The Daily Reckoning
London, England
Wednesday, 24 March 2004
The Daily Reckoning PRESENTS: The good doctor on what's in vogue
among wonks in Washington.
POLICY TRACTION
By Kurt Richebacher
"Policy traction" is an expression that lately has come into
fashion. In essence, it is about the relationship between the
size of the monetary and fiscal stimulus injected into an
economy... and their effect on economic growth and employment.
In the past three years America has experienced an interest rate
collapse, a record fiscal stimulus and the loosest monetary
policy imaginable fueling money and credit creation at a scale
that has no precedent in history. Has it really worked?
Well, in one way it had fabulous traction. It engendered the
greatest credit and debt bubble in history. Total outstanding
debt, financial and non-financial, in the United States has
ballooned by almost $6,500 billion since 2000, as against GDP
growth of $1,238 billion. For each dollar added to GDP, there
were about six dollars added to indebtedness.
And it had fabulous traction in a second way: The runaway money
and credit creation went with a vengeance into asset markets --
stocks, bonds and housing. When the equity bubble popped in early
2000, the consumer simply moved on to the housing bubble that had
been waiting in the wings, helped by the Fed-inspired bond bubble
driving mortgage rates sharply downward.
Their joint result was the unprecedented mortgage finance excess.
While businesses were slashing the consumer's income growth, he
offset this income loss largely by stepping up his borrowing.
Yet in the course of 2002 it became clear that the lowest
short-term interest rates in nearly half a century were failing
to create the customary strong economic recovery. In June, the
Fed cut its interest rate for the 13th time, to 1%, a 45-year
low. In the following month, it admitted in its report to
Congress the fact that the economic performance during the first
half of the year had remained sub-par.
On the other hand, however, the Fed stressed the success of its
easing by mentioning the recent rise in stock prices, the sharp
narrowing of credit spreads on corporate debt, the strong housing
and mortgage refinancing market and rising consumer sentiment.
What, in fact, had emerged was an unprecedented dichotomy in the
effects of the Fed's most aggressive monetary easing between
economy and financial markets. Instead of jump-starting consumer
and business spending, the extreme monetary looseness and
rock-bottom short-term interest rates generated multiple, price
bubbles in the stock, bond, mortgage and housing market.
Without great discussion, the U.S. economy has been shifting to a
growth model that radically differs from past experience. In the
old model that has ruled for centuries, monetary easing was
conceived to work directly on the real economy, and it could be
counted on to promptly do so. But it was a world with low debts
and strong employment and income growth.
Most importantly, it was a world in which financial systems of
very limited size principally served as mere conduits for
channeling savings into capital investment, creating national
wealth in the form of productive plant and equipment, and
commercial and residential buildings.
Faced with an economy that responded poorly to its aggressive
monetary easing, and with very little scope for further cuts in
short-term interest rates, a desperate Fed reacted in an
unconventional way. Internally, it was obviously considering an
attempt to increase policy traction by bringing long-term rates
down as well.
Wanting to avoid direct intervention, it apparently decided to
put America's highly vigilant, huge, financial and speculative
community before the cart, by using nothing more than simple
opportune rhetoric. Repeated public talk by Mr. Greenspan and
other Fed members of looming deflation in the economy was one bit
of bait. Simultaneous talk of two new policy considerations was
the other.
The first idea, was to repeat in public an explicit commitment to
maintain the existing rock-bottom short-term rate peg of 1% as
far "as the eye can see"; and the other one, was public hints
that "unconventional" measures, like direct purchases in the
market, were being considered to push long-term rates further
down as well.
It was really an unreserved invitation to investors and
speculators around the world for greater engagement in playing
America's yield curve with heavily leveraged carry trade. Many
heard and acted promptly. In just six weeks, U.S. 10-year yields
fell from 3.9% to 3.1%.
It should, by the way, be clear that this manipulated indirect
intervention vastly outdid what the Fed could have possibly done
with direct purchases. We have no idea about the scale of the
purchases that suddenly flooded the U.S. bond market, but it was
without question in the range of several hundred billion dollars.
What followed is well known: A frenzied stampede of the financial
community into the highly leveraged bond carry trade sent bond
yields plummeting, pulling in their wake highly correlated
mortgage rates sharply downward with them. In the same vein, the
loose money helped to boost house prices.
Given in addition extremely aggressive mortgage lending
institutions, eager to lend prodigiously against rising house
prices, consumer borrowing just went parabolic.
All in all, four interrelated bubbles have kept the U.S. economy
going after the bursting of the stock market bubble in 2000:
rising house prices, falling bond yields and mortgage rates, and
soaring mortgage loans feeding the consumer spending binge. Yet
the key role fell manifestly to the bond bubble. By pulling
mortgage rates precipitously down, it provided the big bait that
lured house owners to capture the offered big savings in current
interest rate service by refinancing and increasing their
mortgage.
U.S. economic growth, therefore, is no longer based on saving and
investment. Its essence is that credit excess provides soaring
collateral for still more credit excess creating still more asset
inflation for still more borrowing and spending excess. It seems
like a perpetual motion machine that just goes on cranking out
wealth and spending.
The traction that these policies have so far achieved, and its
probable economic and financial effects in the longer run, have
therefore become the most important issue in the current
development in the United States.
The true name of this game is bubble-driven growth... and all
bubbles end by bursting.
Regards,
Kurt Richebacher,
for The Daily Reckoning