Thursday, November 27, 2014

America’s Strategy Vacuum

NEW HAVEN – Apparently, policymakers at the Federal Reserve are having second thoughts about the wisdom of open-ended quantitative easing (QE). They should. Not only has this untested policy experiment failed to deliver an acceptable economic recovery; it has also heightened the risk of another crisis.

The minutes of the January 29-30 meeting of the Fed’s Federal Open Market Committee (FOMC) speak to a simmering discontent: “[M]any participants…expressed some concerns about potential costs and risks arising from further asset purchases.” The concerns range from worries about the destabilizing ramifications of an exit strategy from QE to apprehension about capital losses on the Fed’s rapidly ballooning portfolio of securities (currently $3 trillion, and on its way to $4 trillion by the end of this year).

As serious as these concerns may be, they overlook what could well be the greatest flaw in the Fed’s unprecedented gambit: an emphasis on short-term tactics over longer-term strategy. Blindsided by the crisis of 2007-2008, the Fed has compounded its original misdiagnosis of the problem by repeatedly doubling down on tactical responses, with two rounds of QE preceding the current, open-ended iteration. The FOMC, drawing a false sense of comfort from the success of QE1 – a massive liquidity injection in the depths of a horrific crisis – mistakenly came to believe that it had found the right template for subsequent policy actions.

That approach might have worked had the US economy been afflicted by a cyclical disease – a temporary shortfall of aggregate demand. In that case, countercyclical policies – both fiscal and monetary – could eventually be expected to plug the demand hole and get the economy going again, just as Keynesians argue.

But the US is not suffering from a temporary, cyclical malady. It is afflicted by a very different disease: a protracted balance-sheet recession that continues to hobble American households, whose consumption accounts for roughly 70% of GDP. Two bubbles – property and credit – against which American families borrowed freely, have long since burst. But the aftershocks linger: Household-debt loads were still at 113% of disposable personal income in 2012 (versus 75% in the final three decades of the twentieth century), and the personal-saving rate averaged just 3.9% last year (compared to 7.9% from 1970 to 1999).

Understandably fixated on balance-sheet repair, US consumers have not taken the bait from their monetary and fiscal authorities. Instead, they have cut back on spending. Gains in inflation-adjusted personal-consumption expenditure have averaged a mere 0.8% over the past five years – the most severe and protracted slowdown in consumer demand growth in the post-World War II era.

The brute force of massive monetary and fiscal stimulus rings hollow as a cyclical remedy to this problem. Another approach is needed.

The focus, instead, should be on accelerating the process of balance-sheet repair, while at the same time returning monetary and fiscal policy levers to more normal settings. Forgiveness of “underwater” mortgages (where the outstanding loan exceeds the home’s current market value), as well as reducing the foreclosure overhang of some 1.5 million homes, must be part of that solution. How else can the crisis-battered housing market finally clear for the remainder of US homeowners?

The same can be said for enhanced saving incentives, which would contribute to longer-term financial security for American households, most of which suffered massive wealth losses in the Great Recession. Expanded individual retirement accounts and 401K pension schemes, special incentives for low-income households (most of which have no retirement plans), and an end to the financial repression that the Fed’s zero-interest-rate policy imposes on savers must also be part of the solution.

Yes, these are controversial policies. Debt forgiveness raises thorny ethical concerns about condoning reckless and irresponsible behavior. But converting underwater “non-recourse” mortgage loans, where only the house is at risk, into so-called “recourse liabilities,” for which nonpayment would have consequences for all of a borrower’s assets, could address this concern, while simultaneously tempering America’s culture of leverage with a much greater sense of responsibility.

Timing is also an issue, especially with respect to saving incentives. To avoid the shortfall in aggregate demand that might arise from an abrupt surge in saving, these measures should be phased in over a period of 3-5 years.

The main benefit of these proposals is that they are more strategic than tactical – better aligned with the balance-sheet problems that are actually afflicting the economy. As the quintessential laissez-faire system, the US has outsourced strategy to the invisible hand of the market for far too long. That has left the government locked into a reactive and often misguided approach to unexpected problems.

Thus, the Fed is focused on cleaning up after a crisis rather than on how to avoid another one. The same is true of US fiscal policy, with an event-driven debate that now has ever-shorter time horizons: the fiscal cliff on January 1, sequestration of expenditures on March 1, expiration of the continuing budget resolution on March 27, and the new May 18 debt-ceiling limit. A compliant bond market, which may well be the next bubble, is mistakenly viewed as the ultimate validation of this myopic approach.

The dangers of America’s strategy vacuum and the related penchant for short-termism have been mounting for some time. Harvard Business School professor Michael Porter famously raised this concern in a 1996 article in the Harvard Business Review. His focus was on corporate decision-making and misaligned incentives leading to a worrisome dichotomy between the short-term tactics of “operational effectiveness” (cost cutting, outsourcing, and reengineering) and the long-term visionary bets that frame successful strategies.

While Porter’s critique was directed at business managers, it bears critically on the current US policy debate. A successful long-term strategy cannot be seen as a succession of short-term fixes.

The internal debate in the FOMC represents a healthy and long-overdue recognition that the central bank may be digging itself into an ever-deeper hole by committing to misguided policies aimed at the wrong problem. A comparable debate is raging over fiscal policy. Can America finally face up to the perils of its strategy vacuum?

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    1. CommentedRobert Lunn

      This hits the mark. "Acceleration the process of balance sheet repair" surely can be accomplished more productively. Increasing the size of the balance sheet to 4 trillion in order to create a "wealth effect" impact for growth is a sort of "Rube Goldberg" machine. The resulting carry trade solution only serves to widen the gap causing more concentrated wealth.
      Debt forgiveness is thorny but exists in the bankruptcy code with appropriate consequences for those receiving the forgiveness. This should have been practiced in 2008-9 as those bailed out got away with it. However, two wrongs don't make a right.
      The risk in this suggestion resides in the lack of leadership. Not the President alone but the opposition clearly has little interest in "strategy". This too may be a result of not allowing markets to clear in the crisis.

    2. CommentedLuis de Agustin

      A concern should remain that should the recovery path for the U.S. stock markets falter, does easing ratchet up even beyond the one trillion dollars the Fed is on track to add this year?

      According to economics and strategic investment research house Wainwright Economics, the bullish stock market message is real but should not be expected to last long. The “nil upside” reading in Wainwright’s analysis signals that recovery from the 2008-09 selloff and subsequent setbacks is complete. From a valuation standpoint the economics and investment research firm sees the short-term recovery path for the S&P 500 as continuing to signal nil upside.

      Historically, according to Wainwright, the vital factor in stock-market performance is the constancy or depreciation of the dollar, and the firm’s long-term outlook for the dollar is as bearish as ever. Thanks to Washington’s inability to deal with the growth of entitlement spending, federal indebtedness is growing several times faster than the economy. Over horizons of three, five, or ten years Wainwright sees the market heading sideways at best. Should it fall, true to form, the Bernanke Fed should be expected to double its efforts to easing (and depreciating the US dollar).

      By now, an excellent indicator of future returns, corporate spreads narrowing, has been capitalized in stock prices. Since spreads now appear to have stabilized, there is little basis to expect a further boost in US stocks. Left is the delayed effect of the spreads narrowing that’s already taken place.

      Short term, everyone is happy. The outlook seems bullish for U.S. stocks. It also implies risky assets in general will continue to outperform haven assets such as government bonds and gold. Can there be any doubt that absent good numbers from the economy, the soothing strategy of easing will not react with even greater effort? According to Wainwright the hyperactive Fed will not disappoint, and do so sooner than later.

      Luis de Agustin

    3. CommentedFlint O'Neil

      This article was silly imo. He tries to take a "strategic" approach instead of a tactical one but fails dismally. He uses the idea that QE and monetary policy has failed, so let's go back and just use fiscal policy by buying up houses and perpetuating the bubble further! And remember this is taken from a "strategic" point of view allowing domestic savings to rise and repair balance sheets....what about the government's balance sheets after another layer of failed fiscal stimulus????? This article needs to be compared with the recent one from raghuram rajan about failed stimulus to find a common ground...other wise we are stuck in an endless spiral of debt increasing policies followed by excessive liquidity

    4. CommentedRobert Wolff

      Despite that face that the US is in a demand-side crisis there is little effort to implement a demand-side solution.

      QE depends on trickle-down. It puts trillions of dollars of cash in the hands of the same people who already have trillions of dollars and are not investing it. It doesn't trickle down which is why it has no effect on unemployment or growth.

      Where did the Fed get the ida that QE was anything more than another supply-side solution failed because there is no trickle-down?

    5. CommentedFrank O'Callaghan

      "Let us create a casino for our friends where everyone wins. When the casino cannot pay the government will cover the bets by printing money. The winners will then gamble their winnings. This situation will continue ad infinitum"

    6. CommentedJoshua Ioji Konov

      Dear Mr. Roach, I must disagree with you about the problems that hold the US economy down: not the debt is the major problem, but the income, for which there are countless proves. The US consumers have always known how to pay their debt as long they have access to proper jobs same is with the demand. To consider debt as the reason for weak demand whereas everything else is business as usual is just not serious enough. The outsourcing and moving of industrial production, the industrialization of China, the high tech in manufacturing, etc. have reduced the access to well paid jobs, and the 2007-9 Recession has aggregated the effect. Things are deeper and more complacent than debt... see

    7. CommentedJan Smith

      Superb essay. Five years after the financial crisis, the American economic decline still is in phase two:
      1) Out-migration of manufacturing
      2) Rising net debt (private and public)
      3) Rising unemployment, declining debt
      4) Declining wages, declining unemployment

    8. CommentedProcyon Mukherjee

      The recent FOMC minutes have raised a couple of pointers. I refer to the H.4.1 Statistical Release of Federal Reserve dated 21st February 2013 ( where on section 8 we have the asset size of the balance sheet showing $3096 Billion while liabilities are shown as $3041 Billion, leaving as total capital (assets minus liabilities) as $55 Million. These deposits are from thousands of depository institutions, the U.S. Treasury, and others hold in accounts at the Federal Reserve Banks. This is money which is not moving into goods and services. While Fed has grown its assets at an unprecedented level, its rise of liabilities holds testimony to the growing concern that if QE3 continues at this pace, together with the rise of liabilities would entail the risk of a balance sheet squeeze when the eventual unwinding happens and interest rates rise.

      The corporations on the other hand with piles of cash have no where to go (and some cannot avoid dividends any longer). The deluge of liquidity is not moving to goods to services which would generate economic activities; all new information on the other hand is directed towards extremely short term view of things.

      Perhaps it is not lack of strategy, the vision of a hopeless tomorrow forces the collective wisdom to ruminate on narrow small time debates & exchanges that take us nowhere.

    9. CommentedG. A. Pakela

      Many Americans were on a credit-driven spending binge that lasted for at least a couple of decades and artificially propped up demand and growth, particularly in the 2000s. Now that there are no longer any assets to tap into, there can be no impetus for increased demand from consumers that are still gainfully employed. Government efforts to substitute deficit spending, fully accomodated by the Fed, have indeed proven to be inadequate to the goal of stimulating demand-driven growth.

      The only way to increase demand is to reduce the overhang of the unemployed, underemployed and non participating workers. This would require supply-side stimulus. How about restructuring the tax code to effectively reduce the after-tax cost of capital and labor force participation? Is it really necessary to tax investment income at the corporate level at a marginal rate of 50% when double taxation is taken into account? Is it necessary to have a tax rate of 25% on middle income Americans, plus another 7.65% in payroll taxes, when the average federal income tax rate on the same taxpayers is only about 5 or 6%? Why would a non-working spouse go for that deal when you have to earn $1,500 to clear $1,000?

        CommentedTim Chambers

        Supply side stimulus was supposed to be answer for stagflation, but it was really just a justification for the GOP's eternal agenda of tax cuts for the rich, union busting for the working class, and more austerity for the poor. It put us in the mess we are in now. We already have overcapacity due to a lack of demand, which is what you get when you cut wages and benefits. And you want to create even more capacity? Get real. You have to be able to sell the stuff.

        The answer to deflation is to stimulate demand, not supply. Give the executives a huge pay cut and the workers a bit of a raise.

        You just want another tax cut.

    10. CommentedPatricia Flanagan

      Is it any wonder that America has a strategy vacuum when a Morgan Stanley macro analyst has the audacity to suggest that a bailout of the private sector debt should hinge on the private sector putting more skin in the game? Could such a suggestion have any currency after the financial sector has so obviously profited from fraud and greed at the expense of the private sector.
      It is beyond ridiculous to think that you can craft an argument for raising interest rates in a debt deflationary environment. Is there no limit to the financial's sector's greed? The monetarist gambit which is to load down the system with debt and then swoop up private sector assets as soon as the debtor defaults is nearing the end of its run. The first rule of survival for any parasite is not to kill the host.
      Lets be honest here, quantitative easing was never meant to address the balance sheets of the private sector. The interest that the private sector pays on their debt bears no resemblance to what the government or financial institutions pay. QE was designed to allow the government to finance the deficit and bail out banks but it has done nothing to support the balance sheets of the private sector.
      Qe is not Keynesian in that it does not support private sector demand and you are right, this is not a temporary cyclical problem.
      It is the product of a monetarist ideology that believes that economies can be managed through monetary policy alone and that smaller government and pro supply side policies will create economies that will not self implode.
      Monetarism is dead because when interest rates raise we get busts and when interest rates decline we get booms that bust. And it is very difficult and not pragmatic to raise interest rates when the economy is in a recession.
      In these circumstances, the only option is to use fiscal policy, that is governments need to increase the size of their deficits to assist the private sector to repair their balance sheets.
      The federal reserve printed trillions of dollars to repair the balance sheets of the financial interests and this has not fixed the problem. Surely we can do the same to serve the public interest. Rentier economics is dead and raising interest rates will not resurrect the unemployed.