This story in today’s Financial Times, “As America falters, policymakers must look ahead,” is remarkable because, as far as I can tell, it is the first time a prominent economist has come out and said the unwinding of the housing bubble is likely to have nasty consequences (actually, take that back, Paul Krugman had a New York Times article, “The Big Meltdown,” but it was an odd piece, more a badly spooked riff than a reasoned argument). No matter what you think of Summers as a Harvard president, he is still very well regarded in economics circles.
He uses surprisingly blunt language (for starters, “strong grounds for anticipating that the economy will slow down significantly in 2007”), and is also the first writer I have seen play out what the deflating of the housing market might mean for our global imbalances. He foresees a weaker dollar and higher inflation and lower growth. In other words, stagflation, a word we’ve used before and Fedwatchers read into the latest FOMC report. And he also anticipates, if the Fed isn’t successful in buffering the fall, the damage could feed on itself:
It would have been desirable if policymakers had done more to restrain imprudent subprime lending to households with dubious credit in recent years. But with the sector littered with bankruptcies, this is not today’s problem. The problem is the opposite: to avoid a vicious cycle of foreclosures, declining property values, reduced consumption demand, rising unemployment, more delinquencies and more foreclosures.
It’s a bit tacky to pat ourselves on the back, but we have long pointed to what Summers contends: that too much has hinged on the spending of US consumers, and that overextended consumers have depended on housing as a piggy bank. Take that cash source away, and they have to rein in their spending. Frankly, this is obvious, yet for some reason commentators have been reluctant to connect the dots.
This article also coincides, and in a crucial matter, disagrees with an opinion piece by Mohamed El-Erian, the president of Harvard Management Corporation, and Nobel Prize winner Michael Spence, “Capital Currents,” that appeared in the weekend Wall Street Journal. It painted a fairly benign picture of global imbalances (meaning all that foreign capital financing US consumer spending) and depicted how they forestalled the normal corrections you’d see in a self-contained economy that had too much consumption and too little savings (oddly, acknowledges a host of global imbalances that exist in parallel with the capital influx, like compressed risk speads, but does not link them causally, nor does it mention asset price inflation). They depict the likelihood of an orderly reversal of these imbalances, while Summers anticipates a faster, and potentially disruptive reduction in foreign flows to the US.
From the WSJ:
Over time, emerging markets will inevitably divert more of their assets to more sophisticated investments abroad. That shift will have many effects, some of which depend on the decisions taken by emerging economies while others depend on the evolution of the global context. One effect will surely be to put upward pressure at some point on the cost of capital in the U.S., as the incremental demand for treasuries declines.
While the shift is inevitable, it would be unlikely that the emerging economies as a group would deliberately take actions that directly undermine global economic markets. There will also be domestic pressure on policy makers in emerging countries to gradually shift their emphasis away from the producer and towards the consumer. That will mean lowering the savings rate relative to investment, increasing consumption and letting it assume a more important role (relative to exports and global demand) in driving growth.
Under this state of the world, domestic consumption in the rest of the world picks up over time, facilitating the needed adjustment in the U.S. The result is a gradual journey to a more normal relationship between assets and income returns, with savings moving to a more normal long-run pattern.
But this process is not automatic and faces significant disruption risks; and it is particularly sensitive to “policy mistakes.”
Note that the scenario described by Summers below is not on their list of “significant disruption risks,” which seems particularly odd, since the article specifically mentioned, earlier, that “the potential pressure on house prices could also reduce household’s propensity to consume out of their accumulated equity windfall.”
Maybe they simply differ with Summers as to how bad things could get. But to not consider that possiblity would seem to be a serious oversight.
The full Summers article:
Three months ago I was able to write in this space that in economics “the main thing we have to fear is the lack of fear itself”. This is no longer true today. With clear evidence of a crisis in the subprime US housing sector, risks of its spread to other credit markets, sharp increases in market volatility, reminders of the fragility of global carry trades and signs of slowing economic growth, there is enough apprehension to go around.
While it would be premature to predict a US recession, there are now strong grounds for predicting that the US economy will slow down very significantly in 2007. Whether in retrospect 2007 will prove to have been a “pause that refreshed” a nearly decade-long expansion like the growth slowdowns in 1986 and 1995 or whether it will see the end of the expansion is not yet clear.
It is clear though that the global economy has been relying on the US as an importer of last resort; that the US economy has been relying on the consumer for its primary impetus; and that until now consumers have been encouraged to spend their incomes fully or more than fully by being able to access the wealth in their homes.
This growth syllogism has appeared fragile for some time, but has continued longer than many observers expected as US consumers have kept spending even after it was clear that the housing market had peaked and foreigners – particularly those in the official sector in Asia and the Middle East – have been willing to continue financing, on very attractive terms, the US in importing nearly 70 per cent more than it exports.
But the growth syllogism is now in doubt. Recent developments in the subprime sector exacerbate housing’s brake on US economic growth. Foreclosures will bloat the supply overhang of houses. At the same time reductions in capital in the housing finance sector and more rigorous credit standards will reduce the demand for new homes. Even as these developments reduce housing prices and the construction of new houses, housing finance problems are likely to magnify wealth effects on consumption as consumers face upward resets on their mortgage rates and are unable to refinance as they had planned, and as home equity, car and credit card lending conditions tighten.
If consumer spending declines and interest rates fall or appear likely to fall, there is the real possibility that the foreign lending to the US that has financed imports far in excess of exports will start to dry up, leading to a combination of higher long-term interest rates and a weaker dollar. This would tend to raise inflationary pressures, transmit US weakness to the rest of the world and could, by discouraging foreign demand for US assets, lead to further downward pressure on investment in plant, equipment and commercial real estate.
How should economic policy respond to a potential fall-off in US demand? The great irony is that just as the worst investment decisions are made by those who do today what they wish they had done yesterday – buying assets that have already risen and selling those that have just lost their value – so also the worst economic policy decisions are made by policymakers who, instead of responding to current circumstances, seek to rectify past mistakes.
It would have been desirable if policymakers had done more to restrain imprudent subprime lending to households with dubious credit in recent years. But with the sector littered with bankruptcies, this is not today’s problem. The problem is the opposite: to avoid a vicious cycle of foreclosures, declining property values, reduced consumption demand, rising unemployment, more delinquencies and more foreclosures.
Some argue that the Federal Reserve should have started tightening monetary policy earlier in the current cycle and avoided what they see as liquidity-driven bubbles. Regardless of the merits of this position, the theory that this constitutes a reason to avoid easing monetary policy, come what may, hardly follows. If, as may prove the case, the dominant economic concern becomes a shortage of demand, it is incumbent on the Fed to provide stimulus so as to maintain conditions for growth and financial stability.
Those in the rest of the world who have been insisting on the global imperative of increased US saving and a reduced US current account deficit should fear getting what they want too quickly. So also should those US observers who have insisted that foreign countries stop artificially holding their currencies down by purchasing dollar assets. While US current account adjustment is a medium-term imperative, an effort to bring it about rapidly in the face of an already declining economy could turn a soft landing into a hard one.
Similar principles can be extended to almost every macroeconomic policy area from fiscal policy to financial regulation. Good economic policies operate counter-cyclically, slowing booms and mitigating downturns. It follows that when the dominant risk changes from complacency and overheating to risk aversion and economic slowdown, the orientation of policy must change as well.
Economic policymakers who seek to correct past errors by doing today what they wished they had done yesterday actually compound their errors. They are in their way as dangerous as generals fighting the last war. We do not yet know how much economic conditions will change or whether current concerns will prove transitory. But if recent developments mark a genuine change, let us hope that policymakers look forwards rather than backwards.
