FED HELPED CREATE NEW THREATS - long, but..

  • Thread starter Thread starter Guest
  • Start date Start date
G

Guest

Guest
imported post

Fed Helped Create New Threats Low Rates Bolstered Economy, But Housing, Foreign Debt Appear Out of Balance Greenspan's Legacy at Stake By GREG IP WSJ 6_9

By many yardsticks, the Federal Reserve's response to the bursting of the stock and tech-spending bubbles in 2000 has been a remarkable success. The 2001 recession was mild and economic growth since has been brisk. Employment is up and inflation remains within the Fed's hallowed zone of price stability.

But five years after the stock market's peak, the economy faces other threatening imbalances: a potential housing bubble, rock-bottom personal saving rates and a gargantuan trade deficit. And the Fed's post-bubble prescription bears some responsibility for all three. Fed officials acknowledge as much but say the alternatives were worse.

By slashing short-term interest rates to 45-year lows, the Fed encouraged Americans to borrow more, gave them little reward for saving and helped ignite a surge in housing prices. President Bush and Congress joined in with steep tax cuts that boosted household purchasing power. All that spending contributed to a growing U.S. economy, a steady increase in imports and -- given that Americans are so eager to borrow and foreigners so eager to lend -- a mountain of foreign debt.

This is pleasant for Americans as long as it lasts. But Fed officials, international financial
watchdogs and private economists say it can't. At some point, American consumers must spend less, save more and rely less on foreigners' savings.


How that will happen puts the nation in uncharted territory: After treating a bubble, how does the Fed manage the side effects of its medicine?

"We have done what no other economy has done before, faced with an asset bubble," Lawrence Lindsey, a former Fed governor and Bush adviser, said at a recent panel discussion. Praising both the Fed's rate cuts and Mr. Bush's tax cuts, he said, "This is the first time in history the textbook economic policy... was used, and worked. The problem is, once you finish that chapter of the economic texts, you turn the page and the page is blank -- because no one has gone through the process before."

The Fed is confident these imbalances will be resolved with little pain. As it raises interest rates, consumers will slow their spending and save more. Foreigners' appetite for U.S. goods will rise. The engine of U.S. growth will shift smoothly from consumers and government to business investment and exports. Fed Chairman Alan Greenspan might address this when he testifies on the economic outlook to Congress today.

But a minority of economists warn of a more damaging scenario. Some say the Fed has simply replaced the stock-market bubble with one in housing, which could burst. That would sap the consumer spending that mortgage refinancing and home-equity loans have fueled. Or foreign investors could stop buying U.S. stocks and bonds, sending the dollar down and inflation up, prompting both the Fed and bond market to jack up interest rates sharply. In either case, the U.S. economy could slow sharply or fall into recession.

Faced with an asset bubble, a central bank has two choices: Prick it early or wait for it to burst and try to contain the damage. The Fed in 1929 and the Bank of Japan in 1989 tried the first route, raising interest rates in response to rapidly rising asset prices. The result in the U.S. in the 1930s was depression and deflation. In Japan it was stagnation and deflation that continues today.

In the 1990s, Mr. Greenspan chose the second route. As long as the prices of goods and services were stable, he would leave the stock market alone. When the stock bubble finally burst, the Fed cut short-term rates aggressively beginning in 2001 and then held them at a 45-year low of 1% through early 2004 until the Fed was sure the threat of deflation had receded.

Mr. Greenspan knew his strategy carried risks. But he saw far greater ones in responding timidly as the collapse of the biggest asset bubble in history wiped out more than $5 trillion in shareholder value, and terrorist attacks, war and corporate scandal rattled confidence. The economic expansion to date suggests he was right, and the odds are that he will retire as scheduled next January with his reputation for economic stewardship intact. But if a collapse in housing prices or a run on the dollar triggers a new recession, Mr. Greenspan's legacy may be different. The Fed is conducting a "crucial experiment" in post-bubble monetary policy, says Edward Chancellor, a financial historian. "We don't know what the outcome is yet."

Lower interest rates normally operate through several channels. They encourage consumers to buy things on credit today instead of saving to buy the items later. They boost stock and home prices, which makes the owners of those assets wealthier and more willing to spend. They encourage businesses to borrow and invest. And they depress the dollar, boosting exports.

But after 2001, some of these channels were blocked. Businesses, burdened with a glut of unused equipment from the bubble years and cowed by geopolitical and regulatory uncertainty, didn't borrow to invest. And the dollar didn't fall initially, but rose because foreign economies were in even worse shape than the U.S.'s. This meant the economy relied disproportionately on the one channel that did respond: consumers. They bought record numbers of houses and cars, mostly on credit. They also borrowed against their houses' appreciated values, allowing them to spend more still.

To Mr. Greenspan, who had studied housing and mortgage markets all his life, this came as no surprise. "Households have been able with increasing ease to extract equity from their homes, and this doubtless has helped support consumer spending in recent years, complementing the traditional effects of monetary policy," he observed in August 2003.

A Worse Alternative

Accused by some of fostering excess, Fed officials responded that the alternative was worse: a deeper recession and the risk of deflation -- a period of generally falling prices, which can worsen a downturn by making it harder for workers and companies to repay debts. In a February 2003 speech Fed Governor Donald Kohn, one of the central bank's principal monetary-policy strategists, agreed low interest rates had had an outsize impact on car sales, home construction and housing prices. But that "has kept more people employed and reduced the risk of deflation," he said.

By January 2004, the expansion seemed entrenched enough for Mr. Greenspan to declare victory: "Our strategy of addressing the bubble's consequences rather than the bubble itself has been successful." While "large residues" of household and foreign debt remained, they would not be a barrier to growth; such imbalances, he suggested, would dissipate with time.

Instead, they have grown. "The magnitude of these imbalances is increasingly moving into unfamiliar territory," Mr. Kohn said in April. Since his February 2003 speech, house values have risen 25% and total mortgage debt by 28%, while after-tax incomes have expanded just 13%. The household saving rate, a low 2% in 2000, has fallen to 0.9%. A growing share of mortgages have gone to speculators and people making little or no down payment. House "prices have gone up far enough since then -- relative to interest rates, rents and incomes -- to raise questions," Mr. Kohn said in April.

Dangerous Zone

Meanwhile, the current-account deficit, the broadest measure of the shortfall on trade and investment income between the U.S. and the rest of the world, has moved into a zone that many economists consider dangerous. It stands today at 6% of gross domestic product, the nation's total output of goods and services, up from 4% in 2000. To finance it, the U.S. now borrows about $2 billion a day from foreigners. As the foreign debt mounts, so does the risk that investors will demand a higher interest rate or lower dollar to keep on lending.

To be sure, a major cause of the U.S. current account deficit is that weak European and Japanese growth reduces demand for U.S. exports. And China's fixed exchange rate keeps the prices of Chinese goods artificially low, giving its television sets, bicycles and barbecue grills an edge in the U.S. market.

But the U.S. saves so little that when the U.S. cuts taxes and consumers take out mortgages, the money to finance both increasingly comes from abroad, in particular, foreign central banks. Those banks purchase U.S. dollars to keep the greenback high against their own currencies, thereby supporting their exports to the U.S. They then invest those dollars in U.S. bonds, in effect providing the financing for Americans to buy those exports.

Since 2000, foreign-brand cars have surged to 43% of the U.S. market from 35%, according to Motorintelligence.com. In the meantime, foreign holdings of U.S. Treasury bonds and bonds backed by Americans' home mortgages have jumped 80%.

In the first quarter of this year, General Motors Corp. made more money on mortgages than on cars or car loans. Since the beginning of 2001, the number of Americans employed in manufacturing has fallen by 2.8 million, or 16%, while the number in residential construction, real estate and banking has risen by 766,000, or 14%.

"If I were a biologist I'd call this a perfect example of symbiosis," former Fed Chairman Paul Volcker mused in a February speech at Stanford University. "Contented American consumers matched against delighted foreign producers. Happy borrowers matched against willing lenders. The difficulty is, the seemingly comfortable pattern can't go on indefinitely."

Almost every economist agrees. The debate is over how, not whether, the global economy rebalances: Will it be smooth, through some combination of declining dollar and accelerating foreign demand? Or will it be chaotic, with a dollar collapse, much higher U.S. interest rates and perhaps a global recession?

Mr. Volcker thinks a crisis is likely. Investor confidence could fade "at some point," he said, with "damaging volatility in both exchange markets and interest rates."

His successor is more sanguine. Capitalist economies, Mr. Greenspan believes, always have imbalances but are also continuously reallocating resources and capital to correct them. Thus, imbalances seldom become crises. "The number of forecasts of crises...is far in excess of the number of crises that actually occur," Mr. Greenspan told a recent audience in Chicago. "There is something equivalent to an invisible hand which continuously is readdressing market imbalances to reach equilibrium."

Fed staff research shows that in the past, when a big, rich country has a large current account deficit, it usually narrows without crisis. Homes may be overvalued but are much harder to trade than stocks and thus unlikely to collapse abruptly. Fed officials expect home prices to stagnate while incomes advance, bringing affordability back to historic ranges.

Having helped create today's imbalances, Fed officials acknowledge some responsibility to reduce them. By raising rates, Mr. Kohn explained, the Fed will make saving more attractive, slow the rise in housing prices, and "thereby lessen one of the significant spending imbalances." And Mr. Greenspan adds, "an increase in household saving should also act to diminish borrowing from abroad," narrowing the current account deficit.

That benign scenario has yet to unfold. Business investment is growing but by less than the Fed had expected. And while the trade deficit narrowed sharply in March, for the first quarter as a whole it hit a record of $694 billion on an annualized basis, or 5.7% of GDP. Meanwhile, even as the Fed raises short-term interest rates, long-term interest rates, which are set on markets, have actually declined, a development that baffles Mr. Greenspan. Since mortgage rates are tied to long-term bond yields, home prices have advanced at one of their fastest rates yet over the spring. Mr. Greenspan has acknowledged "a little froth" in the housing market.

Added Weight

What should the Fed do? Mr. Volcker, focusing on the current account deficit, thinks the Fed ought to put added weight on keeping inflation under control. "I am worried about a tendency to relax our guard," he said. It is critical foreigners remain confident that "those trillions of dollars they are piling up are going to be protected against inflation." Some of today's Fed leadership shares this view: The Fed can minimize the odds of crisis by keeping inflation down, which means erring on the side of higher interest rates.

Mr. Lindsey, on the other hand, believes the Fed should worry less about inflation and more about keeping the housing market from sinking. "You don't want to collapse asset prices," he says. "You want to give people time to adjust in a gradual way." He thinks the Fed should slowly raise its target for short-term interest rates, now at 3%, to 3.5%, and then stop.

Mr. Kohn, in his April speech, made it clear the Fed would not let imbalances deter any necessary action to keep inflation down: "We should not hesitate to raise interest rates to contain inflation pressures just because it might set off a retrenchment in housing prices, just as we were willing to keep rates unusually low as house prices rose rapidly."
TradingPlaces.gif
RewardsRisks.gif
 
Back
Top