Gary Becker looks back the history and draws the analogy that today's Fed will face difficulty (political pressure) reversing quickly the recent huge monetary expansion once the economy recovers (highlights are mine).
Central Banks Cannot Easily Maintain their Independence
Most richer nations nowadays, and many developing nations, have "independent" central banks, such as the European Central Bank and the Federal Reserve Bank. "Independence" cannot be precisely defined, but it is supposed to indicate that the central bank of a country has the freedom to make decisions which the government, represented by the Treasury in the United States, does not like. The purpose of independence is to allow monetary policy to be decided independently of fiscal policy, although obviously even independent banks and governments may respond in consistent ways to broad economic events, such as the present recession.
The motivation for having an independent central bank is the many occasions in the past when subservient central banks accommodated the government's desire to spend more without raising additional taxes. Central banks accommodate fiscal authorities essentially by buying government securities that help finance government spending. In return for receiving government debt, a central bank would either directly print additional currency that governments can spend, or it would create reserves in commercial banks that lead to an expansion of bank deposits and monetary aggregates, such as M1. Either way, inflation would result from this monetization of the government debt, often severe inflation and even hyperinflation. Hostility to rapid inflation led to the political support behind giving central banks much greater independence from fiscal authorities.
The history of the Federal Reserve's transition in and out of independence is illuminating (see Allan Meltzer's book, A History of the Federal Reserve, 2003). The Fed fully and enthusiastically compromised its independence from the Treasury during World War II. It bought large quantities of government debt to help the government finance the large wartime deficit. Inflation from the resulting big expansion of the money supply was suppressed through wage and price controls. This inflation became open after removal of these controls at the end of the war.
For a half dozen years after that war was over, President Truman and the Treasury pressured then much more reluctant Fed officials into maintaining the Fed's subservience. Eventually, however, the Fed regained its independence in the famous Accord reached in March 1951. Nevertheless, the Vietnam War, the Great Society Program, and the reinstitution of wage and price controls by Richard Nixon in the early 1970s led to later erosions of the Fed's independence.
Even during normal times, central banks, whatever their nominal independence, are under strong pressure to accommodate expansionist fiscal policy, especially as elections approach. During extraordinary times, whether in peacetime or during wars, this pressure usually becomes too powerful to resist. So the rather complete bending of the Fed to the Treasury's wishes during the present worldwide recession is not surprising. Still, that does not make it right, and I have some doubts about the Federal Reserve's recent behavior.
One concern is the somewhat arbitrary choices the Fed made about which banks to bailout and which ones to close or merge into other banks. This added significantly to the enormous uncertainty already prevalent in financial markets. I am also worried about the Fed's support of the huge federal deficits generated by the sharp expansion in federal spending. I understand such actions are necessary to help governments fight wars, but why help finance so much spending during this recession, particularly spending that has dubious stimulating potential? One example is the almost $800 billion so-called stimulus package that will do little to stimulate the economy, but will greatly raise long term government spending in directions desired by the President and Congress (see the posts on January 11 of this year). Another example of dubious government spending that the Fed seems willing to help finance is the ill thought out Treasury plan for hedge funds and other financial institutions to buy toxic bank assets (see the criticism of this plan in my posts on March 29 and 31).
The huge increase in bank reserves is a major consequence of the Fed's monetization of the government's large spending programs. Reserves went from about $8 billion in early Fall to around $800 billion, or a hundred fold increase in only 6 months. The recession rather than the wage and price controls imposed during prior periods is keeping inflation suppressed at present. Once the economy begins to recover, the inflationary risks will be enormous. In order to soak up these reserves, the Fed would have to sell large quantities of its government securities back to the private sector. These sales would put downward pressure on security prices- that is, upward pressure on interest rates- that will slow the economy's expansion at that time. For this reason, any government in power then, whether Democratic or Republican, will vigorously resist such Fed actions.
Hence it is not obvious that the Fed will be able to conduct these sales sufficiently smoothly to prevent either a recession or a serious bout of inflation. These are not pressing concerns when a serious recession is the immediate problem, but they will become major challenges down the road.
Eric Rosenfeld brings us back to ten years ago what went wrong at LTCM. Refreshing if you link the collapse of LTCM to the current financial crisis.
A few take-away points:
1. The benefits from diversification based on historical correlations is great only if correlations don’t change during sudden move;
2. The collapse of LTCM is not a problem of flight-to-quality, rather, it’s the problem of everybody trying to get out of the same trades LTCM had.
3. We need to seriously deal with counterparty risk, and work out a solution. Otherwise, the too-big-to-fail problem will haunt us, always.
David Wessel at WSJ ponders on what kind of recession and recovery we will end up with.
There is no doubt where the economy is now. “By any measure, this downturn represents by far the deepest global recession since the Great Depression,” the International Monetary Fund declared Wednesday.
But there’s more than the usual uncertainty about where it is going. The key is the U.S. Even though its slice of the world economy is smaller than it once was, it’s still huge. The U.S. led the world into the abyss, and it will lead the world economy out of it.
But how fast and when?
The alphabet can help to imagine the possibilities and the path of the economy. There’s the letter V: the kind of quick rebound that usually follows a deep recession. Or U: a longer recession and slow recovery. There is L: years of painfully slow growth. And W: a temporary upturn as the economy feels the jolt of fiscal stimulus that quickly wears off. Finally, there’s the big D, not the shape but another Great Depression.
With history a guide, consider three starkly different scenarios.
The late Victor Zarnowitz, a student of the business cycle, had a rule: “Deep recessions are almost always followed by steep recoveries.” The mild recession of the early 1990s and early 2000s were followed by mild recoveries. But the U.S. economy grew faster than a 6% pace in the four quarters after the deep 1973-75 recession and faster than a 7.75% pace after the even deeper 1980-82 downturn.
“In deep recessions,” says Michael Mussa of the Peterson Institute for International Economics, “there is usually a growing sense of gloom as the recession deepens.” Then the forces that triggered recession — say, plunging home prices — abate. The adrenaline of tax cuts and government spending kicks in. With inventories so lean, the slightest uptick in demand prompts a sharp increase in production, and the natural dynamism of capitalism reasserts itself.
“Experience suggests all of this should work, and I believe it will,” Mr. Mussa predicts. Governments have administered huge doses of fiscal and monetary stimulus. Home-building and car-buying are so low they can’t fall much further. Many consumers shy away from buying because they’re frightened, not broke, and that state of mind can change quickly and liberate pent-up demand.
But the Federal Reserve caused the deep recessions of the 1970s and 1980s when it put its foot on the brake to stop inflation; it ended them when it let up. This time, Fed has its foot to the floor and the economy is still slowing. And so much stock-market and housing wealth has evaporated that a quick turn in consumer spirits seems unlikely. Plus, the repair of the banks remains far from complete, restraining lending.
The odds of the V: 15%.
The Big D
If one asked a roomful of economists two years ago to put odds on a repeat of the Great Depression, nearly all would have said zero. In early March, The Wall Street Journal posed the question to about 50 forecasters — defining depression as a decline in output per person of more than 10%, four times worse than the decline the IMF anticipates. On average, they put odds at one in seven; several put them above one in four.
“This is a Depression-sized event,” says economic historian Barry Eichengreen of the University of California at Berkeley, citing the global decline in industrial production and world trade. The big difference: In 1929, governments dithered, or worse. In 2009, they’ve rushed to the rescue.
To go from today’s deep recession to a depression something would have to go wrong. It could be a financial catastrophe on the scale of last fall’s bankruptcy by Lehman Brothers or another panic-inducing event. Or a crash in the dollar, one that forces interest rates up at just the wrong moment. Or it could be political gridlock that stops governments in the U.S. or Europe from spending enough to fix the banks before a big one fails, or keeps them for doing more on the fiscal or monetary fronts as the economy deteriorates.
Or it could be virulent deflation that pulls down prices and incomes, making debts, which don’t fall when prices do, a heavier burden. The textbook remedy is easy money and big government deficits. But so much of that has been tried it’s easy to question its efficacy or to imagine resistance around the world to doing.
The odds of the big D: 20%.
For a decade after its stock market and real-estate bubble burst in 1990, Japan bumped along at an annual growth of just 0.5%. It was dubbed the Lost Decade, and it could happen here. The recession ends but the economy plods along, growing too slowly to bring down unemployment for years.
As the IMF observed this week, recoveries following recession caused by financial crises are “typically slower.” Those following recessions that occur simultaneously across the globe “have typically been weak.” Back in the 1990s, as U.S. banks struggled, the Fed talked a lot about “financial headwinds.” Those were zephyrs compared to the gale-force winds that the economy confronts today.
If financial markets stabilize but don’t improve steadily, or if housing prices continue to drift down, or if confidence remains shaky, the U.S. economy could languish for a time. American consumers, once known for spending in the face of prosperity or adversity, could finally decide to prepare for retirement by saving more, having just learned that neither 401(k) retirement accounts nor home values rise inexorably. And the U.S. can’t count on increasing exports, the solution when emerging-market economies run into financial trouble and the reason Japan didn’t do even worse in the 1990s. The rest of the world is in no shape to buy.
An unfolding depression could scare Congress to act boldly, but the L is less ominous — and perhaps more likely as a result. There would be months when the economy appeared to be strengthening so the temptation to wait-and-see would be strong.
Put the odds of the L at 55%. That adds to 90%. So put 10% odds on the U, less pleasant than the euphoric V but far less painful than a Lost Decade. That’s the rough consensus of economic forecasters; it means U.S. unemployment grows for another year and a half.
Bottom line: The odds favor a long slog.
Bamboo shoots, or green shoots, or whatever. The signs of recovery in China seem to be much more robust than in the US. In the US, what we have is a deceleration of decline; but in China, some key economic indicators actually had a big rebound. One of the common misconceptions about Chinese economy is the importance of trade. The argument goes since trade accounts for more than 40% of China’s GDP, a global economic slowdown led by the US will undoubtedly drag down China. There are certain truth in the argument and we did see China’s GDP growth had a dramatic fall, but the 40% share number is deceiving.
According to recent research (see my previous post), China’s trade sector, if measured by value added, only accounts for less 10% of GDP. The importance of trade is overly exaggerated. I quote Justin Lin, chief economist of the World Bank: What China is experiencing is a decline of absolute rate of growth (recoupling), but relatively speaking, China is going to grow much faster than all the advanced economies, including the US (decoupling).
According to another research done by Albert Kiedel at Carnegie Endowment, China’s GDP growth is almost independent of US GDP fluctuations (see the chart below), at least from 1988 to 2007.
This Economist piece below has a more detailed analysis:
Signs that a giant fiscal stimulus is starting to work
THE Chinese consider eight to be a lucky number because it sounds like the word meaning “prosperity”. And luck, combined with a massive fiscal stimulus, may yet help the government to achieve its growth target of 8% in 2009. Earlier this year, most economists thought such growth was impossible at a time of deep global recession, but some are now nudging up their forecasts.
At first sight, the GDP figures published on April 16th were disappointing. China’s growth rate fell to 6.1% in the year to the first quarter, less than half its pace in mid-2007. On closer inspection, however, the economy is starting to perk up. Comparing the first quarter with the previous three months, GDP rose at an estimated annualised rate of around 6%, after nearly stalling in the fourth quarter (see chart). By March the economy was gaining more speed, with the year-on-year increase in industrial production rising to 8.3% from an average of 3.8% in the previous two months. Retail sales were 16% higher in real terms than a year ago, and fixed investment has soared by 30%, signalling that the government’s infrastructure-led stimulus is starting to work.
Exports, on the other hand, tumbled by 17% in the year to March and global demand is widely expected to remain weak this year. This is the main reason why some economists expect GDP growth of “only” 5% for 2009 as a whole. But the gloomier forecasts tend both to overstate the importance of exports and to understate the size of the government’s stimulus.
Contrary to conventional wisdom, China’s sharp economic slowdown was not triggered by a collapse in exports to America. Its growth began to slow in 2007, well before exports stumbled, driven by a collapse in the property market and construction. This was the result of tight credit policies aimed at preventing the economy from overheating. The global slump dealt a second blow late last year, but China is less dependent on exports than is commonly believed. Exports account for nearly 40% of GDP but they use a lot of imported components, and only make up about 18% of domestic value-added. Less than 10% of jobs are in the export sector.
If a collapse in domestic demand led China’s economy down, it can also help lead it up again. Not only is China’s fiscal stimulus one of the biggest in the world this year, but the government’s ability to “ask” state-owned firms to spend and state banks to lend means that the government’s measures are being implemented more rapidly than elsewhere. To take one example, railway investment has tripled over the past year.
Only about 30% of the government’s 4 trillion yuan ($585 billion) infrastructure package is being funded by the government. Most of the rest will be financed by bank lending, which had already soared by 30% in the 12 months to March, twice its pace last summer. JPMorgan thinks that this credit and investment boom could lift GDP growth to an annualised pace of over 10% in each of the next three quarters.
Jonathan Anderson, an economist at UBS, argues that the property market could be as important as the fiscal stimulus in determining China’s fate. After falling sharply last year, housing sales rose by 36% in value in the year to March. Housing starts are still down, but if sales continue to strengthen, construction could pick up in the second half of 2009. That would also help to support consumption: about half of China’s job losses among migrant workers have been in the building industry.
If construction does recover and infrastructure spending continues to rise, then even if exports remain weak, China could see growth of close to 8% this year—impressive stuff when rich economies are expected to contract by 4-5%. There are growing concerns about the quality of that growth, however. The World Bank estimates that government-influenced spending will account for three-quarters of China’s GDP growth this year. The clear risk is that politically directed lending creates more overcapacity, poor rates of return and future bad loans for banks.
These are valid concerns. But Andy Rothman, an economist at CLSA, a brokerage, reckons that state-owned firms mainly plan to increase their spending on upgrading existing production facilities, rather than expanding capacity. Also, about half of the increase in investment is on public infrastructure. This will inevitably include some white elephants but, in a poor country, the return on infrastructure investment is generally high. There is no need to build “bridges to nowhere” when two-fifths of villages lack a paved road to the nearest market town.
What about the risks to banks? The last time they were forced to support the government’s stimulus policy, during Asia’s financial crisis in 1998, Chinese banks were left with large non-performing loans. Bad loans will rise again this time, but Tao Wang, also at UBS, argues that banks are in a stronger position than in 1998. China is one of the few countries in the world where bank credit has fallen relative to GDP over the past five years. Banks have an average loan-to-deposit ratio of only 67%, low by international standards, and less than 5% of banks’ loans are non-performing, down from 40% in 1998.
The biggest task for China is to find a new engine for future growth. It cannot rely on exports, nor can the investment stimulus be sustained for long. Without stronger consumer spending, China’s growth will be much slower than in recent years. Reforms to improve health care and the social safety net will take many years to encourage people to save less.
Andy Xie, an independent economist based in Shanghai, suggests that the quickest way to boost consumption would be for the government to distribute the shares that it holds in state-owned enterprises to households, and to force those firms to pay larger dividends. But the authorities in Beijing are unlikely to take his advice. How else could they lean on big firms to support the economy in times like these?