A reader pointed me to a great post at Institutional Risk Analytics, which consists of an interview with Richard Alford, an economist in the Federal Reserve Bank of New York’s foreign department during the heady years of the Plaza Accord and active FX intervention by the Group of Seven who now works as an expert in macroeconomic trends.
I’m particularly keen about Alford’s views because he picks up on themes that are important yet sorely neglected. One is that the US formulates its monetary (indeed its broader economic policies) as if the nation was an independent actor. The role of the trade sector and our dependence on boatloads of foreign inflows to fund our trade deficits is missing from the official calculus (note this is also one of my pet peeves in most analyses of the Great Depression: the role of the breakdown of the financial flows among Germany, which had to pay reparations to England, which had to repay war loans from the US, which in turn was lending money to Germany to pay its reparations, is generally omitted). Alford says the Fed in fighting deflation has misread the US situation. He also warns our trading partners don’t believe we will drive the dollar to the level required to get US consumption back in line (he has an intriguing view of why other countries won’t be so keen to step into the reserve currency role).
Alford, with his focus on the trade/international funds flows component, highlights another aspect too often neglected: our unsustainable level of consumption and what bringing it down might entail. He is blunt in saying that the Fed did damage by defining the problem incorrectly and implementing wrongheaded measures. It’s a compelling, sobering analysis.
The IRA: Dick, in your latest missive you say that the Fed has misread inflation for deflation, and that former Fed Chairman Alan Greenspan and now Ben Bernanke are fighting the wrong battles. There is clearly a lot of new inflation in the system due to energy prices, but you rarely hear anyone talking about monetary policy as a secular source of inflation.
Alford: One of the interesting aspects of economic policy in the US is a belief that we exist independent of the rest of the world. In the minds of many policy makers, the US is the focus and the rest of world economy is just a stable background. To open the model up to external factors, market imperfections, and quasi-floating exchange rates would increase the complexity of the model and limit the number of policy prescriptions that could be made, so most US economists pretend that the rest of the world does not exist, is stable, or that the dollar will quickly adjust so as to maintain US external balances. It has only been in the past few years that the trade deficit has moved to a level that is clearly unsustainable. The US economic model is yet to catch up with reality.
The IRA: But don’t you argue that because no other nation wants to be a reserve currency this allows the US to play this game without limit?
Alford: A lot of people thought that the game would end when foreign investors no longer wanted to hold dollars. All of a sudden China and Japan or OPEC would just say “no mas.” But the problem with that view is that in most cases the reason to accumulate dollar reserves still exists. China, among others, still wants to grow through exports. They’ll let the exchange rate appreciate until it really affects their growth, but no more. In addition, it is useful to remember that for a currency to function as a reserve currency, non-residents must hold large net claims denominated in that currency. This can only happen if the country of issue runs a large current deficit. I do not see any policymaker in the EU or Japan permitting large current account deficits. The dollar still may be the only game in town. But the other part of the equation, what people often forget, is that Americans must also be willing to hold more debt. At some point – and I think we are here now – Americans are not going to want their debt to income ratio to go up any more. They will stop borrowing and this whole game is going to come to an end. If Americans can’t or won’t borrow, they can’t spend and the US economy goes into recession.
The IRA: Not only a recession, but a lowering of overall expectations, don’t you think?
Alford: The primary effect is going to be that aggregate demand growth, especially consumption, is going to fall. We’ll be at a point where the Fed can lean on monetary policy, but like Japan, these policy moves will do absolutely nothing. I can see a rather long period where the US underperforms trend growth by a significant amount.
The IRA: But going back to the point about the insular US mentality, isn’t it obvious that once debt and other sources of new “bubble” financing are exhausted that we must see a downward adjustment in consumption?
Alford: If you look at the difference between gross domestic purchases and potential output, by US consumers, businesses, and government — all are above potential output. The only time in recent memory when the difference between these two measures started to narrow was in 2001 when we were in a recession. One of the things we need to consider is that that US may need to see consumption drop significantly before we can achieve a sustainable position, for example vis a vis the dollar. That is going to be painful. I think private consumption must drop because a fall in investment will further limit income and job growth. I do not believe government expenditures are about to contract nor do I believe that the US has “decoupled” from the rest of the world. If we slow our growth rate and our consumption falls, then the rest of the world will slow as well.
The IRA: Correct. So if, for example, you take the worst case scenario of our friend Nouriel Roubini for US consumption, such a retreat by American consumers could ripple throughout the global economy, possibly causing an absolute decline in trade and financial flows.
Alford: Part of the issue is that where the US does have exchange rate flexibility, it is where we least need it. We certainly are competitive with the EU, but there are parts of the world where we are not competitive, where the exchange rate is not moving or not moving quickly enough. But we’ve past the point where prices alone- namely exchange rates – could adjust the system. Now we see income starting to adjust.
The IRA: Americans certainly are feeling the adjustment, especially in view of energy prices. Given what you see on the trade and economic front, how would you characterize Fed monetary policy?
Alford: Fed policy has been inappropriate to say the least. If you listen to Chairman Bernanke, he and the members of the Board of Governors are responding to the prospect of deflation in the US – a deflation which he describes as the result of a shortfall in aggregate demand.
The IRA: Thus the Bush stimulus package.
Alford: Yes. My view is that the demand side is fine. Remember, US domestic purchases are still running around 105-106% of potential domestic output. The problem is not the level of demand but rather the composition of demand. Americans are buying too many imported goods and the world is not buying enough of our exports. So we have a growing wedge growing between gross domestic purchases, which is what the Fed really controls, and net aggregate demand, which is defined as gross domestic purchases less the trade deficit. Given the inability or unwillingness of the US to correct the trade imbalance, the Fed has run expansionary monetary policy almost continuously, generating higher levels of domestic purchases so as to keep net aggregate demand near potential output. The Fed did this using low interest rates, which generated asset bubbles, large increases in consumer debt and sharp declines in savings, and also a larger trade deficit. What has been totally missing is any policy aimed correcting the external imbalance. We are relying on the tools of counter-cyclical domestic demand management to address problems caused by a structural external supply shift.
The IRA: All in the name of maintaining the nominal appearance of growth. So what measure does the Fed use to gauge its policy actions? Is the Fed’s measure the dollar or what Americans have come to expect in terms of income levels?
Alford: The Fed is living in a Taylor rule world. Given the Taylor rule framework and the deflationary impact of globalization, the policy goal has been to generate sufficient levels of demand to support full employment. It is important to note that the Taylor rule framework implicitly attaches zero cost to growing external imbalances or financial instability. They are trying to get net aggregate demand to equal potential economic output. That would be fine if we did not have a net trade sector or at least had a stable net trade sector. But globalization has occurred and we’ve had a flood of imports which have depressed prices in tradable goods. Fed Governor Don Kohn gave a speech recently that said imported deflation knocked 50-100 basis points off measured per annum inflation. At the same time, rising imports have hurt American workers. From the US is an island, Taylor rule perspective, such a result is consistent with a shortfall in aggregate demand and requires expansionary policy. But today the underlying problem is not deficient US demand, but a structural external increase in supply (globalization). Given the inability of the dollar to serve as an adjustment mechanism, we are consuming too many imports, but instead of US policmakers addressing this global development, we created a number of unsustainable domestic imbalances to keep employment at politically acceptable levels. Higher levels of debt and asset bubbles have been the result of policy responses to external imbalances.
The IRA: Your description of the macro economic situation makes us think of the deteriorating credit quality of the American consumer. The higher debt levels and reliance upon speculative binges to manufacture the appearance of economic vitality at the national level ultimately manifest as higher default rates for individual consumers. Your scenario for the US adjustment process makes us feel even more bearish about US bank asset quality, if that is possible.
Alford: It seems that while the regulators and the Congress abhor (some might say abet — editor) leverage and dodgy financial structures, they are also addicted to the asset prices only reached because of leverage and financial engineering. So now it seems that that the authorities will want better capitalized banks to support inflated asset prices previously reached through excessive leverage! We’ll see how the great deleveraging plays out.
The IRA: Right, but this is not a particularly credible policy for a central bank to take over the medium to longer term. In the meantime, something had to move – namely the savings rate?
Alford: Yes, something had to move. You had to have net demand rise relative to income, which means that savings had to fall. Since 2000, the demand increases relative to GDP in the US mostly came from the consumer and housing sectors. Now with domestic demand waning, the attention has turned to stimulating foreign demand via a weaker dollar.
The IRA: OK, so what happens when the US consumer reaches the natural limit in the deterioration in their credit quality? When consumer have to become net savers, how much of US aggregate demand disappears from GDP?
Alford: That is a very complex question and one that is best addressed in pieces rather than via a point in time forecast. If the US consumer were to go back to savings rates of the 1996 period, then you are talking about savings going from essentially zero today to approximately 8% of disposable income. Since US GDP is about 70% consumption, that implies a decline in demand of about 5 to 5.5%. That would be a very dramatic effect. I don’t think that this type of shift will happen all at once. It would occur over time. A shift back to a higher level of savings by the US consumer implies that the actual growth rate of the US economy will trail potential growth and will not support full employment-unless the trade deficit collapses.
The IRA: Well that’s precisely the point, is it not? The US has an aging population that is intent upon drawing down savings in the later years of their lives. This means that the relatively smaller population of younger workers must be saving like crazy to offset the continued dis-saving by the Greatest Ever Generation.
Alford: Young people will have to save like crazy and the public sector will also have to save as well, though recent history is not encouraging in that regard. The Clinton deficit drawdown of the 1990s was a transitory event driven by tax policy and bubble induced stock market capital gains, not the underlying dynamics of the US economy.
The IRA: So how does the Fed’s moves to re-liquefy Wall Street and bailout Bear, Stearns (NYSE:BSC), JPMorgan (NYSE:JPM) and the rest of the dealer community figure in the monetary policy equation?
Alford: Lots of people in a position to know have told me that they could not say no to a BSC rescue, that it was OK for the Fed to intervene. We’ll it’s not OK. This intervention may have been necessary, but it is also very troubling. To say it is OK or doesn’t free policymakers from responsibility for their role in promoting the financial excesses that lead to the current dislocations in the world’s financial markets. The policies that we followed since 1996 explain how we got to the present juncture, including keeping Fed Funds at 1% for almost a year and then the Fed taking its sweet time raising rates, and doing so in quarter point increments! The Fed’s actions provided an incentive for economic agents to lever up and run maturity mismatches. Even households went out and got ARMs while the Fed was keeping rates artificially low! Banks (SIVs) and municipalities (auction rate securities) and corporate were all funding long-term obligations with short-term debt, so it’s no big surprise that the economy takes a hit when rates finally rise back to normal. Short-term interest rates were clearly too low for financial stability in the early part of the decade and everyone in the US economy was running grotesque maturity mismatches that have now collapsed.
The IRA: So it was Fed monetary policy that has in fact created a safety and soundness problem in the US?
Alford: Yes. The policy stance was sufficient to generate asset bubbles and misallocations of resources. The regulatory system helped shape the crisis, but isn’t a sufficient explanation for the crisis arising. That is a far easier explanation than to say that the regulatory system somehow simultaneously failed in the mortgage industry, the banking industry, municipal finance, etc and that we now require new layers of regulation in every corner of the financial system to correct the imbalances in the system. The Fed’s monetary policy, in fact, was a necessary component of the systemic instability. No amount of regulation could prevent market participants from taking advantage of the incentives created by the Fed from 2001 through 2005 via extreme easy money policy. The incentive to run maturity mismatches would still be there and people would find a way to take advantage of it. This is not say that all regulation is futile, but rather that incentives are also important.
The IRA: So Milton Friedman was right when he said that keeping money policy relatively stable helps to avoid other evils.
Alford: The Fed has taken an approach that focuses on apparent price stability to the exclusion of other policy goals. The problem is that while price stability is necessary for long run economic and financial stability, it is not sufficient. When the Fed decided to focus on relative price stability, the US did not have a functional policy regarding the dollar. We did not and still do not have a functional trade policy. We have deficient regulatory policy. So by pursuing this one policy goal, which would be admirable if there other areas were being addressed, the Fed actually contributed to vast problems elsewhere.
The IRA: In fairness to the Fed, aren’t they simply trying to make up for a government that is completely dysfunctional in areas like trade and the dollar? The Bush Administration’s approach to things like economic policy is to simply have no policy.
Alford: It is incumbent on the Fed to go to the Congress and even the American people and say “we do not have the tools to address globalization.” The Fed can clearly ease the transition, but adjusting the Fed funds rate is not an adequate response to the changes that the globalization of trade and investment flows are having on the US economy.
The IRA: Agreed. Why is it that the Fed cannot tell the White House and the Congress that these issues fall outside the realm of monetary policy?
Alford: Under Greenspan, there was this aura at the Fed that said “let’s take credit for everything that’s good” regarding the economy. The trouble with that position is that politicians and markets then expect the Fed to keep the party going. Fed policy, monetary policy has been vastly oversold. By focusing on short-term inflation and employment, the Fed misses a lot of other factors – like global trade and investment flows, like the decline in household savings as percentage of income, like leverage in the financial markets – which we can now see are rather important. Going back to the early part of the decade, economists within the Fed system apparently saw a world where US prices and incomes were made at home. Now we see that is not the case. In the EU and around the world, currency movements are seen as a constraint on monetary policy, but in the US economists have grown up thinking that the dollar would never be a constraint on policy. I think that the FOMC was probably a little surprised recently when they found that the dollar and commodity markets impinged on their ability to ease.
The IRA: Fine, so let’s assume that you are a Fed governor – which we think is a good idea, by the way – what would you do differently?
Alford: Asking what should have been done in 1996 or 2000 is a tough enough question because the imbalances were all smaller, but today by comparison we have serious problems. Politically and economically, there is no painless solution to the imbalances in the US. For US policymakers, it seems that even short-term pain is intolerable. Nobody in Washington wants to bite the bullet and explain the full dimension of the required change to the US electorate, so we muddle. Going back to the early 1990s, US politicians have bought support from the voters by keeping consumption on an ever rising trajectory. For at least 12 years, we’ve had debt induced increases in consumption and the political class optimized their behavior to maintaining that illusion of rising consumption even as the economic fundamentals worsened.
The IRA: Members of Congress actually believe that endlessly rising home prices are now part of the American Dream.
Alford: Precisely. The US population is not ready to hear that their real levels of income, assets prices and other indicia of national well being may be falling or relatively stagnant for the foreseeable future. This is just politically not acceptable. So our politicians will attempt to maintain the appearance of growth, but not address the underlying causes. Devaluing the dollar alone is not going to correct the issue. World financial markets would destabilize if they perceived that the dollar was about to depreciation enough to restore the US to external balance. They still believe that it will never happen.
The IRA: Never say never. Thanks Dick.