Why the Fed should not prevent a US recession

By: Paul de Grauwe, K. U. Leuven

A recession is looming in the US. The Fed started a policy of aggressive rate cutting in an attempt to stall the downward spiral in which the US economy risks to be embroiled. Is this a repeat of the aggressive rate cutting of 2001 when the Fed, then under the stewardship of the Maestro, quickly reduced the short term interest rate from more than 6% to less than 2% in about a year? And is this more recent rate cutting policy going to sow the seeds of future crises as the 2001 episode undoubtedly turned out to be?

 

On the first question the answer is very clear. The present rate cutting is very different from the 2001-version. Then, the Fed reacted to the effects of the crash in the IT stock market bubble. That crash had relatively few systemic implications, as it did not involve the banking system, nor did it put the debt overhang of the household sector at center stage.

 

Today the situation is profoundly different in nature. The subprime crisis that erupted in August last year laid bare a number of unsustainable developments in the US economy. Credit and liquidity were allowed to expand at unsustainable rates by the US monetary authorities during the past seven years. This fueled an unsustainable consumption boom in the US that had already started at the end of the 1990s. During the last ten years US consumption expanded yearly by 3.6% while GDP grew by only 2.9% per year. Had consumption been growing at the same pace as GDP during the last ten years, US consumption would have been lower by $600 billion last year. The yearly gap between consumption and production growth has created an ever increasing current account deficit. Thus the rest of the world helped to finance the richest consumers on earth in their frenzy to accumulate new consumption gadgets. And these consumers were rushing to the shopping malls paying with IOUs that are now coming back with a vengeance.

 

During all that time the Federal Reserve watched and applauded. Greenspan who was responsible for the supervision of the banking sector, marveled at the ingenious new financial products that helped to create the housing bubble and the consumption boom. He formulated a beautiful metaphor: “Why do we wish to inhibit the pollinating bees of Wall Street”. And he refused to do anything to supervise these bees that were mostly pollinating each other.

 

What we experience today is also the crash of a myth. The myth of a superior US economy; dynamic and flexible, producing wonders of productivity growth and material welfare. The truth is that most of the above average growth experienced by the US during the last ten years was the result of an unsustainable consumption boom that must now come to an end.

 

The mirror image of the myth of US economic superiority is the European inferiority complex that has been building up over the years. Hypnotized by high growth numbers the European authorities tried to emulate US economic successes by Lisbon strategies and all that. This led to largely futile attempts to introduce “structural reforms” that did very little to stimulate the economies in Europe.

 

I come to my second question, which can also be reformulated as follows. Since US consumers will have to restore healthier balance sheets, they will have to start saving again. Is it wise for the US authorities to give them renewed incentives to start spending again and thereby postponing the necessary reduction of household’s debt position?  My answer is negative. The present policy stance and the announced further interest rate reductions postpone the inevitable day of reckoning. A recession would be the best way to restore healthier balance sheets of the household sector, and bring US consumers back on a path of sustainable consumption. In addition, a recession is the only mechanism that can restore equilibrium in the US current account. Exchange rate adjustments would have to be much too large to bring about such equilibrium. 

 

While I disapprove, I understand Bernanke’s policy stance. The fear of a recession is strong, and the Chairman of the Fed certainly does not want to be blamed for its occurrence. The fact that a recession would be healthy for the long run development of the US economy will not impress a Chairman who is under constant scrutiny of the politicians and the press, even if this argument of social Darwinism is entirely correct.

 

There is a second reason why the Fed is taking its current policy stance. This has to do with the fragility of the banking system. During the last few years, the yield curve was flat. That’s bad news for the banks that make much of their living riding the yield curve by borrowing short and lending long. An upward sloping yield curve creates the conditions for more profitable banking. The Fed’s policy stance can be seen as an attempt to create such an upward sloping yield curve thereby providing the banks with a welcome source of profits.

 

The pressure from politicians and the media and the fear of a banking meltdown make it all but inevitable that the Fed will go on onto the path of interest rate cuts. It is becoming increasingly clear that this path will also lead the US economy into its next crisis.

 

It may be useful to rephrase this conclusion using the phraseology that has been used so often to describe Europe’s economic woes. The US economy suffers from a structural problem. This is that its high growth rate has become structurally dependent on unsustainable consumption. Structural reforms will be necessary in the US to make the growth of the economy sustainable. The best way to achieve this structural reform is through an old-fashioned recession. Unfortunately, the US monetary authorities will do everything they can to prevent such a structural reform.

 

 

  

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