Global: Time to Reload
morganstanley.com
By Stephen Roach (New York)
Morgan Stanley
Feb 06, 2004
Economic policy-making requires a touch of art as well as science. But it also needs a good deal of common sense. Like war, one of the basic principles of stabilization policy is never to run out of ammunition. Policy stimulus is to be used in bad times, but when circumstances improve, it is critical to “reload the cannon.” Otherwise, there will be no ammo for the inevitable next battle.
As simple as this basic rule is, it has all but been forgotten in the current climate. The Bank of Japan’s zero interest rate policy is the most obvious case in point — a central bank that has completely run out of basis points. But it’s not as if the monetary authorities in America and Europe have vast stockpiles of arms either; their policy rates are only 1% and 2%, respectively. The same rule, of course, applies to fiscal policy — deficit spending in bad times should be followed by fiscal restraint in good times. The recent globalization of fiscal profligacy is not exactly comforting in that regard either.
The basic principle of the “policy reload” is particularly relevant to the dilemma now faced by America’s Federal Reserve. Alan Greenspan’s recent “victory lap” in celebration of the Fed’s so-called successes of the past few years makes me especially worried that the US central bank is ignoring this principle at great peril. In a now infamous speech given about a month ago, the chairman argued that the Fed should be vindicated for its controversial approach in dealing with the great stock market bubble of the late 1990s (see “Risk and Uncertainty in Monetary Policy,” remarks presented at the meetings of the American Economic Association, San Diego, California, January 3, 2004). Notwithstanding the usual caveats of Fedspeak, one phrase from that speech says it all: “Our strategy of addressing the bubble's consequences rather than the bubble itself has been successful.”
Think about the implications of this strategy. Chastened by the criticism he faced after declaring the stock market “irrationally exuberant” in December 1996, Greenspan now argues that central banks should remain agnostic on the existence of a bubble. Their job, instead, should be to contain the post-bubble damage — if and when it occurs. Fortunately for the Fed, it had some 600 basis points of ammunition in the federal funds rate at the time the equity bubble popped. But now 500 of those basis points have been used up.
That underscores the critical issue: With only 100 bp left on the federal funds rate, what can the Fed do for an encore? Last spring, in the midst of the great deflation scare, Fed officials argued that they had plenty of options left — namely, the “unconventional” weapons that could be deployed in the event the central bank ran out of basis points. But, in my view, there was more bluster than substance to those long-discredited monetarist claims. Japan’s post-bubble pitfalls seem to add considerable credence to this critique. But that’s really not my point. The real problem with using monetary policy only to contain post-bubble damage is that the central bank unwittingly locks itself into an asymmetrical policy tilt — ending up with an economy that becomes addicted to rock-bottom nominal interest rates. That makes it all but impossible to reload the policy cannon.
That is precisely the Fed’s dilemma today. Sure, the US economy came through the bursting of the equity bubble in considerably better shape than most feared. But the real question is, at what cost? Ironically, post-bubble America finds itself even more dependent on asset markets than was the case during the pre-bubble build-up. In part, that’s because a new and unexpected development has also come into play — a jobless recovery that has put an unprecedented crimp in the economy’s personal income generating capacity. In retrospect, that was the critical complication that called the Fed’s bluff at precisely the point when it had all but run of ammo.
Lacking in the traditional fuel of income support, consumers have had little choice but to extract purchasing power from yet another asset — this time, property. But such asset-driven growth spawns the lethal combination of debt and reduced saving. And America has willingly complied. Household debt outstanding has soared to a record 82% of GDP, while the net national saving rate plunged to a record low of less than 1% in 2003. Unfortunately, the shortfall of domestic saving has given rise to America’s massive current-account deficit — leaving the US economy with the worst confluence of macro imbalances in its modern history. All this and more is an outgrowth of the Fed’s asymmetrical strategy of coping with asset bubbles — holding its fire on the upside but then deploying maximum defenses on the downside.
Meanwhile, this approach has another worrisome by-product: It has become a breeding ground for a string of additional asset bubbles that have come on the scene in the aftermath of the burst equity bubble. That’s not just true of property but also of bonds, credit instruments, emerging market debt, and tech stocks (again). This multiple-bubble syndrome is strikingly reminiscent of the moral hazard play that became central to the Great Bubble of the late 1990s — the recognition on the part of investors and speculators that Fed accommodation was here to stay. As long as the Fed takes interest-rate risk out of the equation, one bubble begets another.
And so today’s Fed finds itself very much at odds with the time-honored principle of the policy reload. And yet the imperatives of replenishing the ammunition have never seemed greater. What would the Fed do if the US economy unexpectedly stumbled, another asset bubble popped, or an exogenous shock occurred? What worries me the most is that the Fed’s new strategy as articulated in San Diego by Alan Greenspan could boil down to a one-bubble fix. Unless the Fed can replenish its policy arsenal, it may well be helpless to deal with the inevitable next problem. Far from congratulating itself on the brilliance of its post-bubble-containment tactics, America’s central bank should be doing everything in its power to replenish its arsenal and get its policy rate back up to a more normal level.
This is a delicate balancing act, to say the least. Deflation still lurks on the downside, but there is also a need to take advantage of swings to the upside. The risk-reward calculus is daunting, but the Fed has no choice, in my view. It needs to exploit any chance it can to normalize its policy rate. It’s the analog of what became known as “opportunistic disinflation” in the early 1990s — allowing periods of economic slack to reinforce the Fed’s battle for price stability. That war is now over. Now it’s time for “opportunistic reflation” — a Fed that uses every instance of strength as an occasion to reload the policy cannon. There is always the risk of overkill — an increase in short-term interest rates that takes a toll on the real economy. But the far bigger risk, in my view, is a central bank that is not only fostering a series of asset bubbles but is also lacking in ammunition for future problems.
Nearly two years ago, the Fed’s research staff published a now seminal paper that tipped us off on how the US central bank would cope with America’s asset bubble. Billed as an assessment of the lessons of Japan, the Fed’s economists argued that the Bank of Japan should have eased quickly and aggressively in the immediate aftermath of the bursting of the bubble in the Nikkei (see Alan Ahearne et al., Preventing Deflation: Lessons from Japan's Experience in the 1990s, Federal Reserve International Financial Discussion Paper No. 729, June 2002). The Fed obviously took those lessons to heart in implementing its own post-bubble strategy of aggressive monetary accommodation. Unfortunately, the Fed’s research staff never took their analysis to the next level — how a central bank executes the policy reload by extricating itself from the exceedingly low nominal interest rates of a post-bubble period. Let’s hope someone at the Fed is hard at work on writing that paper. |
