Monday, April 21, 2014
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Macro Malpractice

NEW HAVEN – The wrong medicine is being applied to America’s economy. Having misdiagnosed the ailment, policymakers have prescribed untested experimental medicine with potentially grave side effects.

The patient is the American consumer – the world’s biggest by far, but now in the throes of the worst funk since the Great Depression. Recent data on consumer spending in the United States have been terrible. Growth in inflation-adjusted US personal consumption expenditures has just been revised down to 1.5% in the second quarter of 2012, and appears to be on track for a similarly anemic increase in the third quarter.

Worse, these numbers are just the latest in what has now been a four-and-a-half-year-old trend. From the first quarter of 2008 through the second quarter of 2012, annualized growth in real consumption spending has averaged a mere 0.7% – all the more extraordinary when compared with the pre-crisis trend of 3.6% in the decade ending in 2007.

The disease is a protracted balance-sheet recession that has turned a generation of America’s consumers into zombies – the economic walking dead. Think Japan, and its corporate zombies of the 1990’s. Just as they wrote the script for the first of Japan’s lost decades, their counterparts are now doing the same for the US economy.

Two bubbles – property and credit – enabled a decade of excessive consumption. Since their collapse in 2007, US households have understandably become fixated on repairing the damage. That means paying down debt and rebuilding savings, leaving consumer demand mired in protracted weakness.

Yet the treatment prescribed for this malady has compounded the problem. Steeped in denial, the Federal Reserve is treating the disease as a cyclical problem – deploying the full force of monetary accommodation to compensate for what it believes to be a temporary shortfall in aggregate demand.

The convoluted logic behind this strategy is quite disturbing – not only for the US, but also for the global economy. There is nothing cyclical about the lasting aftershocks of a balance-sheet recession that have now been evident for nearly five years. Indeed, balance-sheet repair has barely begun for US households. The personal-saving rate stood at just 3.7% in August 2012 – up from the 1.5% low of 2005, but half the 7.5% average recorded in the last three decades of the twentieth century.

Moreover, the debt overhang remains massive. The overall level of household indebtedness stood at 113% of disposable personal income in mid-2012 – down 21 percentage points from its pre-crisis peak of 134% in 2007, but still well above the 1970-1999 norm of around 75%. In other words, Americans have much farther to go on the road to balance-sheet repair – which hardly suggests a temporary, or cyclical, shortfall in consumer demand.

Moreover, the Fed’s approach is severely compromised by the so-called zero bound on interest rates. Having run out of basis points to cut from interest rates, the Fed has turned to the quantity dimension of the credit cycle – injecting massive doses of liquidity into the collapsed veins of zombie consumers.

To rationalize the efficacy of this approach, the Fed has rewritten the script on the transmission mechanism of discretionary monetary policy. Unlike the days of yore, when cutting the price of credit could boost borrowing, “quantitative easing” purportedly works by stimulating asset and credit markets. The wealth effects generated by frothy financial markets are then presumed to rejuvenate long-dormant “animal spirits” and get consumers spending again, irrespective of lingering balance-sheet strains.

There is more: Once the demand problem is cured, according to this argument, companies will start hiring again. And then, presto – an unconventional fix magically satisfies the Fed’s long-neglected mandate to fight unemployment.

But the Fed’s policy gambit has taken the US down the wrong road. Indeed, the Fed has doubled down on an approach aimed at recreating the madness of an asset- and credit-dependent consumption model – precisely the mistake that pushed the US economy toward the abyss in 2003-2006.

Just as two previous rounds of quantitative easing failed to accelerate US households’ balance-sheet repair, there is little reason to believe that “QE3” will do the trick. Quantitative easing is a blunt instrument, at best, and operates through highly circuitous – and thus dubious – channels. Significantly, it does next to nothing to alleviate the twin problems of excess leverage and inadequate saving. Policies aimed directly at debt forgiveness and enhanced saving incentives – contentious, to be sure – would at least address zombie consumers’ balance-sheet problems.

Moreover, the side effects of quantitative easing are significant. Many worry about an upsurge in inflation, though, given the outsize slack in the global economy – and the likelihood that it will persist for years to come – that is not high on my watch list.

Far more disconcerting is the willingness of major central banks – not just the Fed, but also the European Central Bank, the Bank of England, and the Bank of Japan – to inject massive amounts of excess liquidity into asset markets – excesses that cannot be absorbed by sluggish real economies. That puts central banks in the destabilizing position of abdicating control over financial markets. For a world beset by seemingly endemic financial instability, this could prove to be the most destructive development of all.

The developing world is up in arms over the major central banks’ reckless tactics. Emerging economies’ leaders fear spillover effects in commodity markets and distortions of exchange rates and capital flows that may compromise their own focus on financial stability. While it is difficult to track the cross-border flows fueled by quantitative easing in the so-called advanced world, these fears are far from groundless. Liquidity injections into a zero-interest-rate developed world send return-starved investors scrambling for growth opportunities elsewhere.

As the global economy has gone from crisis to crisis in recent years, the cure has become part of the disease. In an era of zero interest rates and quantitative easing, macroeconomic policy has become unhinged from a tough post-crisis reality. Untested medicine is being used to treat the wrong ailment – and the chronically ill patient continues to be neglected.

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  1. CommentedRobert O'Regan

    So the medicine is to forget Nixon's efforts (successful) to help his buddies and the USA for a bit, and re-instate the gold standard, over the wished of Wall Street et al.

  2. Commentedpeter fairley

    Can anyone give the boring details of Roach's "household indebtedness at 113% of disposable personal income"?? Like if u make 80k/yr...have disposable income of 10k...your debt is 11.3k? is that like auto and credit card payments/year?? so you are kiting balance transfers to get by?
    I used to do that before I left America in 2004...now everyone does it?

  3. Portrait of Hosein Maleki

    CommentedHosein Maleki

    I agree. The institutional approach can help suggesting alternative solutions to such a predicament. I just want to add a theoretical part to that:

    We've already had models that deal with long-term effects of different shocks [core argument in the first part of the article], be it consumption, or any other macro-level variables. There has also been a parallel debate concerning the "heterogeneous" nature of such factors: for example, the increase to 3.7% in savings may well over-or under-represent the true increase in savings. Same for consumption. A successful link to the monetary policies, I guess, may yield better results- with more mature policy implications.

  4. CommentedLuke Ho-Hyung Lee

    Excellent article, but I think something is still missing.

    Most people agree with the adage that if you don't diagnose the problem correctly, the odds are you won't prescribe the right medicine. So, have we diagnosed our economic situation correctly and prescribed the right economic policies over the last several years? Obviously not, for look at the mess we are now in.

    If someone insists that he could figure a clear way out of the current economic crisis, more specifically, the current new-business establishment and job crises, what would you do?

    Please see this article: “The Real Cause of the Current Economic Crisis and a Suggested Solution” http://goo.gl/GkBCP

  5. CommentedMark Pitts

    Great piece.

    Readers might also want to look at an article on the PIMCO site by James Moore. He shows how near-zero interest rates might be causing many of the problems they were designed to alleviate - specfically by

    (1) forcing middle aged / older consumers to save more and consume less to make up for their lower investment returns, and

    (2) keeping older workers in the work force longer, thus increasing unemployment, mostly among younger workers.

    With demand for credit weak, it is hard to see how pumping in more money will do anything - except perhaps create another bubble.

  6. CommentedTim Chambers

    Overcapacity in housing.
    Overcapacity in manufacturing.

    The supply side won't help us there.

    An over-leveraged public sector.
    Raising taxes would help with that.

    An over-leveraged private sector.
    Raising wages would help with that.


    Tax rates at an all time low and it's not helping create jobs, hasn't helped create jobs since 2001. Why do we keep doing what isn't working? Isn't that madness?

    Use tax policy to encourage higher wages by making them tax deductible, and reduce executive compensation with a cap on deductibility of all forms of compensation in the aggregate.

  7. CommentedProcyon Mukherjee

    Let us get attracted to the solution than to the analysis that monetary policy is not working. Yes, it is true that it has not worked in the first two bouts (with a continuing price-wage stickiness)and we have a genuine problem with the polity who believe that government spending is not the solution (although one side does not declare it), then it leaves us with very little to be done with an economy that has a savings rate of less than 4% and an output gap in the 6% (potential) and successive bouts of monetary easing from saving bank balance sheets to providing unprecedented levels of liquidity into the system has done precious little in terms of creating jobs.

    Yes, credit induced demand has to contend with the silent adversary that when the unwinding happens and interest rates have to harden we have the same contraction to deal with. But the good point is that here we are actually doing NGDP targeting with a commitment that till unemployment numbers reach a threshold level we have the backstop in place. This is virtually the maximum that one could expect from a monetary stance and if businesses do not see the opportunity now there is little to be expected in the future.

    ‘Made in America’ must return as a credo as opposed to the virtual wealth creation that the stocks bring in as the immediate response. I am reminded of a Lichtenstein resident stating, “Our people are more than willing to pay more for something made in Lichtenstein, than elsewhere”. Markets know better in America, but who knows the way to remove the price-wage stickiness could be just that simple realization, that sacrifice could be the starting point of a revival.

    Procyon Mukherjee

  8. CommentedRobert Pringle

    The conclusion is spot on. But like so many excellent accounts of our present predicament, it does not supply satisfactory - or indeed any - answers to the two key questions: why? and what to do? The assumption is that policy-makers are driven by mistaken ideas. So if we put a different group of economists in, hey presto, economies would start growing again. But does anybody believe that? And the silence about what to do in practice is deafening.

    The article rightly points out that policy-makers keep on making the same mistakes in the US, Europe and Japan. But this is because of flawed institutions, not wrong-headed individuals. The rules of the game need rewriting nationally and internationally. A radical reform of banking should be combined with a reform of international money. Yet as insiders like Haldane and Hoenig admit, Basel-based banking regulation is on the wrong track, while reform of international money is ruled out politically. The efforts of fine economists like Stehen Roach should be focussed on the design of new rules and instiutions, as I try to explan in my recent book, The Money Trap.

  9. CommentedZsolt Hermann

    I agree with the article completely, the only thing that is missing is the correct diagnosis of the patient.
    Indeed the current cure is making the problem worse, indeed the costumers, and also all the nations are zombies, only the previous momentum carrying the world economy on, as even the fastest growing nations are slowing down and gradually screeching to a halt.
    All the treatment at the moment is aimed at the misdiagnosed symptoms, none of them addressing the root cause.
    The problem is that our whole lifestyle, socio-economic model is based on a misunderstanding, an illusion: that constant quantitative growth is possible in a closed, interconnected, interdependent and finite living system.
    Our approach, function and direction is exactly the same how cancer cells work and destroy the whole body.
    It was not fully obvious before because humanity has not evolved into this global, closed network until recently, and we haven't exhausted the natural and human resources with this reckless, excessive and harmful model yet, but now we have passed peak points in both respects.
    Our whole life is based around producing and consuming goods that are simply unnecessary and harmful for ourselves and for the natural environment we live in. This vicious cycle is maintained by a sophisticated brainwashing marketing system and the subsequent social pressure. This model has nothing to do, is way beyond true necessities and available resources.
    Our present treatment is based on trying to encourage the cancer cells to grow even more thus increasing the ill effects instead of curing them.
    The crisis, the sluggish consumption, the gradual collapse of the present system is actually the natural cure, as the vast natural system we live in and is based on unbreakable natural laws of general balance, simply "removes" the foreign body from the system. There is nothing mystical about it, as our biological body rejects harmful parts, foreign bodies, as our immune system tries continually repairing ill body systems, the natural living ecosystem human society has become "self repairs". It has done so even before, but so far we evolved through violent, forced revolutions, wars when the actual state has become intolerable and we simply had to move on. If we allow for such involuntary evolutionary step to happen today, with the vast nuclear arsenal around with the multiple flash-points all over the globe, with itchy fingers over the buttons the violent next step could become fully destructive.
    Humanity has accumulated enough knowledge and experience and wisdom to take the next evolutionary step with full awareness, with the knowledge of the true situation and working out the proper cure.
    But first we need to acknowledge the real disease, we have to look into the mirror instead of putting our heads into the sand.

  10. Commentedjames durante

    This is a solid analysis. It gets to the key point, over-leveraged households and resulting lack of demand. What it misses, unsurprisingly given this site and these authors, is the long-term stagnation of middle class and decline of lower class incomes. Decline of unions, erosion of the safety net, massive tax breaks for the uber-rich, and outsourcing have combined to severely erode wages. What had been a century and a half long rise in income for workers fell off the cliff starting in the 80's and culminating in the a.t.m./refi phenomenon of the 2000's.

    Roach hints at a cure when he writes, "Policies aimed directly at debt forgiveness and enhanced saving incentives – contentious, to be sure – would at least address zombie consumers’ balance-sheet problems." Contentious? Uh, debt forgiveness? Only corporations and banks get that. What might work, though, are policies aimed directly at increase in wages--radically higher minimum wage and the card check bill for unions--as well as a radically progressive tax system. Back to the future. Any real solution would probably only come into focus in circumstances of depression and rioting. Ahhhhhh, capitalism.

  11. CommentedRichard Foosion

    The collapse of the housing bubble took a large amount of spending/income (my spending is your income) out of the economy. With less income, people have less money to pay down debt and less money to buy things. More spending/income would fix the problem.

    Austerity has taken over fiscal policy. Where else is there to turn if not monetary policy?

    Also remember that for every debt there is a creditor who holds an asset.

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