The Fed’s Dangerous Experiment May Be Drawing To A Close
August 17, 2004
“Carry on rising” is not the latest instalment from the famous British “Carry On” film comedies of the 1960s, but seems to be the new message emanating from the suddenly “hawkish” Greenspan Fed. In spite of a plethora of June data indicating a potentially softening economy, America’s central bank indicated last week that neither slower employment growth, nor sharply rising oil prices, would induce a reluctance to raise rates further as the year progresses. If one is to believe the Fed, the recent constellation of economic data is merely “the pause that refreshes”, rather than presaging an imminent collapse of economic activity.
July’s retail sales would appear to confirm the Fed’s relatively optimistic assessment of the US economy, although the July employment figures do give rise for some concern, given that they were “beyond the wild imaginings of the most confirmed pessimist”, in the words of one stunned market commentator. In any event, the Fed has become a prisoner of its own expectations management game: Since there was a universal expectation that the Fed would raise rates by one-quarter point last week for the second successive time, not doing so would have been seen as an admission that things were going badly wrong.
But if the Fed is truly serious about continuing in its tightening mode, then its actions in the coming months could push an economy – now precariously tottering between credit boom and bust – toward its tipping point. One of the big questions which has persistently dogged market practitioners over the past few years is the following: Could Federal Reserve policy successfully rekindle the powerful bubble dynamics of the late 1990’s, or simply manage to ignite an echo of that speculation, which would ultimately be overwhelmed by massive balance sheet adjustments hitherto uncompleted by the vast majority of US households and corporations? Related to this question is the vexed issue as to whether treating the aftermath of a credit bubble with the same policy measures as that which arguably induced the disease in the first place (i.e. further massive doses of monetary and fiscal stimulus) would facilitate a cure, as the Greenspan/Bernanke wing of the Fed has consistently argued; failing that, would more “unconventional measures” ultimately prove necessary to salvage this unique experiment in the annals of central banking history.
Certainly from the point of view of standard macro-economic financial balances theory, it was hard to make the case that Policy had successfully eradicated the excesses of the 1990s bubble in spite of the Fed’s increasingly confident pronouncements last year to the contrary. True, the economy has gained momentum throughout much of the past 12 months. But it is important to recall that the roots of this current growth spurt (massive debt expansion) ultimately remain part of the problem, which is why we question the notion it is better to deal with the after-effects of a bubble, as Greenspan and Bernanke have consistently argued, rather than attempting to break the back of an incipient bubble (as the pre-1995 Greenspan used to maintain before he caught the “New Economy” religion).
Keep in mind that when the consumer is deficit spending (as it is today), it means that households are adding to their outstanding debt load. Although the private sector in aggregate did reduce debt during the early part of 2000-2001, (during which a severe recession was largely averted through a substantial relaxation of fiscal policy), this process was insufficient to cleanse personal balance sheets by the time the Fed declared “mission accomplished” last year (evoking sentiments today as laughably ill-judged as President Bush’s appearance on an aircraft carrier last May when he declared an “end” to combat operations in Iraq). The fact remains that private debt has not been paid down in this recession, but has in fact risen to record levels, thereby placing the basis of the current “economic recovery” on hugely fragile foundations.
Decades of government intervention to prevent financial crises and price deflation have encouraged economic agents to accumulate the highest private debt burdens ever attained, including even the high debt levels created by the most severe price deflations of the past. Even without outright price deflation, these debt private burdens ultimately threaten stagflation (probably a best-case scenario), recession, a severe currency decline and concomitant financial crisis in which debt deflation dynamics take over.
Financial flow imbalances, if allowed to persist, lead to stock disequilibria on balance sheets. Should income flows to households or firms be disrupted, the ability of the private sector to meet its prior financial commitments becomes jeopardized. Alternatively, should foreign portfolio preferences change, perhaps as comfortable risk and return perceptions of US assets are disturbed, the level of US interest rates, equity prices, and foreign exchange value of the dollar held would also have to change to insure these assets remain held voluntarily.
When a sector of the economy has a high existing debt load relative to income, and it continues to deficit spend, a fall in rate of income growth relative to interest rates can trigger a surge in the debt to income ratio. However, once it becomes apparent to creditors that a sector of the economy is entering an explosive debt path in this fashion, credit rationing is generally not too far behind. Since income growth depends to a certain extent on net new credit creation in a monetary production economy, the end result of these debt trap dynamics is not an explosive growth of debt, but rather a collapse of income generation, which leads in time to the invalidation of prior debt.
That “debt deflation dynamics” have not manifested themselves thus far in the US does not invalidate the theory. The Fed has had a “partner in crime” – ongoing flows of foreign credit from the emerging world, notably Asia. Today, the net inflow of foreign capital to the United States represents a staggering 75 percent of the net outflows from the rest of the world, according to economist Jane D'Arista of the Financial Markets Center. Even more abnormal is that nearly one-fourth of this lending comes from emerging-market nations, such as China, when traditionally capital flows the other way: from the developed world to the emerging markets.
The persistent recycling of export surpluses into US Treasuries by the foreign (primarily Asian) official sector has had a two-fold effect: it has prevented a calamitous fall in the external value of the dollar, which in turn has forestalled a private sector credit revulsion, given that these agents accurately (thus far) view Asia’s central bankers as “sub-underwriter of the dollar of last resort”.
Both the Bank of China and Bank of Japan in particular are prodigious financiers of US consumption--the two largest foreign holders of US Treasury bonds--despite the weak returns they get from low US interest rates. China and Japan are willing to do this because they calculate that sustaining their own industrial output and employment is worth more than seeking stronger financial returns elsewhere.
Although both sides recognise a self-interest in keeping the game going--avoiding a global meltdown that might occur were external flows to the US rapidly withdrawn -- it is important to note that the “benefits” from this co-operation are not equally distributed: The US consumer can continue his/her buying binge. But through increased indebtedness he/she must repay from future production, future production which in the meantime is rapidly being shifted offshore. By contrast, Asia’s central bankers are prepared to let the US consumer accumulate debt now (even at the cost of non-repayment in the future) in order to expand their industrial capabilities to produce in the future and (in the case of China) ultimately to supersede the US in economic terms.
Which means that the role of the foreign creditor and, by extension, the dollar, is crucially important. According to the Fed statement last week, accompanying the announcement of a 25 basis point hike in the Feds fund rate, current softness in the economy is only temporary and it is 'poised to resume a stronger pace of expansion'. The hawkishness of the statement was indeed puzzling, coming as it did amidst a plethora of June indicators (e.g. retail sales, the employment numbers, car sales, housing starts, etc.) which severely disappointed market expectations of a rapidly recovering economy. Ed Hyman, usually at the forefront of identifying the Street’s new conventional wisdom, had declared that the economy had entered a “soft spot”.
How soft and for how long? If we are to listen to the Fed chairman, the June data was a mere breather, a small bump in the road, and not the leading edge of a new economic slowdown (which would certainly validate the latest rate rise). But in light of the release of last Friday’s disastrous trade number, we suspect that something else is going on.
Today, after a decade and a half of current account deficits, the U.S. has a huge current account deficit and a huge net external debt. The Fed has shown that, for countries other than the U.S., whenever the current account deficit has reached the 5 per cent threshold of GDP, as now prevails in the U.S. for the first time in its’ modern history, there follows a severe currency depreciation, along with a major financial/economic crisis.
Such a currency depreciation which often is associated with adverse impacts on domestic financial markets and the course of domestic output. Net external debts of now exceeding 25 per cent of GDP like that of the U.S. today appear to be manageable, but, far more often than not, when they go higher, there ensues a country debt crisis. With the U.S. the crisis threshold may be especially high given the status of the dollar as the world’s reserve currency, but none the less crisis levels cannot be that far away. Even Asia’s central bankers may fear that at some point they will have to “cut and run” in the interests of their own self-preservation. They have seen this show before: the interplay between the U.S.’s large current account deficit and large external debt places the American economy ever closer to what the Asians themselves experienced back in 1997/98.
For the Fed to avoid this panicked withdrawal of foreign capital, it is particularly important to pacify the country’s ever growing legion of foreign creditors. As far as conventional policy, we wonder what else the Fed might have up its sleeve. After all, if economic growth is indeed decelerating than the worry must surely intensify as the world realises there are a mere 150 basis points between the current fed funds rate and zero. The long threatened move to “unconventional policy measures” (the Fed’s hitherto unsheathed sword) looms ever closer and this, paradoxically, might prove the final straw to foreign creditors panicked by the apparent need to resort to highly unorthodox economic policy.
The Greenspan Fed, however, has hitherto chosen to manage expectations in the hope that market participants (especially those friendly Asian central banks) will do their work of lifting asset prices for them and help keep the dollar aloft because they know they can’t actually succeed in carrying out the radical interventionist action they have sometimes hinted at (such as the ill-judged bluff to peg bond yields).
But the country’s monetary authorities are clearly backed into a corner by multiple bubbles of their own making which they are juggling to keep aloft. Policy has already gone to unimaginable extremes. Fiscal deficits have exploded and monetary policy is now reminiscent of a Third World basket case economy. The trade deficit continues to head toward hitherto unimaginable extremes. As we have noted many times in the past, the U.S. is now beholden to the kindness of strangers to an extreme degree. If they view the U.S. external account balance as unsustainable, they might sell Treasury bonds on a scale that will be very large relative to the operations in the same market by domestic market participants. Once currency losses are coupled with many quarters of capital losses, the willingness of foreign investors to maintain their existing holdings of US financial assets, never mind increase the share of US assets in their portfolios, is likely to decay rapidly. US asset will need to get cheap enough or offer high enough yields to keep foreigners willing holders and accumulators of US assets. This may prove to be the ultimate credit tripwire for the US economy. By starting down the road to a more “neutral monetary policy stance”, the Fed may get more than they have bargained for. Time for the Working Group on Financial Markets to step it up another gear?
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