THE BEAR'S LAIR The policy mix from hell
By Martin Hutchinson
The increasing divergence of the economies of the United States and the
European Union, and the sluggish statistics coming out of the former, point to
one inescapable conclusion: the US policy mix, in fiscal, monetary and
regulatory areas, has been uniquely bad.
This is not simply a question of party or ideology: under the Democrat Bill
Clinton administration, economic policy was pretty good, while the present
Federal Reserve chairman, Ben Bernanke, was appointed by a Republican
president. Nevertheless, the combination of misguided theories and poor
execution is now doing damage to the US economy that will take a very long time
to repair.
Begin with monetary policy, a subject that has been a staple of this column
since it began in November 2000. The effect of the loose money of 1995-2008 on
creating the bubble and reducing the US savings rate to zero has been
acknowledged by most observers since the days in late 2008 when pillars of the
US financial system were still crashing about us.
Given that the horrible error was realized by everybody but Bernanke so early
on, you'd think something would have been done about it. No such luck. Interest
rates have been stuck close to zero for more than 18 months, while inflation
has never shown the slightest tendency to go below 1.5-2%. Indeed if you remove
the Bureau of Labor Statistics fudges from US price series and look at the
"harmonized" series produced (in an obscure corner of its website) by the
bureau itself, in which it compares inflation in the US to that in other
countries, all calculated by EU methodology, you will find that the 12-month
rate of US price inflation was 3.2% as of May 2010.
A brief period of very low interest rates after the crash might have been
expected - though we should in this context remember Walter Bagehot's advice in
a financial crash to lend large amounts of money at very HIGH interest rates,
not low ones. However, zero interest rates that persist for close to two years,
in a period when inflation remains safely positive, become indescribably
damaging, especially when they follow more than a decade of monetary policy
that was erroneous in the same direction.
Instead of correcting to a sustainable level, the US savings rate, deterred by
the negative returns available, has once again become inordinately low. So also
has the lending rate to small businesses, since banks can borrow at close to
zero, invest in government guaranteed mortgage bonds at 4-plus percent,
leverage 15 times and retire to the golf course. Who needs the aggravation of
lending to small business, anyway?
On the fiscal side, it can now surely be recognized that the US$800 billion
fiscal stimulus passed in February 2009 was a mistake. A recent European
Central Bank study studied fiscal stimuli from the past, and calculated that
the average "multiplier" of fiscal stimulus was about 0.5 - in other words, for
every $100 billion spent on stimulus, only about $50 billion was added to
output, with $50 billion being lost from the private sector in "crowding out"
and the original $100 million being borrowed and added to debt.
In practice, it seems likely that multipliers vary according to a number of
factors. The fiscal position before stimulus is undertaken is one: if the
stimulus puts the government only modestly into deficit, then "crowding out" is
unlikely. Another is the state of the economy; "crowding out" is less likely in
a very deep depression, like that of 1929-33, because private spending is
already so depressed. A third is the savings rate; "crowding out" is likely to
be less when, as in Japan, the domestic savings pool is very large and being
added to substantially. Finally, the contents of the stimulus package matter a
lot; a reduction in high marginal tax rates may well have a supply-side effect,
while investment in bottleneck infrastructure may also yield a high return that
increases the "multiplier".
The Chinese stimulus package of 2008 passes most of these tests. It was imposed
on a budget that was initially in surplus. It consisted mostly of
infrastructure (though the Chinese government may not have chosen the
infrastructure optimally). China has a very high savings rate, so "crowding
out" was minimal. Only the state of the economy was in question; although
exports dropped sharply in the winter of 2008-09, the Chinese economy never
went into recession, so the stimulus risked producing overheating, which now
appears to have occurred.
The US stimulus package was at the opposite end of the scale. The economy had
suffered a major financial shock, but it was too early to tell whether it was
settling into a long period of stagnation. US savings rates were very low, so
the chances of deficits crowing out private activity were substantial. The
deficit was already large, and swollen by the bank bailouts, making "crowding
out" more likely. Finally, the quality of the stimulus package itself was very
poor, with large amounts of pork-barrel spending and subsidies to heavily
unionized public sector workforces.
It is thus not surprising that the US stimulus appears to have had a net
negative effect, with a multiplier that was very low or even below zero. This
was not unknowable beforehand; a study "Public Employment and Labor Market
Performance" in Economic Policy as far back as 2002, based on data from the
Organization for Economic Cooperation and Development, had shown that on
average creating 100 public sector jobs destroys about 150 private sector jobs
and increases net unemployment by about 33. One would like to think that
policymakers boned up on this stuff before taking office.
The US economy bottomed out in about May 2009, before stimulus spending took
effect, but it has recovered far more slowly than might have been expected,
with very anemic job creation. European Central Bank president Jacques Trichet
wrote earlier this month that every country should be moving to balance its
budget and raise interest rates to normal levels as quickly as possible, and
that speed in imposing stimulus should not be followed by sluggishness in
removing it.
The United States and Japan were the two most obvious targets of his remarks;
it is indeed notable that the EU, where stimulus was smaller and is now being
reversed, has recently shown a much healthier growth trend than the United
States. When traditionally Keynesian, big-spending Europe is rebuking the US
for its profligacy, it is clear that policy has gone seriously adrift.
It is not just fiscal and monetary policies, however, that are posing problems.
The complete lack of reform of the US housing behemoths, Fannie Mae and Freddie
Mac, and the miscellaneous subsidies and handouts to the housing market have
both wasted resources and hugely distorted the market. Instead of finding a
true bottom at a price level at which the market cleared, the housing market in
2009 found a false bottom, with prices still above the 50-year average, in
terms of incomes. The Case-Shiller 20-city house price index, based at 100 in
January 2000, is still at a relatively lofty 146.45, having overall risen
faster than consumer prices during the decade.
However housing was not in a slump in January 2000, far from it; it had
benefited like other assets from the immense easy-money stock market boom of
the late 1990s - prices were a third above their lows of 1993. Now that the
artificial subsidies for housing are being removed, house prices will start to
slump once again, and may well fall further than they would have done
initially, as the false bottom has locked millions of new buyers into
overpriced houses, further damaging market confidence.
The US government guarantee of home mortgages needs to be ended, the market
needs to be returned as far as possible to its local origination buy-and-hold
model, in which credit assessment and monitoring can be carried out
effectively, and the mortgage interest tax deduction needs to be removed. Only
then will the housing market become healthy; the resources poured into it since
2008 have made the problem much worse.
While Fannie and Freddie represent a gap in legislative activity, the manic
activity on pretty well all other fronts has also been damaging. The healthcare
bill increased costs in healthcare, without doing anything significant to
reduce that market's grotesque distortions; it has thus added additional cost
and uncertainty to the US economy, although most of that cost is several years
in the future. In addition, while "cap and trade" climate change action has
been stalled for the present, the prospect of it remains there, blighting
investment in a number of sectors. The arbitrary ban on deep sea drilling is an
additional example of policymaking that is both whimsical and vindictive.
The financial reform bill fails to achieve real financial reform because most
of the key provisions - the Volcker Rule for example - were gutted after
lobbying by the financial industry. Nothing significant was done to reform risk
management, which remains a huge weakness. A Tobin transactions tax on
financial transactions, the one provision that could have done some real good
by reducing rent-seeking and rebalancing the sector from traders towards
corporate financiers, was completely ignored by the "reformers", who thus
failed to address the sector's largest single problem.
It now appears that financial "reform" has had serious unintended consequences
in the bond market. The reformers correctly addressed the problem of rating
agencies failing to understand the securities they were rating, but their
solution was typical of a Democrat congress, opening the rating agencies up to
the depredations of the trial lawyers.
At present, the rating agencies are refusing to give ratings because of their
potential legal liability, and so activity in the bond market has ground to a
halt. If the problem persists, corporate bond issues may remain feasible
because investors are capable of doing their own credit analysis on corporate
credit. However securitizations, in which a miscellaneous pool of assets is
bundled together, become impossible without the rating agencies because the
cost to each investor of investigating the asset pool properly is prohibitive.
Even though a move back from securitization to buy and hold in the housing
market is desirable and reduced outstandings on credit cards equally so,
removing the current provision for those markets without providing an
acceptable alternative is highly economically damaging in the short term.
It is thus not surprising that the US economy is sharply underperforming its
competitors. It has been subjected to policy choices from all policymaking
participants that were poorly designed and arbitrary in their application. The
successes of Chancellor Angela Merkel in Germany and the new David Cameron
government in Britain demonstrate that with better policy, much better results
could have been achieved.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-10 David W Tice & Associates.)
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