US Recession May Be the Best Medicine

The headline above isn’t precisely how Gilles Saint‑Paul of the Toulouse School of Economics states his conclusions in his article at Vox EU, “How the US imbalances can be corrected.” But he makes a solid case that a US recession is likely the better way to deal with our current economic mess than rate cuts. Some of his argument covers familiar ground (rate cuts will merely shore up inflated asset prices, create moral hazard, and worsen the eventual, inevitable unwind), but he also makes some novel points. For example, he discusses the role that imports have played in keeping inflationary pressures at bay.

From VoxEU:

Many observers call for US interest rate cuts to avoid a recession, but this is likely to perpetuate the current imbalances in the US economy. The US probably needs a recession to get the required correction in house prices and consumer spending. The Fed should signal its intention to hang tough and start thinking about how big a fall in GDP it will tolerate before intervening.

There is agreement among many analysts that the Fed should pursue a low interest rates policy in order to prevent the US credit crisis from degenerating into a recession. On what grounds are we told that? The bottom line is that monetary policy is supposed to fine-tune the economy by targeting inflation and the output gap. Thus, monetary policy is supposed to become tighter when there are fears of inflation, and looser when there are fears of a recession and no sign of inflation. Consequently, the fed’s recent moves to lower interest rates seem perfectly orthodox.

This focus on macroeconomic aggregates ignores any other effect that interest rates can have on the economy. It totally ignores that interest rates are a price which affects many allocative decisions and has important distributive consequences. In 2001, the Fed engaged in a policy of drastic reduction of interest rates, for fear that the conjunction between the end of the so-called “Internet bubble” and the attacks of September 11 would drive the US economy into a recession. These considerations were compounded by the increasingly popular view that inflation was no longer a problem. The strong expansion of the late 1990s had been accompanied with little inflationary pressures and there were fears that the deflationary experience of Japan might hit the United States.

The result of these policies is that the US was in a regime of very low real interest rates. From 2002 to 2004, the federal funds rate did not exceed some 1.5 %, while inflation moved from 1.6 % to 2.7 % during that period. Thus short-term real interest rates were clearly negative. As for longer maturities, some real rates fell to 1.5 %. Many would argue that this was the right thing to do; GDP stayed at its potential level, or below it, and the incipient increase in unemployment was reversed.

The problem is that low interest rates not only stimulate the economy, they do plenty of other things. In other words, focusing only on GDP has costs and may generate mounting problems—the low rates policy makes a current recession better, but the next one may be worse.

One reason why the US economy is less inflation-prone than in the past is that a bigger share of any increase in domestic demand is absorbed by imports: the economy is more open than it used to be. Thus, instead of having “overheating” because demand is greater than supply, the gap between the two is filled by trade deficits. Hence, low rates stimulated consumer spending and the trade balance deteriorated by two percentage points of GDP. The US is rapidly accumulating foreign debt and that may lead to a brutal correction with a sharp drop in consumer spending and a large depreciation of the real exchange rate. In fact, that correction may have already begun. Yet the Fed is not supposed to look at the net foreign asset position of the US economy, even though both its deterioration and rising inflation are the symptom of the same problem – excess domestic demand.

The other issue is asset prices. When interest rates are very low, and expected to remain so, asset prices can be very high. In fact, when interest rates fall below the growth rate, assets become impossible to price. Consider, for example, a share that pays a dividend which grows at 5 % a year. With a 2% interest rate, it is profitable to buy that asset regardless of its price, because I only need to hold it for a sufficiently long time for the dividends to eventually exceed the interest payments. So the price of the asset is in principle infinite. In fact, people do not live forever, so they will have to sell the asset back at some point; but one can show that any change in markets’ expectations about that future price can be validated by a corresponding change in the current price—so, the current price can be anything.

In particular, low interest rates may start asset bubbles. One mechanism is as follows. As the price starts rising due to lower interest rates, irrational speculators start buying the asset on the grounds that the price increases are going to continue. That fuels the price increase which may eventually develop into a bubble where all speculators, including the rational ones, pay a high price for the asset because they expect the price to be even higher in the future. So one by-product of the fall in interest rates is that real house prices started to go up very quickly.

To summarise, the low interest rate policy led to a wrong intertemporal price of consumption – consumption was too cheap today relative to the future – which led to excess spending and trade deficits. It also led to a mis-pricing of housing, which led to excess residential investment and excess borrowing by households. That is the price that was paid to make the 2001-2002 slowdown milder.

These imbalances have to be corrected. In principle, consumer spending can be brought down without the economy having to go through a recession, provided there is a sharp real depreciation of the US dollar, which would shift the structure of demand away from domestic spending and in favour of exports. On the other hand, the correction in house prices is likely to be contractionary. Some consumers have borrowed against the capital gains they made on their house, to purchase, for example, a second house or consumer durables. They are going to cut their consumption since they are more likely to become insolvent. As the collateral value of their houses falls, consumers will get less credit; hence a further drop in consumption. Furthermore, the securities backed by mortgages, subprime or otherwise, have been used as collateral by financial institutions; that collateral is worth less, thus reducing credit between those institutions. As a consequence, they will have more trouble lending to firms, so that investment will also be hit. The housing bubble has jeopardised the financial sector both because people have borrowed to hold it and because institutions have used the corresponding securities as collateral.

Because of this gloomy scenario, the Fed has been under pressure to cut rates. The problem is that such a policy is likely to perpetuate the current imbalances. Indirectly, it amounts to bailing out the poor loans and poor investment decisions made by many banks and households in the last five years. The bail-out comes at the expense of savers and new entrants in the housing market. The signal sent by the Fed is that it is sound to join any market fad or bubble provided enough people do so, because one will be rescued by low interest rates once things turn sour. Worse, the more people join, the greater the lobby in favour of an eventual bail-out.

All this suggests that the US has to go through a recession in order to get the required correction in house prices and consumer spending. Instead of pre-emptively cutting rates, the Fed should signal that it will not do so unless there are signs of severe trouble (and there are no such signs yet since the latest news on the unemployment front are good) and decide how much of a fall in GDP growth it is willing to go through before intervening. As an analogy, one may remember the Volcker deflation. It triggered a sharp recession which was after all short-lived and bought the US the end of high inflation.

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  1. Anonymous

    I think there are parallels and correlations to financial bubbles, hurricanes and conditions related to not being prepared and thus being caught off guard. Without going into a long well researched report, the hundred year event of Katrina, is a pattern, just like The Great Depression is a pattern or model to be examined in terms of risk.

    In this hyper-linked world of split-second internet information gathering, our populations are connected to arrays of satellites that can predictively map and forecast chaotic weather patterns into minute-by-minute pinpoints of strom projections and trajectories, guiding our collective insight as to where the course of storms may drift. However, with all our massive technological advances, one still has to think back to Katrina and ask why so many things went wrong with all the models that were in place; one has to question why so little was done so late, with such advance notice.

    The correlation in regard to subprime is related to bad investments made by banks — as a result of the flood of liquidity produced by a disconnect between risk management and regulation. Banks (starting around 2001) were lending on average home values of apox $150,000 or less, but suddenly within the course of perhaps 2 years, lenders were issuing more and more loans for $300,000+ and in this process, the rules for normal reality were warped by allowing a flood of no documentation loans to be spun into the financial system. That is where the chaos began and the storm gathered force. These no doc loans — without collateral — fed a sustained supply of “easy money” into massive pools of mortage backed securities which would be linked, swapped, traded and morphed into endless variaties of derivatives that relied on indexed substitutions of securities linked assets that became less and less reality based, but now, these are the fruits that many, many pension funds bare; these substituted swaps that were engineered to be confusing, to be chaotic are the pay off for countless cities and states that basically get what they paid for by ignoring risk models.

    In regard to financial modeling, the recent subprime mortgage flu is a condition which evolved like a a hundred year event, a condition that was like a hurricane that gathered force by feeding on cheap easy liquidity, further fueled by unprecidented successive rate cuts, hyperactive pumping, fanning and agreesive marketing from NARs army of realtors, lock-step and arm-in-ARM with banks, mortgage lenders, homebuilders, developers and anyone willing to do whatever it would take to sell more homes.

    Along the way as this storm grew, every city in America looked the other way on permits and every environmental impact issue as they rushed to help crush small town businesses which were in the way of corporate America Big Box stores — which were obviously designed as conduits for future debt. This tsunami-like expansion was well tolerated on the whole because every appraiser in America was willing to help re-value properties and homes by pushing the comparitive square/foot higher and higher to absurd valuation ranges. All the while, every bond, CMO, SIV anything and everything tossed out by Wall Street was eagerly rated AAA by every rating agency, but now, with the bubble popped, with naked reality exposing the game for all its faults, do we see the damage done? Was anyone caught off guard, or did we all look the other way?

    The storm damage and physical impacts from Katrina or its sister storm 100 years earlier resulted in massive destruction, and the reality here is, forecasting and models in this day and age are irrelevant if people are reckless and take quantum risks. Its really just simple greed and stupidity that cause failure. This subprime storm is not about a few thousand people that lied, its about millions of people that lied, cheated and failed to stay within “the model”, and as a colective result, we may drift towards The Next Depression!

    Needs work, but….the storm is coming and The Fed aint gonna be there and the damage will be real!

  2. s

    The analogy on consumption is encapsulated by the auto industry. Two massive dislocations happened: (1) future consumption was pulled forward and (2) massive intergenerational wealth transfer to the soon top be retiring baby boomers. Since people are living longer an greater percentage of that wealth will be used for cost of living and the residual will be expropriated by the government and wasted. The question is how the genx will and y folks replicate their parent’s success by accident? Let’s see: wages are declining, asset prices are totally inflated (even with a 20% fall) and job prospects are bleaker than ever outside of the super skilled. Perhaps that is why so many are so eager to go into the casino.

    Can I say again: what we need is wage INFLATION and asset price deflation? This is basically what the OECD is calling for by saying the Fed should not be cutting rates (well at least the asset deflation side). The wage inflation side of the equation is not fixable and thus the real conundrum; the one conveniently ignored by the Greenspan’s Fed out of deference to the globalization at all costs crowd. I suppose the equity markets can at least breath a modest sigh of relief as one component of margin pressure will be ventilated. Nevertheless, the peak profits (% GDP: see Hussman) are unsustainable as they have been driven largely by wage divergence (capital beats labor) and zero percent financing for share repurchase (leverage recapitalization).

    These conditions have nothing to do with sub prime (nor will they be fixed by these half baked political schemes), which is essentially a side show in my view to the massive structural problems / challenges that globalization has created. Oh yeah, when people talk of china revaluing panacea, keep the long march in mind. The sad realty for the United States is that they have numbers on their side. Benign neglect is not a strategy. We need a Marshall Plan in the economic and foreign policy arena.

    The US is in the process of slowly off shoring our standard of living to the rest of the world. We are the most benevolent no doubt, but do you think most Americans are even aware that this charity is not likely to come back to them ever?

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