied by Martin’s remark, ‘Today’s credit crisis, then, is far more than a symptom of a defective financial system. It is also a symptom of an unbalanced global economy’ (21/08).
Take the case of Iceland, from where I write. Iceland is running a current account deficit to GDP of more than 25%, which must be a world record for any ‘developed’ economy. When the new Alcoa aluminium plant reaches its 350,000 ton/year capacity by the end of 2007 Iceland’s net exports will increase by the electricity used to produce aluminium, and imports will fall by the investment in plant and equipment. But a sizable deficit will remain. Inflation is running at around 6%. The central bank lending rate is 13.3%; consumer credit is about 17%, overdrafts more than 20%. Yet Icelanders are borrowing as though there is no tomorrow, as though only a loser would worry. The narrow streets of Reykjavik are choked with giant SUVs cruising in search of a parking place, each driver cursing the others for blocking the space. The SUVs are bought on credit, quite a bit of it denominated in Japanese yen.
In the face of this world record current account deficit what has been happening to the krona? The theory of flexible exchange rates would predict depreciation as an adjustment to the current account deficit. Instead the krona has been appreciating – showing sustained periods of appreciation and capital inflows, disrupted by short panicky sharp devaluations in 2005 and 2006 and now as carry traders unwind their positions.
In short, financial markets have been sending the key price in Iceland’s economy in the ‘wrong’ direction. Iceland is an extreme case, but the same dysfunction is occurring much more widely. Of the 18 non-minnow countries with the biggest current account deficits between 1996 and 2006 15 experienced appreciation of the real effective exchange rate (REER) in that period, 3 had no change, none had the depreciation predicted by standard theory. Of the 7 countries with the biggest surpluses, 5 experienced a depreciation.
These numbers suggest that the interaction between financial markets and trade has become destabilizing, not stabilizing. It is as though financial markets are functioning like drunken air traffic controllers. In particular, inflation targeting using the short term interest rate generates interest differentials, the response to which erodes the effectiveness of the interest rate in fighting inflation – and imposes steep costs on the real economy through lower investment. The argument suggests central banks should use interest rates in a more balanced way to check both inflation and exchange rate appreciation, even at the cost of higher inflation – though other instruments should also be deployed to curb inflation.
Of course, all these dysfunctions occur in an international financial architecture of (1) floating exchange rates in OECD economies, and (2) free capital movements. Floating exchange rates and free capital movements are not written in stone. They could be changed. Whether and how depends partly on whether one thinks soaring income and wealth inequality at the top constitute a problem which public policy should curb — for these features of the financial architecture have been important in generating the processes by which the top percentile, based on finance, has taken off from the rest of the population. Willem Buiter declared in these pages that he does not care what happens to inequality, as distinct from poverty. I beg to differ, as much for instrumental reasons (the impact of US-level income inequality on other components of the quality of life) as for moral ones.
I take up some of these issues in: ‘A new global financial architecture?’, New Left Review, July/Aug 2007; ‘Choking the South’, New Left Review, Mar/Apr 2006; ‘Should we worry about income inequality?’, in David Held and Ayse Kaya (eds.), Global Inequality, Polity 2007; and ‘Globalization, growth, poverty, inequality, resentment, and imperialism’, in John Ravenhill (ed), Global Political Economy, OUP, forthcoming 2007 or 2008.
Posted by: Robert Wade | August 28th, 2007 at 7:42 pm | Report this comment