Wednesday, February 06, 2008

My Final Response to Desmond

Dear Desmond,

I have said that I don’t expect a recession but I am the first to admit that is a position that is increasingly hard to defend. The economic statistics have deteriorated dramatically over the last two months and the credit crunch continues. Bank balance sheets have taken a big hit and I wouldn’t be surprised if there are more writeoffs to come. Housing prices are falling and it appears they will fall further with inventories at record highs. The stock market, even if the Dow and S&P 500 haven’t met the accepted definition of a bear market, have dropped dramatically. We are about to get a real world test of the wealth effect.

The long term problems we face will not be solved by monetary policy:

1. The housing market is in trouble because the Fed reduced interest rates to generational lows and held them there too long. Given a huge incentive to borrow, Americans did exactly that. Given a huge incentive to lend, banks did exactly that. Now as the credit spigot is tightened the process is working in reverse. Home prices are indeed falling and absent Fed action to reduce rates, they would no doubt go down faster. Now that the Fed has lowered rates again, ARM resets will not affect as many people as they would have absent Fed action. That will just prolong the price adjustment that is needed to bring home prices down to the long term trend (which is roughly the rate of inflation). This is not a pleasant prospect, but it is a necessary one. The US government needs to get out of the business of subsidizing the housing industry. Fannie Mae and Freddie Mac helped to create this problem by making the “originate to distribute” model so profitable that it would have been dumb for banks not to participate. More cheap money does not address the root cause of the housing problem and will only prolong the pain of the adjustment.

2. The banking system is in dire straights because of exactly the medicine being peddled once again by the Federal Reserve. The problem with the banking system is not a lack of liquidity. Funds are available; banks aren’t willing to lend them on the easy terms that got them into trouble in the first place. Nothing the Fed does will change that in the short term, but over the longer term, a yield curve artificially steepened by the Fed will get banks back to borrowing short and lending long. The last thing our economy needs is more debt. As you point out the US household debt to income ratio is at an all time high. Lower interest rates will only further exacerbate the problem by discouraging saving and encouraging further debt accumulation.

3. Oil prices and other commodity prices are high because Fed policy has fed a boom in every country with a currency pegged to the dollar (and that boom has led to a boom even in countries without a peg, such as Brazil). China is the prime example but the Middle East countries are another often overlooked example. If we have to live with the Fed it would be nice if they spent at least a little of their time defending the purchasing power of our national currency. Cutting interest rates and expanding the supply of dollars will not solve this problem. The economic slowdown (or recession if you prefer) will only bring commodity prices down temporarily unless we cure our addiction to cheap money.

4. You have written about the current account deficit as a major problem facing our economy and I agree. In 2003 you wrote in the Washington Post:

In normal times, an orderly decline in the dollar would be a welcome development. By cheapening American exports and increasing the cost of imports here, the fall of the dollar would facilitate the needed long run adjustment in the current account deficit. Moreover, by raising import prices it would play a useful role in countering the rapid pace of disinflation that is bothering Federal Reserve Chairman Alan Greenspan.

Well, the dollar is cheaper now and with oil and gold at or near all time highs, disinflation no longer seems to be an issue. Unfortunately, the current account deficit is still with us. I’m sure your response would be that the dollar has fallen against the wrong currencies and if the Chinese would only revalue the Yuan, that current account deficit would disappear. You might be right, but what would be the consequences of that revaluation? My bet would be much higher interest rates. If the Chinese know they are going to revalue the Yuan, why would they continue to fund our current account deficit when that revaluing would result in a huge loss in their sovereign wealth fund? So if the path to solving the current account deficit is higher interest rates, why should we wait for the market (or the Chinese in a sense) to force the issue. The only way to solve the current account deficit is through higher domestic savings and that will only happen with higher interest rates. I am not saying that there is no pain involved in that adjustment; just the opposite in fact. Solving our debt problems will be very painful, but it will only be more painful the longer we put off the day of reckoning.

You are right that we part company when it comes to the correct policy response. I don’t know if we will have a recession, but I do know that monetary policy has worked every time in my adult lifetime to minimize the impact of economic slowdown. It is powerful medicine. And I suspect that it will again. As I said in my last response though, just because we can minimize the pain doesn’t mean that we should. I could be wrong and in that case we will finally get the unwinding that some are looking for. If that happens, monetary policy will not be able to respond to the crisis. What worries me is the potential for bad fiscal policies in response. If the stimulus package currently being considered is an indication of the type of economic thinking we can expect from our politicians, I mourn for our future.

I believe the only way to solve our long term problems is to suffer some pain now in lieu of suffering much greater pain down the road. Policies that I think can move us in the right direction include:

1. A dramatic reduction in corporate tax rates.

2. A dramatic change in our individual tax system. I would prefer a consumption based tax, but I have problems with the Fair Tax proposal. A flat tax seems the most likely change. The change should include an elimination of capital gains taxes and the mortgage deduction.

3. A unilateral removal of all import tariffs. If we fund our government through income taxes, import tariffs are by definition punitive. And the way I see it the one being punished is us.

4. A new international currency regime based on gold or possibly a basket of commodities. A pure gold standard is probably impossible but the only way we will get any kind of currency stability is in a system that doesn’t allow governments in the system to run excessive deficits. I suspect the Chinese are planning to switch to a gold standard at some point in the future and it would be to our advantage to beat them to the punch.

Unfortunately, I don’t think any of these things (or the myriad other proposals I can think of) will be enacted. I expect us to muddle through this time and face a bigger crisis down the road. Politicians cannot think past the next election cycle and have no incentive to think long term. My fear is that when the crisis finally arrives (if it hasn’t already), the policy responses will be toward ever greater government intervention. The results of such a course are easy to predict. One need only look to Europe with double digit unemployment and a stubbornly high inflation rate.

Best regards,


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