Yesterday, we saw the most extraordinary failure of economic leadership in recent years, when the US Federal Reserve pressed the “emergency morphine” button and cut Federal Reserve rates by 0.75%. It will not help.
These are extremely testing times, and thus far, the US Fed under Bernanke has been found wanting. Historians may well lay the real blame for current distress at the door of Alan Greenspan, who pioneered the use of morphine to dull economic pain, but they will probably also credit him with a certain level of discretion in its prescription. During Greenspan’s tenure at the Fed, economic leaders became convinced that the solution to market distress was to ensure that the financial system had access to easy money.
This proved effective in the short term. When LTCM looked set to explode (private investments, leveraged up dramatically, managed by Nobel prize-winning financial theorists, placed a bet on a sure thing which didn’t pan out quite as expected) Greenspan engineered an orderly unwinding of its affairs. When the dot com bubble burst, Greenspan kept the financial system energised by lowering rates so far that they were, for a substantial period, at negative levels.
A negative real interest rate means we are effectively paid to take out loans. That might sound good, but how would you feel if I used the words “paid to take a few more hits of crack cocaine”? The underlying problem was that people had become accustomed to high rates of return and did not want to accept that real rates of return in the US were moving down. They had become accustomed to easy money, and Greenspan’s policy ensured that money remained accessible at a time when people had demonstrated a low ability to invest that easy money well.
Low rates give people an incentive to invest in stocks, even if those stocks are not earning very much. This meant stock prices recovered quickly, and the effect was amplified by the fact that low rates increased corporate earnings. This was a so-called “soft landing” – disaster averted. He must have known the risks, but the one big warning sign that would likely have convinced Greenspan to return to normal rates was missing: inflation. Low rates, and especially negative rates, have historically always resulted in inflation. Greenspan kept rates low because there were no signs of inflation. It seemed as if the US had entered a new era where the correlation of rates and inflation no long held true. People explained it by saying that the US was increasing its productivity dramatically (productivity increases are like anti-inflation medicine). Now, with hindsight, it appears that the real reason for the absence of inflation was that the Chinese were increasing their productivity dramatically, and that US consumers were spending so much on Chinese goods that Chinese productivity growth, not US productivity growth, was keeping US prices low.
When tech came off the boil and people should have been using the pause to clean up their affairs, Greenspan made it easy for people to get themselves into a worse position. Easy money made stock market prices artificially high, so stock market investors felt rich. Worse, easy money made house prices artificially high (by about 45%), so everybody felt wealthier than they had planned or expected to.
To make matters worse, a series of financial innovations created a whole industry designed to help people go back into debt on their houses. I remember trying to watch TV in the US and being amazed at the number of advertisements for “home equity withdrawals”. They made it sound like turning your major personal financial asset – your paid-off house – into an ATM machine was a good thing. In fact, it was a means to spend all of your primary store of wealth. And with inflated house prices, it was a way to spend money that you did not really have. A convenient way to get into a deep, dark hole of family debt. The result? The average American owns less of her home today than she did 30 years ago – 55% as opposed to 68%. Easy money makes people poorer.The company with the most irritating ads, Ditech (and I feel ashamed to be contributing to their website search ranking with the mention, perhaps it will help instead to link to their customer feedback), has a tagline “People are smart” and a business model built on the idea that “People are dumb”. Their “most popular” product strikes me as being tailor-made to make it easy to turn home equity – an asset – into new debt.
Why did Greenspan do it? I think he genuinely believed that there was something different about the modern world that had altered the laws of economic gravity. I suspect he no longer feels that way.
But Greenspan is no longer Chairman of the Fed. Ben Bernanke blinked, yesterday, and in that blink we have the measure of the man.
Greenspan acted carefully, logically, and basically prudently. Several years of anomalous economic data are a reasonable basis to think that the rules have evolved. You would have to have a Swiss (700 years of stability) or Chinese (“we think it’s too early to tell if the French Revolution was a good idea”) approach to stick with economic theories that are at odds with the facts for very long. Greenspan made a mistake, and it will have huge consequences for the US for a generation, but he had reasons for that mistake. Bernanke just blinked, he panicked, despite knowing better.
We now have rigorous economic explanations for all that is happening. We have come to understand, quite clearly, what is going on in the world. The deflationary Eastern wind has been identified. We know there is no productivity miracle in the US, no change in the laws of physics or economics. So we know that the US patient is addicted to easy money morphine, medicine that was prescribed with good intentions by Dr Greenspan, medicine that has in the last 7 years made the patient more ill and not less. More morphine today constitutes malpractice, not economic innovation. We know the consequences of more morphine – stock prices will rise artificially (4% yesterday, on the news of the shot), house prices will stumble along, companies will take longer to default on their loans.
Bernanke might be hoping to do what Greenspan did – retire before the addiction becomes entirely obvious. Too late. While the Fed is clearly not willing to admit it, the markets have just as clearly taken their own view, that the prognosis is not good. They are smart enough to see that all Bernanke has done is cover up the symptoms of malaise, and many are using the temporary pain relief to head for safer territory. I expect that any relief will be brief, market recoveries will fade, the rout has been deferred but not averted.
I started out by describing the Fed’s actions as a failure of economic leadership. Some folks are lucky enough to lead from the bottom of the cycle, up – they take over when things are miserable and can only really get better. They look like heroes even if their voodoo has no mojo, so to speak. Others are less lucky, they get handed custodianship of an asset that is at the peak. As for Bernanke, he’s in that latter category. He needs to be able to speak clearly and frankly about the hard work that lies ahead in the US. He needs to appeal to the very best of American industriousness – a traditional willingness to work hard, be smart, and accept the consequences of refusing to do so. He needs to lead under the most difficult circumstances. But that’s what leadership is about.
Fortunately for Bernanke, central bank independence is widely believed to be the only credible approach to economic governance. That independence gives Bernanke the right to stand at odds with political leaders if needed. Given the recent White House announcements – more morphine, further indebtedness for the worlds most indebted country – there’s no stomache for a real program of rehabilitation in the Bush Administration. Bernanke will have to lead without political support, a very difficult task indeed. Our greatest and most memorable leaders are those who lead through difficult times. The same is true of failures of leadership. Appeasement, or rehabilitation. Chamberlain, or Churchill. Thus far, Chamberlain.