Economic oversteering

Wednesday, January 23rd, 2008

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.

68 Responses to “Economic oversteering”

  1. Larry Tullos Says:

    Excellent blog that is sorely needed. For certain there is panic in the markets that needs to be calmed; but this (nor the next round of handouts) are not going to provide any long term help and only serves to make the inevitable day of reckoning that much uglier. A very sad day for our country, and as you say a huge failure or leadership all around.

    On a positive note, I’m buiding my first HTPC as I write this around MythBuntu and am impressed beyond words. I’m still trying to cut loose of Windows; but am finding it much easier than I expected. This is by far the easiest new PC installation I’ve done, and capabilites appear to be outstanding too. Thanks for your quality work and ideas!

  2. Rob Stokes Says:

    Awesome article Mark, your insights are really thought provoking.
    The one thing that has always bothered me though is the fact that the Fed is privately owned… at the end of the day their moves may be seen as in the public interest but at the end of the day they are seeking profits just like any institution.

  3. faustianbargain Says:

    bernanke did not just ‘blink’..he FOLDED to wall street pressure. what a puppet!

  4. Weeber Says:

    “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.”

    I’m sure that most Spanish and British people can see a similarity between what’s happening between the US and China now and what happened between Spain and England back in history when Spain was the biggest empire in the world and had the biggest stake in American Gold.

  5. buzz Says:

    Economic Oversteering…

    Κάποιες σκέψεις για την πρόσφατη ανησυχία για την αμερικάνικη οικονομία….

  6. EduardoWillians Says:

    With(out) your permission, I translated your post to brazilian portuguese. Thanks.

  7. Kevin Says:

    I’m glad that I’m not the only one who thinks his country has lost its damned mind. I’m living here among it, and spent the first part of my life among the crazy, spending what wasn’t mine. Now, I’m sleeping off my debt hangover, and although I have a safer job than most, and relatively little money tied to the stock market, I watch with anxiety at the world financial news. I am glad to see that there are some among us who have roused enough to see the approaching train, even if my own country’s leadership is sleeping through the alarm.

    Mark, I have highest respect for you, and thank you for your contributions to the world (I am posting from a Thinkpad which happily runs one of them). Linux is a good part of my job, and so I have directly benefited from your insight thus far. I just hope the next person in the White House, if they won’t subscribe to such a level mindset, will at least have open ears to those who do.

  8. Nathan Dbb Says:

    My brother and I commiserated about this while we were both recently house shopping in the USA.

    The value of a house should be the cost need to recreate the house (labor, wood, copper, etc.). Plus the value of the jobs that can be worked while living at the house, with land decreasing in value with distance from the jobs due to decreased scarcity of land and increased commute time/cost. Add/Subtract some for factors like parks, schools, roads, etc. (The agricultural opportunity cost is minor.)

    With the USA only having growth in the service (low value) jobs in recent years, it is only easy money policies that were pushing up prices.

    Older people who own homes got “free” money, while the younger generation will have to pay for the mess.

  9. EduardoWillians Says:

    Shuttleworth, I liked your post so much that I translated it to brazilian portuguese. I reviewed the translation again and again to make sure I was doing it right.

    Tank you.

  10. Douglas Scott Says:

    You have written a good article Mark that presents a relatively robust theory on what has been driving the US’s recent, longer then normal, economic growth cycle but don’t think that you are entirely correct on some points. As I am sure you know, having made a respectable living from it, there have been substantial productivity increases in the US economy over the past 15 years due to the “information revolution” (to use an old term) and the subsequent advances that have risen out of this field since; the vast majority of these advances and developments coming out of the United States.

    It is true that much of the productivity gains in global production output have come from China and India over this time period which accounts for much of the increase in relative wealth (such as purchasing power parity, ie you can buy relatively more with the same amount of money) in developed countries. However it has also not been the only one as the US (and OEDC countries in general) have also experienced genuine productivity gains of there own over this period. Having said that these productivity gains are nothing in comparison to the gain experienced in India and China, but then again India and China are both coming off a very low base and still remain a lot less productive then in OEDC countries.

    Having said all of that I think that the crux of your argument remains very valid. Perhaps cutting interest rates so aggressively over the past 15 years has indeed done more bad then good. Either way, only time will reveal that answer to us.

  11. marc Says:

    Don’t blame bernanke, he is doing the right thing

  12. over the moon Says:

    doesn’t the U.S. Federal Government own most of the land in the United States? Wouldn’t it be a boost for the economy and better for humanity (oops we’re talking Federal Government here, I mean better for the Government since humanity never factors in) were they to free up some land for more Americans to own?

  13. Me on Marc Fleury on Mark Shuttleworth on the economy (and fed rate cuts) « Fiji Ecuador Seattle Greece Montana Says:

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  14. Economic 'voodoo has no mojo' « the spike Says:

    […] is an essay written by South African tech entrepreneur, Mark Shuttleworth, a couple of weeks ago, in response […]

  15. Embardée économique Says:

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  16. Evangelina Says:


    I’ll dare abuse your blog a little and invite people to joing something that is of great not only American but international interest too, the 2008 US elections of course.

    “Hillary Clinton vs Obama (Global Discussion)”

    The American Presidency affects everyone on Earth. Please have your say, and do something about it, so that American people can be more aware of the choice they are making.

    (And once you are done with that you might want to get a burning desire to go to )



  17. Ike Hall Says:

    Nice analysis, Mr. Shuttleworth, but you missed the mark. Not your fault, you merely followed conventional economic wisdom. As such, you were far too kind to Greenspan. His chairmanship is rapidly proving to be a disaster, because all of the things that are happening now were set up on his watch. “Helicopter Ben” Bernanke is merely the recipient of Greenspan’s aggressively inflationary policy which has already seen stock-market meltdowns, dot-com booms and busts, and now, housing booms and busts. Only by permitting the malinvestments to fail will we have any chance of recovery. As usual, the Austrians are the only ones who correctly forecast the current situation. I strongly recommend Murray Rothbard’s The Case Against the Fed, plus anything over at

  18. Inez Says:

    Mr Shuttleworth,

    you lost me at the schedule seven drug reference for economic pain and crack cocaine jab to the jaw, but thank you for the overview. It was enjoyable reading. I read this webpage in the hope of finding updates on software etc presented in a relevant and understandable format. I often sign off feeling a little stupid though. However, I hope to sound clever quoting and paraphrasing you in thishere article, one of these fine Cape evenings, chewing the fat over hopeless economics and faithless leaders.

    However, here in the deep south of Africa, we are experiencing an almighty credit crunch on the back end of crazy consumerism, insanely indulged property prices, often ineffectual leadership and all most of us have to show for it, is cheese cake going for 45ZAR per slice at The Waterfront. The effect of HIGH interest rates and inflation are battering our hearts and minds and wallets. Whether the intricacies can be translated into a corrolary of the US situation, I don’t feign to comprehend. But at the heart of economic crisis, is surely the same human condition, regardless of it’s cause. More than the Medicine analogy for US fiscal policy and central bank maneuvres, it is surely the health of a nation that is in jeopardy. The collective consciousness of a people. Without knowing the details of economic pain in the US, I can say from the content of their tabloids and media, that their foundation is not secure, that they strive in emptiness. But in such a perilous and vulnerable common state, how does one then combat hopelessness and lack of ownership in its pure sense.

    Addressing and improving a nation’s morale and morals, without resorting to the temporary high of a credit card transaction , an hour with a motivational speaker, beaching in the Bahamas or new Nike’s, seems an impossible task. Raising a people who have judgement and act autonomously, of independent thought and discernment is necessary to establish a “mature” nation, who won’t be led round by the nose.

    How do you heal a nation? How do you transform the untransformable?