Willem Buiter continues his quixotic campaign to extirpate lousy economic logic in the US. In a colorfully written post, he ridicules the refusal of any US economist (as far as he can tell) to consider that an American recession is necessary. He points to the obvious fact (commented on repeatedly in this blog) that the current level of US consumption in relation to GDP is unsustainable. A drop in consumption and a rise in savings to the degree needed to restore a semblance of macroeconomic balance is certain to trigger a slowdown, more likely a period of negative growth. Yet the current efforts to prop up aggregate demand and keep the distortions going will only make the inevitable correction worse.
Buiter interestingly points to what he considers to be the source of US myopia: an American tendency to see itself as a largely closed system, with at most a simple input-output function (we pay for imports by selling Treasuries) and not recognizing that the US is a participant in a system that is ultimately bigger than it is and might start putting limits on this behavior.
I saw a demonstration of this insularity at a conference on sovereign wealth funds last evening. The participants were all remarkably sanguine about the growing role these entities are coming to play, noting rather blandly that they were being very helpful in shoring up our creaking financial system. And the idea which also held sway that evening, that the investors had no influence because they held minority stakes, is absurd. As veteran deal maker Felix Rohatyn pointed out, “You don’t need to appoint two directors to a board to have influence when you own 10 percent of the company.”
With the continuing leaks in our financial system, we will soon pass 10% in concentrated holdings in foreign hands at quite a few financial players. Standard & Poor’s anticipates that it coming reviews and downgrades of subprime debt will increase writedowns of financial firms from their current $130 billion to $265 billion. And as conditions worsen, future investments will be on less favorable terms, so struggling firms will have to give up more equity to get the needed infusion.
But what perhaps was the most remarkable subtext of the conference, in confirmation of Buiter’s views, was that this situation is sustainable, that the US can indefinitely run a large current account deficit (the consequence of an inadequate savings rate) and continue to import money from abroad. That program guarantees a deteriorating dollar, may precipitate a dollar crisis, and risks the dollar’s standing as reserve currency. If the US has to start funding its current account deficit in foreign currencies, as it did briefly during the Carter Administration, that will put us on a very short leash.
It reminded me of Japan, circa 1986, when very intelligent people were telling me that the even-then-obviously-overvalued Nikkei could never go down because the capital flows were so great. Essentially, it was a weight of money argument. And it still looked correct for three more years.
When otherwise smart people start believing things that are not sensible, it’s a warning sign of serious trouble. And unlike 1986, the volcano has started to emit smoke.
A while ago I argued in this blog that the US might benefit from a recession, because it was highly unlikely that the fundamental adjustment required in the US economy – a substantial increase in the national saving rate – is achievable without a period of growth below potential. Others have made similar points, and not just the usual European suspects, with post-colonial chips on their shoulders and an excess of Schadenfreude whenever the US trips over a banana peel. In recent contributions to the FT, Chrystia Freeland (Canadian, I believe)and Ricardo Hausmann (Venezuelan, when last I met him) have also made the point that the US needs, or would benefit from, an early serious slowdown in economic activity/recession. As the proud owner of both a US and a UK passport (and the former owner of a Dutch passport), my motives are, of course, beyond suspicion.
No US economist working in the US whose views I have read or heard supports the idea that a recession might be what the US needs right now. I think part of the difference in perspective comes from the fact that Europeans and other non-Americans view the US as an open economy that for decades has been saving too little and has been living beyond its means by borrowing abroad. They believe that the external constraint on the US addiction to current consumption is likely to become binding soon and certain to become binding in due course. Americans still tend to do much of their thinking about the US economy as if it were either the entire world economy, or at any rate a closed economy with just a couple of large holes in it: one through which oil imports pour in and another through which US Treasury bills and bonds disappear, never to be seen again.
In fact the US is well on its way to becoming a semi-small open economy on the trade side (with some influence over its terms of trade) and a small open economy on the financial side. The US now accounts for about thirty percent of world GDP at market exchange rates (less at PPP exchange rates).
In the financial field, the speed with which the euro is bridging the gap with the US dollar, once considered unassailable as an international reserve currency, has surprised even the greatest euro optimists. With the US now the world’s largest external debtor nation, monetary policy in the US is increasingly constrained by international financial markets. The (to my mind) reckless interest rate cuts by the Fed risk spooking domestic and international holders of US dollar-denominated securities who have many alternative investment opportunities, both low risk sovereign debt instruments and higher-risk/higher-return investments in non-US equities, including those issued by emerging markets. The risk of a sharp sell-off of US dollar -denominated securities and an associated increase in long-term US dollar interest rates could easily turn the US slowdown into a recession, even a prolonged one. A US recession that would be mild with 10-year US Treasury bonds yielding 3.6 percent could become deep with 10-year US Treasury bonds at 6.6 percent.
But even if the US were a closed economy, I would still believe that the kind of sustained increase in the national saving rate – by at least six percent of GDP to give US citizens hope of a dignified retirement (rather more than the three percent of GDP increase in the national saving rate required to restore external sustainability for the US) – cannot in practice be achieved without passing through a material slowdown, and possibly a recession.
Higher saving means lower consumption or higher income without a commensurate increase in consumption. I am sufficiently Keynesian to believe that a planned reduction in consumption will cause a temporary slowdown in activity. The kind of supply-side miracle that would produce an increase in income without a matching increase in private and public consumption is hard to visualise for the US. China has managed just that during the past decade, but the US is hardly China.
For the past couple of decades, the US consumer has been saved from the consequences of his under-saving by wallet-expanding painless capital gains. Unfortunately these capital gains were to a significant extent bubble-born and these bubbles have imploded one after the other. After the tech bubble and bust and the housing boom and bust, I cannot see another asset bubble coming along in time to rescue the improvident US consumer.
Therefore, to restore a sustainable external balance and to accumulate the financial assets that will support a greying US population in the style it would like to and hopes and expects to be accustomed to, the US private and public sectors must save more. To get to a higher saving and wealth trajectory, the US economy will first have to pass through the valley of the shadow of deficient effective demand, rising excess capacity and growing unemployment. Postponing the necessary adjustment will just make the pain of the eventual unavoidable correction that much greater.
There are two ways to achieve a traverse to a higher saving and financial wealth trajectory without passing through a slump. The first would be for US investment demand to rise by the same amount as consumption demand falls. This, however, would mean that the external imbalance would not be corrected. An increase in domestic capital formation that matches the increase in planned national saving is therefore not part of a sustainable adjustment programme. In addition, it is not easy to see what would motivate such an increase in investment.
A significant increase in private fixed investment is unlikely, because there are now, at the margin, many more attractive investment opportunities in other parts of the world. The US economy labours increasingly under an inadequate and ageing stock of infrastructure capital. The education and skill levels of its labour force are no longer the best in the world. Even in the higher education sector, where the US still has virtually all of the world’s leading institutions, the overall picture is one of islands of excellence in a sea of mediocrity. Secondary education is typically and on average poor, as are numeracy skills and literacy standards. Immigration has helped keep up US skill levels and underpinned it meritocratic traditions. Post-9/11 immigration paranoia threatens that vital contribution to US economic dynamism. Meritocracy is mutating into plutocracy.
A major boost to infrastructure investment would be more than welcome to boost the supply-side of the economy. For external balance reasons it would, however, have to be financed by a further increase in public saving. Any US politician running on a programme of higher taxes or lower current spending to pay for better infrastructure would in all likelihood not get elected.
The second way for the US economy to achieve a lasting increase in the saving rate without a temporary slump, would be for net exports to rise by the same amount as planned saving. That’s possible but not likely. The decline in the nominal external value of the US dollar is certainly helping, but the shift of domestic resources from the non-traded sectors (including construction) to the traded sectors (both exporting and import-competing) is unlikely to be accomplished solely through relative price signals. Painful quantity adjustment, including idle labour and capital in the over-expanded non-traded sectors is likely to be necessary.
So I don’t understand why both Larry Summers and Martin Feldstein, who have for many years preached the need for America to save more, do a 180-degree turn whenever there are signs that a higher saving rate may actually be in the making, and recommend expansionary fiscal and monetary measures to prevent at all cost a decline in the level or even the growth rate of consumption. The American economy is broke. To fix it a slowdown is well-nigh inevitable and a recession is likely to be necessary.
But the ostriches in the Fed, the White House and the Capitol are unmoved by such concepts as unsustainability. The prevailing ethos is myopic at best: let’s just put out this immediate fire, because it threatens today’s comfort level. Postponing adjustment raises the expected cost of the eventual adjustment, but that is then and this is now. Also, something may turn up. Santa Claus could exist after all. We may learn to harness as a source of renewable energy the hot air put out by the Congress.
It is hard to have a rational discussion with those who embody and express the views of a nation that is in denial. The US establishment and political class, and quite possibly much of its electorate, are indeed in denial, and not just about the need for an early traverse to a higher national saving rate. The economic, social and political model of the US has developed serious albeit remediable flaws and needs major surgery. Unfortunately none of those running for office today are likely to be willing or able to wield the scalpel as required.
There is a third way to increase the national saving rate – raise interest rates.
When people have money, they have a choice to spend it or to save it. Increasing interest rates, and restricting money supply, increases the demand for the currency and thus its price in relation to other goods and services.
An increase in interest rates will reduce consumption and increase saving. More people are likely to save if the interest rate is attractive enough.
It is my belief that monetary policy in the US has been too lax, even going back to the 1980s. Personal savings have been eroded because monetary policy has allowed inflation to punish savers while rewarding borrowers, it punishes producers while rewarding consumers. That is why the US has such a large current account deficit and why its consumption over the years has been driven by racking up debt.
As a result, I see the Fed’s response to the current problem to be precisely the wrong solution. It has been cheap money that caused this problem in the first place, so why is it suddenly the solution?
Of course, raising interest rates in the midst of a recession is a very dangerous thing to do. It may also be the only real solution in this case.
At issue is whether or not the deflationary effects of an economic contraction will outweigh the inflationary effects of the currency devaluation. Since many American economists can’t see beyond their own borders (as you said Americans still tend to do much of their thinking about the US economy as if it were either the entire world economy) the danger of inflation from a falling dollar is not understood properly.
When Asian currencies collapsed in the 1990s, the result was high levels of inflation coupled with recession. Although the US Dollar has not fallen as far (yet) the long term effects of a currency devaluation will always be inflation.
The forex market responded to the Bernanke rate cuts last year and this year with alarm. According to the NYBOT, the US Dollar has been trading at historic lows for a few months now. The dollar has fallen by about 10.5% in the last 12 months alone.
If Americans wish to save more and wish to avoid the inflationary problems of a falling currency, then interest rates will have to rise.
Oh… this “third way” will cause a slump. I missed that part of your essay.
But the true underlying cause of the problem is the Asian nations pegging their currencies to the dollar at levels that render the make-or-buy decision a no-brainer, while simultaneously lending the money we pay to them back to us at rates that make the lend-or-borrow decision another no-brainer. Although those decisions may cease to be no-brainers if we consider their long-term consequences, we must then face the issue of just what, concretely, we might do to change conditions such that more of those decisions go to the “make” and “lend” sides.
Given current Asian government policies, the only thing that would bring US trade into balance would be tariffs high enough to make US goods competitive. We know what the consequences would be.
Even if the Fed were to raise interest rates high enough to bring the savings rate back above 8%, it’s not clear to me that in the face of the current Asian determination to run huge trade surpluses this would bring trade into balance. It seems more likely it would send the world into a deflationary death spiral.
In fact, it seems to me that what’s happening is that to maintain the average price level against the deflationary impact of Asian mercantilism the Fed is being forced to print so much money that inflation in the prices of non-tradeables (including assets) is inevitable.
Great stuff by Buiter. I think he’s dead on.