Friday, February 10, 2006

the Greenspan legacy

I've wondered from time to time how it has been possible to keep US interest rates low over the past few years. In particular, I expected that rates would have to rise to attract the foreigners who fund so much of our national debt. Why has it turned out that foreigners wanted to fund our debt despite the low rates? Partly I think they have done so because the US economy has been stronger than other industrial economies and, basically, because they have been satisfied with low but safe returns over high but risky ones. Why has the economy been strong? Shouldn't it have stumbled by now (pressed by war expenditures, hurricane damage, high oil prices and the like)? Shouldn't low interest rates have caused businesses to over expand?

High productivity is surely one reason for sustained growth. Consumer spending is surely another.

And why? There's a clue in one of the "Greenspan Legacy" articles, one from the Washington Post that appeared late last month. It says in part that low interest rates kept the economy going, smoothed over difficulties like Iraq, Katrina, and $50 expenditures at the gas pump, and encouraged Americans to buy, buy, buy. At the same time low interest rates did not stimulate over investment in production and inventories, as often happens, nor did companies hire lots of new employees. Instead they kept trimming payrolls, abandoning marginal products, and taking advantage of automation. Here are some extracts from the article: :
The Greenspan Fed lowered its benchmark rate another 12 times ... as the economy struggled to regain its footing, cutting the rate to 1 percent by June 2003, the lowest level since 1959.

The Fed's rate cuts had little effect on corporate America, which had overinvested in equipment, software and factories during the late 1990s boom; businesses retrenched, slashing both payrolls and spending plans, tipping the economy into recession from March through November of 2001.

But low interest rates worked like an intoxicant on consumers, who snapped up new cars and trucks with no-interest loans and seized on low mortgage rates to buy new homes and refinance old home loans. Those sales and refinancings freed up more cash to spend. Households used much of that extra money to pay off credit cards, student loans and other, higher-interest rate debt -- "cleaning up their balance sheets," in economists' terms. They also kept shopping through the recession, the terrorist attacks and the rocky economic recovery that followed.

The tonic worked. Household spending rose in 2001, 2002, and 2004, even as the wealth and income of the typical household fell or remained flat in the same period, according to an analysis by Moody's The recession was one of the mildest on record. The economy has been growing since November 2001 and was strong enough by mid-2004 for the Fed to start raising the benchmark rate.

Fed officials expected then that longer-term rates, such as mortgages, would rise as well, causing consumers to borrow less and save more.

But it didn't work out that way. For several reasons -- low inflation, economic stability and foreign investors pouring their savings into U.S. stocks, bonds and other assets -- long-term interest rates fell for a year after the Fed started raising the benchmark rate and have stayed relatively low.

Mortgage rates also fell, prompting homeowners to refinance repeatedly. Changes in the financial industry made it easier for homeowners to tap their home equity through refinancing. Lenders provided adjustable-rate mortgages that enabled home buyers to pay higher prices while temporarily making low monthly loan payments.

The housing market kept booming. Consumer debt and spending kept climbing.

Can the US sustain economic growth that is fueled by a consumer binge that itself is fueled by low interest rates? Absolutely not. No one believes that's true. The question that matters more is: Will the US economy make a graceful transition to a more stable basis for growth? And the answer: No one knows. What's certain is that the US cannot act alone. Its economic future is intimately intertwined with those of the other major economies of the world, not just those of the industrial nations, but the emerging nations and the oil-producing nations as well.

As the managing director of the IMF recently put it, the US situation is one element in a world-wide problem of economic imbalace. Governments in many nations need to take responsibility for addressing these global imbalances. He said: "This [acceptance of collective responsibility for action] will make the necessary actions both politically easier and economically more effective. Politically easier, because instead of finger-pointing and recriminations you get mutual support and burden sharing. Economically more effective, because as demand is withdrawn in the United States it is added in Europe and Asia, and as financial flows from Asia become less available, so they become less necessary in the United States. To quote Ben Franklin, at the signing of the Declaration of Independence, this is a case where we must all hang together, or assuredly we shall all hang separately."

Here are some further points in that IMF speech:

Shared Responsibilities: Solving the Problem of Global Imbalances
Speech by Rodrigo de Rato
Managing Director, International Monetary Fund
At the University of California at Berkeley
Berkeley, California
February 3, 2006


United States savings are too low [and] the fiscal deficit remains high.

In emerging Asia on the other hand, savings are relatively high, but in recent years most countries in emerging Asia have suffered an investment drought.

For years there have been expectations that U.S. consumption would fall—following the bursting of the stock market bubble in 2000, for example—but it has proven to be remarkably resilient.

Foreign investors and central banks seem to have an undiminished appetite for U.S. dollars. Why should they not simply continue to finance U.S. consumption?

There are two obvious ways in which global imbalances could unwind quickly, and in a very disruptive way. One would be an abrupt fall in the rate of consumption growth in the United States, which has been holding up the world economy. U.S. consumption growth has to slow because the negative household savings rate is unsustainable, and it will slow, perhaps on the back of slowing house price growth. But if it slows abruptly, it will take away a major support from world demand before other supports are in place. Such a fall could also reduce domestic demand in other economies, for example in Europe and China, because demand for their exports falls. In this scenario, there would be a contraction of global demand, with only moderate correction of current account imbalances.

[Another possibility:] Investors [will] become unwilling to hold increasing amounts of U.S. financial assets, and demand higher interest rates and a depreciation of the U.S. dollar, which in turn forces U.S. domestic demand to contract.

The key challenge then is to unwind global imbalances gradually.

It is particularly important, and increasingly urgent, that the United States tackle its current account deficit by increasing domestic saving. Reducing the fiscal deficit has an important role to play in this. The U.S. administration recognizes the need for deficit reduction, but its plans are focused almost entirely on proposals for unprecedented cuts in spending. These would have been difficult to achieve even before Hurricane Katrina. Uncertainties about the costs of operations in Iraq and Afghanistan and the reconstruction of the Gulf Coast, and the difficulty of curbing entitlement spending, cast further doubt on the realism of the current deficit reduction plan. Meanwhile, on the revenue side, the administration seems to fear that the benefits of any revenue raising measure will be lost, as it is used as an excuse for more spending. This should not be the case, and it need not be the case. The administration and the Congress themselves control both taxes and spending, and action on both is needed to reduce the deficit. With this in mind, I hope that policy makers will give more consideration than they have so far to an energy tax, and also to the measures suggested by the President's Advisory Panel on Federal Tax Reform. In particular, the panel's report contains welcome suggestions on shifting the tax burden from saving toward consumption, which could improve the efficiency of the system, and on how to streamline and simplify the tax code. It is also critically important to reform entitlements, and to address the problems of social security and Medicare.

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