Global: Staring Into the Abyss
by Stephen Roach
April 18, 2001, could well go down in history as an epiphany for America’s Federal Reserve. The central bank is now looking at the U.S. economy through a very different lens. In the aftermath of 150 basis points of monetary easing over the past three months, a garden-variety inventory correction would hardly require another aggressive inter-meeting policy adjustment. A post-bubble shakeout would. In my opinion, the Fed is finally owning up to a very different set of macro risks. As well it should.
Alan Greenspan had it dead right when he first warned of "irrational exuberance" at Dow 6437 more than four years ago. But like many economists, he was early -- a trait that I can certainly relate to. But the very asset bubble he feared expanded and popped before our very eyes. And this has raised the risks of the nightmare scenario that haunts every central banker -- the unwinding of bubble-induced excesses in the real economy. History is not exactly replete with examples of post-bubble shakeouts. America in the 1930s and Japan in the 1990s painfully come to mind. One of the most salient lessons from both of those earlier episodes is that the aftershocks are long and painful -- and, unfortunately, not tempered by lower interest rates. Try as they might, the authorities usually end up "pushing on a string." But that doesn’t stop them from trying -- and that’s exactly what I sense the Fed is now beginning to do.
Few agree with this interpretation. It even puts me at odds with our own U.S. economics team (see the dispatches by Dick Berner and David Greenlaw in the 19 April Global Economic Forum. Following our out-of-consensus recession call for 2001, our baseline case still has a Fed-induced U-shaped recovery beginning in early 2002. I concede that I am posing an extreme depiction of the events of the past several years. It seems particularly farfetched for a U.S. economy that was on such a lofty pedestal as recently as nine months ago. As the champion of the New Economy, America could do no wrong -- and the rest of the world was scrambling to catch up. But Alan Greenspan put it best when he also noted that history is littered with the carcasses of New Eras. Little did he know how close to the mark he was.
With all due respect to the Fed Chairman, I fear he became an integral part of the very problem he is now facing. By raising the possibility of an asset bubble but then failing to address it, the Fed created an excruciating moral hazard dilemma. Moreover, by championing the brilliance of the New Economy, Alan Greenspan joined with the New Paradigm crowd in tacitly encouraging businesses and consumers to do the same. And they did. Companies became convinced that open-ended technology spending was the source of hyper growth in both productivity and earnings. Capacity excesses then took on legendary proportions as the Old Economy embraced this new macro framework and erected e-based platforms that now stand side by side with traditional business models. In an era of hyper growth, such dual cost structures seemed to make great sense. In a period of sluggish growth, they make no sense. At the same time, consumers became convinced that stock-market returns were an accurate reflection of new corporate earnings power; financial assets were perceived as a permanent source of saving that fully justified a drawdown of earnings-based saving and a debt-financed, wealth-induced spending binge. The financial bubble had truly infected the real economy. And the Fed did nothing to stop it.
But now the music has stopped. And by finally recognizing the mounting perils of an investment-led slowdown, the Fed is owning up to a very different reality than it first posed a few months ago. The financial markets see it differently. An aggressive Fed is thought to be just what a battered equity market needs. The cry of "Don’t fight the Fed" finally makes great sense. That raises one of the most intriguing possibilities of all: With the layoff cycle now beginning to take a worrisome upturn, the American consumer is about to get hit by the most powerful cyclical force of all U.S. -- the income effect stemming from headcount reductions and wage compression. To the extent that the U.S. economy is now facing the twin perils of negative income and wealth effects, the Fed may be more than willing to opt for what I have called the "bubble fix" -- in effect, attempting to neutralize the negative wealth effect by reflating the stock market (see my 5 February dispatch, "The Bubble Fix"). Flouting the moral hazard critique is a small price to pay if the US can avoid the perils of a post-bubble climate.
The Fed probably believes it has little to lose from such a gambit. With the war against inflation all but over, there is a new and important asymmetry to policy risks. The central bank can afford to ease with impunity. The big question is whether the Fed will be able to get lasting traction with its actions. The history of post-bubble economies is not encouraging in this regard. A U-shaped upturn would be considered a blessed event. The norm, unfortunately, is far more L-shaped. The V that investors still seem to be banking on in 2002 -- with IBES earnings expectations holding at +16% --seems virtually out of the question.
As I see it, the Fed has sent a strong message with its April 18 interest rate surprise. It is giving up on the V and now sees macro perils in a far more worrisome light. That suggests there is a good deal more to come on the monetary easing front in the months ahead. In my stylized view of the world -- again, far more extreme than that of our US team -- the federal funds rate is headed to 3%, or lower, in the months ahead. And the sooner, the better. I applaud the Fed’s shift, but worry increasingly that it may be too late. But at least Greenspan & Co. are now taking a stand. Aggressive rate cuts may be the Fed’s last hope to avoid the abyss. |
