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Big Freeze part 4: A US recovery Published: August 6 2008 20:17 | Last updated: August 6 2008 20:17 US housing Macroeconomists, like medical scientists, use case studies to teach their students about the maladies to which the system is susceptible. For supply shocks and stagflation, the example is the 1970s. The financial dislocations that occur when bubbles burst are illustrated by the Great Depression and Japan's problems in the 1990s. The importance of central bank credibility in resisting inflation emerges from discussion of the experience of the late 1960s and the 1970s. What is most remarkable and troubling about our current difficulties is that all these elements - supply shocks, financial dislocations and concern about rising underlying inflation - are present at once. Concerns about recession are spreading from the US to much of the industrialised world. Significant slowdowns appear more likely in a number of emerging markets, with inflation concerns worldwide at their highest level in more than a decade. There is a growing consensus that the west is facing the most serious financial crisis since the second world war. Perhaps unsurprisingly in the face of so many adverse surprises, the policy debate has become cacophonous. Some emphasise the necessity of the painful adjustments under way, while others urge their mitigation. Some focus on product price inflation, others on asset price deflation as the principal problem. Some focus on assuring that imprudent lending by financial institutions is discouraged, others on assuring that financing for investment by households and businesses remains available. Some focus on slowing market adjustments to prevent panic, others on the need for rapid adjustment of prices to true fundamental levels, even if this is painful in the short run. Equally unsurprisingly given the chaotic debate, policymaking has become increasingly reactive and erratic, with a growing tendency to repeat traditional errors. While US policymakers have long cited Japan's indecisiveness with respect to troubled financial institutions, its resort to gimmickry and market manipulation, and its lack of transparency in the management of financial crisis in the 1990s as a negative example, they are increasingly repeating Japan's errors.
made explicit the implicit guarantee on the $5,000bn (2,500bn, EUR3,250bn) balance sheet of Fannie Mae and Freddie Mac in order to prevent a run on the government-sponsored enterprises while imposing no penalties on shareholders or forcing any changes on management - not even the cessation of dividends.
make short-selling harder, with the stated objective of raising (many would say manipulating) the stock prices of financial institutions, while some in Congress have proposed to prevent certain investors from going long on commodity futures. Without much sign of official resistance, the global banking industry is pushing for less reliance on market prices and more on managerial judgment in valuing the assets where bad credit and investment decisions have led to hundreds of billions of dollars of losses over the past year. Setting policy in a more proactive and principled way requires reaching a number of judgments regarding where things currently stand and the likely effects of potential actions or failures to act. In an effort to advance the debate, the remainder of this article poses and provides my answer to what seem to me to be the crucial questions for American economic policy. How long will the economy stay weak on the current policy path? The best available estimates suggest that the American economy is operating between 2 and 25 per cent below its sustainable potential level. This translates into more than $300bn, or $4,000 for the average family of four, in lost output. Even if, as I think unlikely, recession is avoided, growth is almost certain to be so slow that the gap between actual and potential output comes close to doubling over the next year or so. Given that unemployment peaked nearly two years after the end of the last recession, output and employment are likely to remain below their potential levels for several years in the best of circumstances. Given the combined impact of rising commodity prices, falling house prices, reduced availability of credit and rising uncertainty, it is surprising that the economy has shown as much strength as it has in recent months.
effects of tax rebates wear off and those of tighter credit conditions feed through, the economy will take another downwards turn. Just as the bottom was called early a number of times in Japan in the early 1990s and in the US in the early 1930s, we have seen and no doubt will see moments of sunlight that create hope that the worst is past. Yet it bears emphasis that in the current context there can be no confident reliance on the equilibrating powers of the market. Alan Greenspan has been fond of explaining that the resilience of the US financial system and economy results from reliance on two pillars: banks and capital markets. When the banks were in trouble, as in 1991, capital markets took up the slack; when the capital markets were in trouble, as in 1998, the banks took up the slack. Unfortunately, today both the banks and the capital markets show signs of crisis. Four vicious cycles are simultaneously under way: falling asset prices are forcing levered holders to sell, driving prices further down; losses at financial institutions are reducing their ability to finance investment, which in turn reduces asset values, causing further losses; the weakness of the financial system is reducing growth, which in turn weakens the financial system; and falling output is hitting employment, which in turn leads to reduced demand for output. Without active efforts to interfere with these mechanisms, there can be no basis for confidence that the American economy will recover even in the medium term. It is often argued that the current economic downturn is an inevitability that cannot be prevented, or that is necessary and desirable. Some observers almost seem to suggest that a recession is a kind of just desert for a country that has lived beyond its means. The more serious concerns are that an economic downturn is a necessary concomitant of increasing US national saving and reducing current account deficits, or of preserving the credibility of the Federal Reserve's commitment to price stability. Granting that US consumer spending grew more rapidly than gross domestic product over most of the past decade and that ultimately the consumption share of GDP will have to fall back to more normal levels, it is hard to see why necessary increases in saving require a protracted recession. Instead, declines in consumer spending and improvements in the government's fiscal position should be sequenced to coincide with improvements in net exports and investment. Allowing consumer spending to spiral downwards without offsetting policy actions risks reducing investment and incomes in the US and transmitting the US slowdown to the rest of the world. Moreover, even if the argument for supporting consumption at present were rejected, there would still be a strong argument for supporting investment in areas such as infrastructure, where there is no evidence of a glut and considerable evidence of shortfalls. As for the inflation question, constant vigilance is necessary. It is certainly true that product price inflation has ticked upwards, though this seems to be heavily commodity-related. Even if commodity prices do not fall but only stop rising, the result will be an improvement in standard inflation measures. Moreover, if the principal problem is commodity price inflation, there are surely better ways to address it than increasing unemployment and reducing capital utilisation. Crucially for the inflation process, there is not yet evidence of rising wage pressures or increases in the growth rate of unit labour costs. Nor do indexed bond markets reveal a significant change in longer-term inflationary expectations. In an environment of rising unemployment, greater worker insecurity and increasing global competition, there are likely to be sub...
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