Ben S. Bernanke, the Chairman of the Federal Reserve, said in the spring that it was time to see whether the economy could stand on its own. Last month he said the Fed would consider new steps if conditions deteriorated significantly. As the Fed’s policy-making committee prepares to meet on August 9, the war drums are beating and stock markets around the world are sending out siren calls.
Last week the stock markets plunged on strong rhetoric about the dollar and the weak job market. At the same time US sovereign ratings were downgraded from AAA to AA+. The US 5-year bond yield is now down to 1.14% and falling fast, a sign of increasing tightness in monetary policy. Nominal GDP growth expectations are dropping rapidly. Deflationary expectations are setting in again. Indeed things are now so bad that even the mainstream US press has woken up to the fact that the Fed might have to act soon. If the Fed fails to ease up on monetary policy much longer, then it will soon be just as “non-stimulative” as the Bank of Japan was a decade ago!
The Fed has been misreading market signals a number of times since 2007 when the economy started to turn downwards. In early to mid 2008 the Fed misinterpreted market conditions and failed to accommodate the surge in market demand for US Dollars. It interpreted low interest rates as a sign that monetary easing should be held back. Fearing inflation more than slow growth, it allowed the US Dollar to surge at that time. Many banks and non-bank financial institutions were already short of liquidity. The rise in the US Dollar worsened their balance sheets and led to an even more severe liquidity crunch in the summer of 2008.
Friedman Has The Right Prescription
Last year the Fed waited until the 5 year implied inflation expectation was bouncing along near 1.2% in late August before QE2 was introduced. The Fed has tended to be late in the game throughout the past few years. You have a lot of policymakers that need to fundamentally shift their intellectual framework to come to terms with a rapid shift in policy. Instead they are failing to act promptly and justifying themselves by pointing to the 10 year implied inflation expectation to say it needs to fall further before they will act.
Like the Bank of Japan over the past 17 years, and the Fed of the 1930s, the present US Fed has failed to loosen up money in time to combat deflationary expectations as reflected by the incredibly low 5-year bond yield. It doesn’t seem to realize that near zero rates are a sign of tight money, not a sign of easy money.
Milton Friedman long ago taught us this critical point. Friedman also criticized the Bank of Japan for failing to act decisively to avert what became a lost economic decade. In an article entitled “Reviving Japan” published in 1998, he gave the Bank of Japan step-by-step instructions for resuscitating the Japanese economy and giving it a “monetary kiss of life.”
Friedman wrote, “There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.
“Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.”
The1.14% yield on 5-year T-notes is now the lowest rate ever seen. This is the market forecast of future rates and an implied prediction that rates will be at zero for much longer than Fed officials believe. Recent monthly averages of rates available from the St Louis Fed, shown below, demonstrate that deflationary expectations are once again setting in
• 2011-02: 2.26%
• 2011-03: 2.11%
• 2011-04: 2.17%
• 2011-05: 1.84%
• 2011-06: 1.58%
The markets are telling us that the current slowdown is not just a pause in growth. The Fed doesn’t seem to realize this yet, and thus has remained passive. But they will eventually need to act if we are to avoid ending up like Japan. The current 1.14% rate can be seen as approaching the Japan scenario, in which case rates could fall even lower. If a more robust recovery generated by more Fed stimulus were to take place, then rates would increase. It will be interesting to see which road the Fed takes.
Maybe it is a blessing that Milton Friedman is not around to see what is happening today and to hear all the talk of a Keynesian revival. I cannot even imagine how frustrating it would have seemed to him to see the Fed’s take on his work A Monetary History of the United States 1857-1960, which showed how the failures of the Fed during the period 1929-1933 prolonged the Great Depression. Bernanke said the Fed accepted Friedman’s work, but to this day has totally ignored its lessons and in effect thrown it into the trash bin.
Inflation Targetting Best Announced
The idea that we should have had a much bigger Keynesian-like fiscal stimulus in the last two years is unlikely to go down in intellectual history as the correct view. What the US and Europe is suffering from today is a repeat of the Asian Financial Crisis that first started in Japan and later swept through the rest of Pacific Asia. Harvard Professor Kenneth Rogoff’s diagnosis is spot on. We are experiencing a balance sheet recession and his prognosis is that it will take a few more years before the process of deleveraging can be completed. Such a result has been borne out in the research he conducted with Carmen Reinhart. The Asian experience is a living testament of the deleveraging process.
Meanwhile, the best cure is to loosen up money to avert the onset of deflationary expectations, as prescribed by Milton Friedman. We need a dose of inflation given the downturn.
According to Professor Greg Mankiw of Harvard, what the Fed could do is codify its projected inflation rate at 2%. That is, the Fed could announce that, hereafter, it would aim for a price level that rises 2% a year. And it could promise to pursue policies to get back to the target inflation rate if shocks to the economy ever pushed the actual price level away from it.
An announced target path for inflation would add more certainty to the economy. Americans planning their retirement would have a better sense about the cost of living a decade or two hence. Companies borrowing in the bond market could more accurately pin down the real cost of financing their investment projects.
Mankiw is a very canny pragmatist and has even anticipated and pre-empted the argument of the hawks against his proposal. “Such an announcement could help mollify critics on both the left and right. If we started to see the Japanese-style deflation that the left fears, the Fed would maintain a loose monetary policy and even allow a bit of extra inflation to make up for past tracking errors. If we faced the high inflation that worries the right, the Fed would be committed to raising interest rates aggressively to bring inflation back on target.”
Mankiw knows the oil shock is probably about over. That means the economy’s slack will push inflation back down toward 1% to 1.5% over the next few years. His proposal would force the Fed to move even more aggressively against declining inflation. And the more Obama tries to reduce business costs, something the President is now beginning to hint at through reducing regulation, the more he forces the Fed to boost the economy.
Fear Not Ratings Down-Grade
There is no point in attacking ratings agencies, who have downgraded US sovereign ratings, for their previous mistakes and stupid, corrupt behavior. How markets will respond to the ratings downgrade is unknown, but an alarmist reaction would be unnecessary and inappropriate. A letter grade is a letter grade and reality does not change with the change of ratings. If the downgrade becomes a turning point of significance then the rating agencies have done their duty. If nothing follows then the world is trying to continue to muddle through without leadership. The markets will then start punishing with vehemence.
The Republican Party should not have missed out on the chance for a grand bargain with Obama. It is time for them to be realistic and recognize that tax revenues have to be increased if the US is going to lower its debt levels, rather than maintain ideological purity as the grass-roots Tea Party folks have insisted so far.
America and the world would do better if the US Congress could devise and agree on a solution for increasing revenue that is preferable to some ad hoc and therefore inferior package. Combining this with significant spending cuts and a credible long-term fiscal plan enforced by tough triggers would be the best case scenario for all. Democrats need to choose which entitlements to give up. If you do not think a Democrat can cut wages then you have not been following the Socialists in Greece. They cut unemployment insurance benefits to 52 weeks maximum, cut the employer side of the payroll tax for two years, and raised the employee side equally. That is what has to be done.
In America, liberals and Democrats are scratching their heads trying to figure out how the Great Recession precipitated by the previous Bush Administration has failed to deliver a New Deal President like Franklin D Roosevelt II. They are rightly furious that President Obama agreed to massive government spending cuts, and the promise of more in the pipeline, without any concessions to increase tax revenues.
But there is a reason for that. Since the economy collapsed in 2008, only one grassroots movement has emerged in response, and it has been a movement of the right – The Tea Party Movement. Compare that with what happened during the Depression. In 1933, Roosevelt assumed the presidency and launched a mixed bag of domestic programs that historians call the first New Deal. By 1935, however, he was looking warily over his left shoulder at Senator Huey Pierce Long, Jr., whose “Share our Wealth” movement demanded that incomes be capped at $1 million and every family be guaranteed an income no less than one-third the national average.
At the same time, the Townsend plan to guarantee generous pensions to every elderly American had organizers in every state in the union. To be sure, Roosevelt had vehement opponents on his right, but he was more concerned about the populist left, which explains why he enacted the more ambitious “second new deal,” which included Social Security, a massive public jobs program called the Works Progress Administration and the Wagner Act, which for the first time in American history put Washington on the side of labor unions.
President Should Lead
Obama, like Roosevelt, had a reasonably successful first two years with a fiscal stimulus package that while too small for the circumstances, was still large by historical standards; and a health care bill that while sub-par in many ways still far exceeded the efforts of other recent Democratic presidents.
But unlike Roosevelt, he ran into a grassroots movement of the right. Historians will long debate why the financial collapse of 2008 produced a right-wing populist movement and not a left-wing one.
Of course liberals and Democrats are confused. But at times like this, the public craves bold leadership. A leader has to quickly rethink what he believes in and what he is committed to; and to chart a way forward that is politically possible with strong and firm leadership. Roosevelt understood what was expected of him.
In an interview on the Charlie Rose show, Harvard Professor Larry Summers made a particularly thoughtful if provocative statement:
“Never forget, never forget, and I think it’s very important for Democrats especially to remember this, that if Hitler had not come along, Franklin D Roosevelt would have left office in 1941 with an unemployment rate in excess of 15% and an economic recovery strategy that had basically failed.”
President Obama is smart enough to recognize that the greatest recession produced a right wing grass roots movement, not a left wing one. He may not like it, but he has to recognize its significance in terms of what will come, not temporarily, not for the time being, but permanently and in the long-term. Moreover, there will not be a Hitler showing up this time.
Roosevelt may not have liked the left-wing populist movement of his time, but he knew they were part of a future rising trend. And he is remembered in history as the New Deal President. How will Obama be remembered in history? Or will he soon be forgotten? What are the future trends of his era? Perhaps, it is time for Obama to reverse the course set in the time of Roosevelt.
The President must lead or become irrelevant.
Milton Friedman, “Reviving Japan,” Hoover Digest, No. 2, 30 April 1998.
Greg Mankiw, “What’s With the Bernanke Bashing?” The New York Times, 31 July 2011.
Kenneth Rogoff, “The Second Great Contraction,” Project Syndicate, 2 August 2011. <http://www.project-syndicate.org/contributor/433>