Greenspan between a rock and a hard place
April 23, 2004
Edward Chancellor is author of Devil Take the Hindmost: A History of Financial Speculation.
By late 2000, the US economy was threatened by the implosion of a stock market bubble and a sharp downturn in business investment. Many observers, myself included, expected that the economy would face a hard landing as consumers retrenched and the imbalances in the US economy were wrung out of the system. Savings would rise, the trade deficit would be righted and the stock market would return to fair value. Such adjustments were bound to be painful, but they were necessary.
It was not to be. Instead, the Federal Reserve Chairman Alan Greenspan engineered the briefest of recessions by cutting interest rates 550 basis points and then holding them for a prolonged period at 1 per cent. Conventional wisdom now holds that economic recovery is secure enough for interest rates to rise. Such a view, however, ignores the weak foundations upon which this recovery is based.
Faced with the collapse of a stock market bubble, the policy of the Federal Reserve has been straightforward. Keep interest rates low enough to stimulate consumer spending and promote sufficient inflation in other assets to offset any negative effects from the decline of the stock market. This policy has been strikingly successful: between 1999 and the end of 2003, real personal consumption rose every year. Furthermore, despite the sharp decline in the stock market, a strong housing market has ensured that the net worth of US households has actually risen over the past five years.
Yet there has been a price to pay for this policy. Over the past five years both total household assets and gross domestic product have risen roughly by 10 per cent. During the same period household liabilities have increased by over 40 per cent. This suggests that both the rise in asset prices and consumption have been largely fuelled by credit growth. The problem is not simply that household balance sheets and spending depend on supplies of fresh credit. Rather, it is that the economy has become adapted to the conditions of a perpetual credit boom.
Take for instance, the recent payroll figures which heralded the creation of 308,000 new jobs in March. On closer inspection, most of the jobs were created in construction, hospitality & leisure and retail - the very sectors that have most benefited from the credit boom (the other jobs were gained in the government sector and education). The booming housing market in particular has become an engine of job creation: the National Association of Realtors now boasts nearly a million members. New housing starts are running at a record 2 million per annum.
The supply of financial services becomes increasingly important in an economy driven by credit. A couple of years ago, former Morgan Stanley equity strategist Steve Galbraith estimated that around 40 per cent of the earnings of S&P500 companies were derived from financial services. Galbraith estimated that about a third of these earnings came from non-financial corporations. It is common knowledge that both General Motors and Ford earn more from providing car and mortgage loans than from selling cars. General Electric, America's largest industrial company, is also one of the largest banks in the world. General Electric Capital Services earns roughly half of its parent company's profits and has total liabilities of more than $500 billion.
During the last few years, while Greenspan has been steering the United States through its mild recession, the secular decline of the domestic manufacturing sector has accelerated. Nearly 3 million manufacturing jobs have gone since 2000. Many argue that this is only to be expected during the transition to a "post-industrial" economy. If this were true, then the US would be exporting software or other intangible services produced by its New Economy to pay for Asian manufactures. In fact, America pays Asia with the credit notes of its giant mortgage - provided by the so-called Government Sponsored Enterprises, such as Fannie Mae and Freddie Mac, which have been issued to finance the domestic housing boom. Over the past five years, the number of empty containers leaving the Port of Los Angeles has doubled to roughly four million and the US trade deficit has climbed to around five per cent of GDP.
The inflationary manifestations of the Federal Reserve's easy money policy are clearly visible throughout the global economy. House prices are soaring around the world. An unprecedented capital investment boom in China is also forcing up commodity prices. Interest rates need to rise.
But what will happen in the United States if they do?
Car loans in the United States are currently of longer duration and require lower down-payments than ever before in history. Around a third of all car owners already owe more on their cars than their actual market value. The era of easy money has brought forward sales from the future. When rates rise, automobile sales will most likely dry up. The housing market is also likely be troubled by rising interest rates. A question mark hangs over the ability of Fannie Mae and Freddie Mac to hedge their multi-trillion dollar loan portfolios as their cost of short-term borrowing climbs and the duration of their loans extends. Once mortgage refinancing and home equity extraction peter out, it is likely that consumer spending will retrench and the housing boom will come to an end. If consumption and the housing market go into reverse, then it is likely that both the stock market and credit system will follow them.
The Federal Reserve now finds itself caught between a rock and a hard place: if it leaves interest rates untouched at their current level, then consumer price inflation will almost certainly take off. Rising interest rates, however, threaten to stall the US economy and bring about a deflationary collapse. Current Fed thinking blames both the Federal Reserve in the 1930s and the Bank of the Japan in the early 1990s for pursuing excessively tight monetary policies after the collapse of earlier speculative bubbles. This suggests that low interest rates will be with us for some time to come. |
