The Daily Reckoning
London, England
Tuesday, 11 May 2004
The Daily Reckoning PRESENTS: The Fed issued a 'deflation
scare' to harness Wall Street's awesome speculative
firepower. The E-Z credit gushed. But if you play with
fire, sooner or later, you'll get burned...
IMBALANCES AND DISLOCATIONS
By Kurt Richebächer
Attempting to assess the U.S. economy's further outlook,
one should first ponder the main causes that have been
thwarting a stronger and healthier recovery, even though
the Fed's monetary and fiscal policy has achieved
aggressiveness without precedent in history.
For most American economists, sufficiently easy money is of
infallible efficacy. The few instances in history when
record-low interest rates persistently failed to work, like
recently in Japan and during the 1930s in the United
States, are summarily discarded with the argument that
central banks failed to act fast enough.
During the whole postwar period, it has, in fact, been
typical that depressed economies promptly took off once
central banks eased. Yet for us, this was never proof of
the efficacy of monetary policy. Since all postwar
recessions had their cause in monetary tightening, it was
only natural that economies promptly jump-started when
central banks loosened their brakes.
But the situation today is radically different. For the
first time in the whole postwar period, the U.S. economy
slumped against the backdrop of rampant money and credit
growth. But if tight money or credit did not break the boom
in 2000, it is hard to see how easy money can be the cure.
Identifying the true causes of the U.S. economy's poor
economic performance in recent years is certainly a most
important task. During 2003, leading Fed members propagated
the idea that the U.S. economy was mainly suffering from an
"unwelcome fall in inflation" - according to the title of a
speech by Fed Governor Ben S. Bernanke, on July 23, 2003,
at the University of California, San Diego. In more detail,
Bernanke said that lack of pricing power was seriously
impinging upon corporate profits, which in turn had
strangled business capital investment.
Considering that the U.S. economy had been booming with the
most rapid money and credit growth in history, this was an
absurd conclusion. But several Fed members managed to
exploit the temporary deflation scare they had raised, the
better to implant expectations for sharply lower long-term
interest rates into the markets - with the desired effect
that the financial community, with its huge speculative
firepower, quickly obliged with prodigious carry trade.
What, then, brought the U.S. economy down in 2000? In
short, several years of unprecedented credit excess. We
realize this is unthinkable for many people, yet it is a
notorious historic fact that serious depressions are always
preceded by extremely loose money and extraordinary credit
excess. Tight money is too easily reversible to cause a
deeper crisis. Ironically, it was always low inflation
rates that misled central banks to excessive credit
accommodation.
The two worst cases of this kind in history are, of course,
the U.S. boom-bust from 1927 to the 1930s and Japan's boom-
bust since 1987. In both cases, extraordinary asset bubbles
played a key role in escalating credit excess. The third,
and probably worst, case of a "bubble economy" is the
United States for the past several years.
Credit excess thwarts economic growth even in the absence
of monetary tightening, through effects ambiguously known
in Austrian theory under different labels: structural
maladjustments, distortions, and imbalances and
dislocations.
The imbalances most often cited are a rock-bottom national
savings rate of 1% of GDP, record levels of personal
indebtedness, a record current account deficit, a record-
high budget deficit, a record ratio of household
indebtedness and an unprecedented shortfall of employment
growth and labor income generation.
But there are important other imbalances that are totally
ignored. One of them is the tremendous gap that has
developed in the United States between virtually stagnating
production of goods and soaring demand, as measured in
retail sales. While the latter have been going from record
to record, manufacturing production, which should deliver
most of the goods sold in the shops, has been badly
lagging. The soaring difference went, of course, into the
soaring trade deficit.
For more than two years, the Fed has been holding its
short-term rate at 1%. That is, below inflation. But
instead of spurring economic growth directly, it stimulated
sharply rising prices in almost all major asset classes,
which in turn stimulated spending, mainly consumer
spending. Rising property values and the increasing ability
and willingness of homeowners to tap accumulated housing
wealth became the major pillars of support both for the
economy and also - given minimal personal savings - for the
asset markets.
The all-important question now, of course, is whether this
ultra-loose monetary policy and the associated development
of asset prices have laid the foundation for a normal,
self-sustaining economic recovery.
Good luck, Dr. Greenspan.
Regards,
Kurt Richebächer
for The Daily Reckoning