September 12, 2007
Challenge of rescuing world economy
The financial markets have taken the world economy hostage. This has presented the world’s central banks with a dilemma. They fear the consequences of paying off those responsible for the mess. But they cannot let hundreds of millions of innocents suffer. Last week’s announcement of the first US monthly fall in employment for four years has made a cut in interest rates from the Federal Reserve this month a virtual certainty. So act it will. But making the right decisions is going to be hard.
Martin Feldstein of Harvard university put the case for big cuts in a powerful summing up at this year’s Jackson Hole monetary conference. He argued that the US housing sector was at the heart of three interrelated events. First was “a sharp decline in house prices and the related fall in home-building that could lead to an economy-wide recession”. Second was “a subprime mortgage problem that has triggered a substantial widening of all credit spreads and the freezing of much of the credit markets”. The third was “a decline in home equity loans and mortgage refinancing that could cause greater declines in consumer spending”.
The remainder of this column can be read here (FT.com subscription required). Discussion from our guest economists is free.
Martin Weale: An important point to add is that relying on rising house prices to maintain demand is much like relying on a fiscal deficit. Both have the effect of transferring spending power from the future to the present and impose the burden of this on future generations. The only difference is that high house prices do not result in distortionary taxation. Neither approach seems to be sustainable in the long run.
Posted by: Martin Weale | September 12th, 2007 at 2:53 pm | Report this commentJim O’Neill: Two pieces of data in the past 24 hours, suggest that the world is adjusting reasonably well, despite the severe challenges in the domestic US economy, which unlike Martin, I still believe requires a notable
Posted by: Jim O'Neill | September 12th, 2007 at 2:53 pm | Report this commenteasing of policy from the Fed . Firstly, the latest US trade data showed exports rose by 14.8 per cent year-on-year, and imports up “just” 4.8 per cent, i.e. exports close to being three times the rate of growth of imports, quite astonishing for the US. Secondly, today (Sept 12) China reported retail sales rose 7.1per cent in the latest month, which suggests they alone are close to contributing as much to global demand already as the US. When you add in double-digit spending in each of the other BRICs, the challenge might be less daunting than Martin fears.
Willem Buiter: I would like to comment on Martin’s discussion of Martin Feldstein’s policy prescriptions at Jackson Hole.
There are times when I am quite pleased that Marty Feldstein, whom I admire as a professional economist and consider a friend, is not Chairman of the Federal Reserve Board. This is because his policy recommendations at the end of his Jackson Hole presentation amount to the proposal that the Fed forget about price stability and instead focus solely on cutting interest rates to minimize the likelihood and depth of a serious slowdown/recession in the US. That advice is dangerous. It is also rather surprising to see Marty express so much concern about a significant fall in US consumption demand, when he has called, for decades, for a significant increase in US private and public saving. When, at last, it looks as though he may get at least half of what he has asked for - lower US private consumption – it makes no sense to immediately ask for measures to boost private consumption.
Marty’s analysis of the origins and likely future course of the current financial turmoil in the US, and of its likely implications for the real economy and inflation, is quite convincing, although marred somewhat by the usual parochialism of US-based economists.
Extremely low credit risk spreads (as well as low long-term real interest rates) were a feature of the global economy, not just of the US. The fact that there was a willing demand for extremely large quantities of US sovereign debt from foreign official holders at very low yields no doubt contributed to the low level of US long-term interest rates and to the US housing boom. The willingness of European and Asian financial institutions to invest in securities that, directly or indirectly, exposed them to the US subprime and alt-A mortgage sectors must have been instrumental in the rapid expansion of this form of lending. The failures of regulation and supervision in residential mortgage lending market and the unbridled growth of off-balance sheet vehicles that had neither capital nor supervision or regulation can be in part accounted for by regulatory arbitrage and by the restraining impact on national regulators and supervisors of competition for business between national financial centres. These pressures no doubt induced national regulators and supervisors in the US and elsewhere to take a hands-off approach and to rely on self-regulation (aka no regulation).
Home building in the US may have fallen by 20 percent over a year, but exports have grown by about 11 percent. Homebuilding is less than 5 percent of GDP, exports are now over 11 percent of GDP (imports are over 16 percent of GDP). Any recent and future decline in US housing construction is likely to be more than offset by the change in the trade balance. That leaves, of course, the wealth effects and liquidity/collateral effects on private consumption of a decline in US house prices.
But is a significant decline in US consumption not exactly what is required (and long overdue) for both internal and external balance reasons? Marty is always telling us that both the US private sector and the US public sector are saving too little. How will the private sector’s contribution to national saving be boosted without a significant fall in private consumption demand.
Given the prevailing nominal rigidities in US wage and price setting, any significant decline in household consumption and aggregate demand will depress economic activity. If liquidity constraints are empirically significant in the US, as they appear to be, the short-run Keynesian multiplier will deepen the economic downturn. One can easily envisage a quite deep recession.
The only mechanism to mitigate this, other than a fiscal expansion which would further weaken the external balance and also not do much for the national saving rate, would be a significant reduction in the US external trade deficit, brought about through an already weak and further weakening US dollar. This scenario would indeed become more likely were the Fed to cut its policy rates.
Marty, however, wants to use lower interest rates to stimulate every component of aggregate demand, with the possible exception of public spending on goods and services: “…lower interest rates now would help by stimulating the demand for housing, autos and other consumer durables, by encouraging a more competitive dollar to increase net exports, by raising share prices that increased both business investment and consumer spending, and by freeing up spendable cash for homeowners with adjustable rate mortgages”
Except for the increase in next exports, this sounds like a recipe for restoring the unsustainable status quo ante. And it is not at all obvious that, given the boost Marty wants to give to private consumption and investment demand, there would be any reduction in the US net external deficit at all.
In my view, given that increasing the US national saving rate is (a) necessary and (b) practically inconceivable without an economic slowdown and a possible recession in the US, it is better to have the slowdown now, while the world economy is still booming, than to wait until the world economy too slows down significantly. It makes no sense to call incessantly for higher private saving and then, when you are at last likely to get what you want, to ask for measures to boost private consumption.
Finally, from my perspective, risk-based “decision theory” would lead to the opposite conclusion from the one reached by Marty. He believes that the risk that the economy could suffer a very serious downturn should dominate the risk of higher inflation. I disagree. The Fed’s triple mandate (maximum employment, stable prices and moderate long-term interest rates) does not support any asymmetric treatment of risk to the real economy and risk to inflation (in the UK and in the eurozone, the central bank mandates are lexicographic, with price stability taking precedence over real economy objectives). So the question is: what would be a worse outcome - a deep recession or a loss of inflationary credibility. I would argue that the risks to price stability and to the anti-inflationary credibility of the Fed should take precedence over the risk of a deep recessions. Recessions tend to be short. Restoring anti-inflationary credibility is a long-drawn out and costly process.
Clearly, if the current state of the economy is such that interest rate cuts would support the real economy without raising the risk of inflation, there is no short-run trade-off, no dilemma and no need for risk-based “decision theory”. Unfortunately, I don’t think were are in such a welcoming environment. Gauging the risk to price stability not from the Fed’s will ‘o the wisp indicator of core inflation but rather from the underlying behaviour of headline inflation, US inflation has been above the Fed’s comfort zone for five years. Unit labour cost growth is rising, quite likely a reflection of a decline in productivity growth that is not just cyclical.
To play fast and loose with inflation at this point risks undermining all that has been achieved since Volcker took over as Chairman of the Fed. This is even more pertinent because we have a new Chairman whose first real test this is. Should he choose to act in a way that undermines the credibility of the Fed’s commitment to price stability, and should this lack of credibility get embodied in inflation expectations and long-term contracts, the cost of regaining virtue would be much higher than the cost of having a slowdown or even a recession now.
Posted by: Willem H. Buiter | September 13th, 2007 at 9:51 am | Report this commentBrad Setser: I share Dr Wolf’s conviction that a weaker dollar – particularly against the emerging world – that supports net exports should play a critical role in helping the US work through the aftershocks of the current housing market troubles. I am not quite as convinced as Jim O’Neill, though, that the conditions for the needed adjustment are in place.
US demand growth has slowed significantly over the past few quarters without prompting a broader global slowdown. And, as Dr. O’Neill notes, the large gap between US import and export growth in the July trade data is encouraging – though the sustainability of 15 per cent or so year-on-year US export growth should the world slow a bit remains a bit of an open question in my mind. But the gap between the US import and export base is large enough that even a 10 per cent differential between the export and non-oil import growth rates yields a roughly $100bn improvement in the trade deficit. Unless something changes, higher oil prices are likely to cut into the improvement in the non-oil balance and some of those gains will likely be offset by an increase in the US net interest bill. Even if the fed cuts, the average interest rate on the United States roughly $10 trillion in existing external liabilities is likely to rise a bit from its 4.4 per cent average level (my estimate, based on the NIIP) in 2006 – and the US is still taking on additional debt.
The adjustment in the dollar zone, so far, has largely come from a rise in China’s surplus (notably v. Europe), not a fall in the US deficit. If oil stays around $80, the US current account deficit looks likely to remain stable at around $800b in 2007. The World Bank now estimates that China’s current account surplus will rise by $130bn (to $380bn). Absent a greater willingness on the part of some key emerging economies, like China, to accept more exchange rate flexibility, there is some risk that the basic pattern that has been evident so far this year will repeat itself.
Given ongoing capital inflows to China, the net result has been a very significant increase in the share of the US current account deficit financed by China. The dollar – as Dr. Wolf argues — needs to weaken without crashing. China’s willingness to finance the US during its slowdown has, in my view, been a key reason why the dollar hasn’t crashed over the past few quarters. But there is a risk that China’s ongoing commitment to a very modest pace of renminbi appreciation may keep the dollar from weakening as much as it should, not just from crashing.
Posted by: Brad Setser | September 13th, 2007 at 3:03 pm | Report this commentMartin Wolf: I would like to thank Willem for writing the column that I should probably have written myself. I agree with every word. The dangers of the path my good friend Marty Feldstein recommends are very great. I indicated this in my column, but, in retrospect, not as clearly as I should have done.
I think Willem has also provided a good response to Jim O’Neill. I should add that his own points undermine his view that the Fed should cut sharply. As he notes (and I stressed), the rebound will, and should, come from the external side. Indeed, it is already happening. If the Fed cuts rates, most of the positive effect on the economy is likely to come via the exchange rate. While this will help the adjustment, it may undermine confidence in the dollar, for reasons indicated by Willem. There is substantial danger here, as I argued. In any case, it is not the job of the Fed to eliminate all slowdowns. Such fine-tuning is impossible and unwise. The risks of slower growth and even recessions are part of a dynamic economy.
I agree with Martin Weale’s point: the rise in house prices is destabilising. I also agree with Brad Setser’s views. The adjustment is indeed not a “done deal”. I am particularly concerned, as he is, that there will be no adjustment by China, but rather explosive increases in its surpluses, with unpredictable consequences for the world economy.
Posted by: Martin Wolf | September 14th, 2007 at 1:46 am | Report this commentRonald McKinnon: Willem Buiter’s posting of Sept 13 is excellent—and, like Martin Wolf, I wish I had written it! A sharp pre-emptive easing of the Fed’s monetary policy (as per Martin Feldstein), by lowering the Federal Funds rate to stimulate U.S. expenditures across the board to offset the housing slump, is bad economics. First a decline in household expenditures, relative to income, is essential for reducing the U.S. current account deficit. Second, inflation is still a global threat with the world wide commodities boom and recent record prices in oil, wheat, dairy products, and so forth. Indeed, the upwelling of primary commodity prices over the last three years is, at least in part, linked to the Fed’s excessively easy monetary policy in 2003-2005—an overreaction to the economic downturn of 2001-2002. If the Fed over reacts again to the current downturn in housing, its credibility for keeping inflation under control could be fatally undermined.
One difference between Martin Wolf and Willem, is that Willem doesn’t mention the dollar exchange rate whereas Martin states that “the dollar needs to weaken, but not crash”. This is like trying to be just a little bit pregnant. The biggest inflationary threat to the U.S. now comes from protectionists in Congress with new legislation to force major currency appreciations on countries with saving surpluses—particularly China, but also possibly Japan again. Instead, America now needs a new strong dollar policy, very much like what Robert Rubin announced in April of 1995 when he ended more than two decades American Japan bashing to get the yen up.
Posted by: Ronald McKinnon | September 17th, 2007 at 10:05 am | Report this commentHowever, without changing their exchange rates, Asian countries and Germany best run with smaller net saving surpluses for a year or two to compensate for any slump global demand emanating from the United States. Although better to be negotiated, this adjustment in international saving imbalances could be already occurring naturally. Jim O’Neil noted the recent remarkable surge in American exports of 14.8% year-over- year, whereas imports increased just 4.8%. And a further fall in American imports seems to be in the cards as household spending finally declines to a more sustainable level
John Muellbauer: Much has been written about moral hazard both in respect of the Fed’s cut in interest rates on Sept 19th and the UK government’s uncomfortable rescue of Northern Rock. Martin Wolf was excellent on the issues in his Sept 5th and 19th columns. When a boat is taking in water rapidly, however, it is better to start baling the water out than to worry too much about the incentives for future boat builders to design better boats. That will be an important debate in the months to come. Martin Wolf was therefore right in his September 12 column to point to the risks to the World economy. As he says, Martin Feldstein’s overview and concluding remarks for the Jackson Hole Symposium, summarised the risks to the US economy outstandingly well. While some of the participants thought Feldstein excessively pessimistic, the data since September 1 have supported his view.
Among the extensive media coverage of Jackson Hole, for example of the sub-prime loan mess and the incentive structures and herd behaviour that led to it, and the moral hazard issues for policy, some issues received rather less attention. I have picked on eight of these.
Lesson 1: the qualities of the Fed Chairman. As Ben Bernanke’s speech at the Symposium indicated, he has a deep appreciation of the problems of asymmetric information, of the credit channel by which interest rate and credit shocks are transmitted, of the importance of institutional change and the lessons of history, as well as the technical command of econometric modelling to use the full resources of the Fed modellers.
Lesson 2: the quality of thinking and modelling at the Fed. The Fed, almost alone among leading central banks, did not adopt for its main model, the current generation of “Dynamic Stochastic General Equilibrium” models. These add some price stickiness and adjustment costs to the Real Business Cycle model founded on the assumptions of efficient financial markets and rational expectations, in which all agents share the same information set and the same view of the future. Not only do the underlying rationality and informational symmetry assumptions look hollow in the 2007 credit and financial market crisis, but these models are not readily adaptable to take on board the lessons of the Symposium and of the events of 2007.
In contrast, the Fed’s FRB-US model is easily adaptable, for example, by shifting some parameters of the consumption function, to produce simulations of a variety of scenarios that take credit market shifts of the kind explored in my Jackson Hole paper into account. These considerations and the huge expertise embodied in the Federal Reserve system certainly increase my confidence in the outlook for the US economy. The half point cuts in the Federal Funds rate and the Discount rate on September 19 were right, and entirely consistent with the above view.
Lesson 3: the importance of the construction sector. The most obvious macroeconomic linkage with housing is the link between residential construction and economic activity. Ed Leamer reminded everyone at the Symposium that fluctuations in house building in the US have substantial effects on activity: he argued that eight out of ten US post war recessions were preceded by substantial problems in housing and consumer durables. The current macro problems posed by the decline in construction are not confined to the US, though the US started about twice in 2005 as many per head as the UK. Spain last year started around five and a half times as many dwelling units as the UK per head of population, while the Irish Republic started seven and a half times as many. In these countries, house building is quite responsive to high house prices. The collapse of the housing and the commercial property booms in Spain and Ireland will have large effects on economic activity, given that construction accounts for between 15 and 20 percent of GDP, while in the UK such effects will matter rather little, particularly since house building is so unresponsive to house prices in the UK.
Lesson 4: the so-called housing “wealth effect” on consumer spending is really a collateral effect. As the value of homes rises, households can increase mortgage debt and spend more. The size of this effect, however, depends on credit availability and other institutional differences: the evidence is that currently in the US around $7 of a $100 rise in housing wealth is spent, while in the UK it is around half that. Higher house prices could well reduce consumer spending in economies with less liberal credit markets such as Italy’s, as prospective first time buyers and renters save more when house prices rise. This was one of the main points of my paper, which provided evidence that there was no effect of higher house prices on spending in the UK or the US before credit markets liberalised.
Lesson 5: Tensions in the eurozone will increase. Sharp falls in homebuilding, the housing collateral effect reversing as house prices fall, and credit tightening with higher risk aversion will affect some economies far more than others. Spain is the classic case: Spain started five and a half times as many houses as the UK in 2006. The collapse of its construction sector and falls in household spending as home prices fall will seriously slow the Spanish economy. However, Spain’s economy has experienced more inflation than the rest of the Eurozone and the profitability of companies is already in far worse shape than the US, which enters this downturn with healthy corporate balance sheets. Many Spanish companies are now highly leveraged with debt. Spain does not have the interest rate and exchange rate flexibility of the US and the UK, as it is locked in EMU. This makes it almost impossible for Spain to escape recession and a long period when its prices and wages will have to fall relative to those in the eurozone. This kind of problem was foreseen by Maclennan, Muellbauer and Stephens (1998).
Lesson 6: neglect of institutional differences increases risk of policy errors. There is a connection here with the criticisms by Ed Leamer and John Taylor of the Fed for keeping interest rates too low and too long in 2002 and 2003. Many macroeconomists and financial market participants at the time, drawing parallels with post-bubble Japan, were worried about deflation and the risk that monetary policy might become ineffective in a low inflation environment. This view influenced an interest rate policy seen to protect against such a risk. The tendency in modern macro to use a “one theory fits all” approach led to a quite erroneous evaluation of the Japanese example. As discussed in my paper, monetary transmission via households in Japan works rather differently than in the US or the UK. One of the most important lessons from Japan was and is that a continued ineffectiveness by the banking system to carry out its intermediation and investment allocation functions has very serious consequences, see Hoshi and Kashyap (2004). But there was no risk of that in the US post-2001, so that the wrong lesson was learned. Indeed, the empirical evidence of my paper suggests that, at this time, US monetary policy via the credit and housing channel was becoming even more powerful than before.
Lesson 7: on the “decoupling of Asian growth”: don’t think that rising house prices in India and China contribute to consumer booms in these countries. A credit revolution is in process in emerging markets, including China, and India. Credit sharing information and credit scoring systems have been or are being installed, and consumer debt markets are growing at enormous rates. In many countries, house prices are increasing rapidly. The conventional wisdom is that these developments are bound to raise consumption relative to income. However, it is important to be aware that, at the current stage of development of many of these credit markets, it is likely that higher house prices are still reducing consumption relative to income. This is because those hopeful of getting on the housing ladder have to save more for that deposit, while home equity loans for existing owners are not yet easily available. Thus, while the direct effect of credit market developments on consumption is positive, there is a partially offsetting indirect effect through higher house prices.
Lesson 8: don’t leave it all to central banks. Governments possess a number of policy levers to influence the housing market with implications for the cyclical behaviour and interest rate response of their economies. It is unfortunate that governments do not accept more of their shared responsibility in dealing with massive and sustained house price fluctuations. The levers they possess include property taxation or subsidies, tax relief on interest payments, the regulation of the financial system, zoning controls for residential land use and incentive structures for local authorities to release land. For example, property taxes in proportion to value, with frequent revaluations, help stabilise house prices, as cash flows for households automatically improve if house prices fall, and automatically increase when house prices increase, while households factor these expectations into their behaviour Subsidies or tax breaks to help first-time buyers overcome the widespread housing affordability problem are likely to be counterproductive, since they will be capitalised in prices. A succession of Dutch governments, for example, appear not to have learned lessons from the collapse of the 1980s housing and credit booms in the UK and the Scandinavian economies. Their policies have increased the current vulnerability of the Dutch economy. Unfortunately, public opinion tends not to understand such issues, opening the field to populist policies, often posing central banks with more difficult policy dilemmas.
References: Hoshi, Takeo and Anil Kashyap. 2004. “Japan’s Financial Crisis and Economic Stagnation.” Journal of Economic Perspectives 18: 3-26.
Posted by: John Muellbauer | September 19th, 2007 at 10:07 am | Report this commentMaclennan, Duncan, John Muellbauer and Mark Stephens (1998, 2000). “Asymmetries in Housing and Financial Market Institutions and EMU.” Oxford Review of Economic Policy, 14 (3): 54-80