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Mon Jan 16 15:35:21 PST 2006

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DANGER TIME FOR AMERICA
Jan 12th 2006  

The economy that Alan Greenspan is about to hand over is in a much less
healthy state than is popularly assumed

DESPITE his rather appealing personal humility, the tributes lavished
upon Alan Greenspan, the chairman of the Federal Reserve, become more
exuberant by the day. Ahead of his retirement on January 31st, he has
been widely and extravagantly acclaimed by economic commentators,
politicians and investors. After all, during much of his 18.5 years in
office America enjoyed rapid growth with low inflation, and he
successfully steered the economy around a series of financial hazards.
In his final days of glory, it may therefore seem churlish to question
his record. However, Mr Greenspan's departure could well mark a high
point for America's economy, with a period of sluggish growth ahead.
This is not so much because he is leaving, but because of what he is
leaving behind: the biggest economic imbalances in American history. 

 One should not exaggerate Mr Greenspan's influence--both good and
bad--over the economy. Like all central bankers he is constrained by
huge uncertainties about how the economy works, and by the limits of
what monetary policy can do (it can affect inflation, but it cannot
increase the long-term rate of growth). He controls only short-term
interest rates, not bond yields, taxes or regulation. Yet for all these
constraints, Mr Greenspan has long been the world's most important
economic policy maker--and during an exceptional period when
globalisation and information technology have been transforming the
world economy. His reign has coincided with the opening up to trade and
global capital flows of China, India, the former Soviet Union and many
other previously closed economies. And Mr Greenspan's policies have
helped to support globalisation: the robust American demand and huge
appetite for imports that he facilitated made it easier for these
economies to emerge and embrace open markets. The benefits to poorer
nations have been huge.

So far as the American economy is concerned, however, the Fed's
policies of the past decade look like having painful long-term costs.
It is true that the economy has shown amazing resilience in the face of
the bursting in 2000-01 of the biggest stockmarket bubble in history,
of terrorist attacks and of a tripling of oil prices. Mr Greenspan's
admirers attribute this to the Fed's enhanced credibility under his
charge. Others point to flexible wages and prices, rapid immigration, a
sounder banking system and globalisation as factors that have made the
economy more resilient to shocks. 

 The economy's greater flexibility may indeed provide a shock-absorber.
A spurt in productivity has also boosted growth. But the main reason
why America's growth has remained strong in recent years has been a
massive monetary stimulus. The Fed held real interest rates negative
for several years, and even today real rates remain low. Thanks to
globalisation, new technology and that vaunted flexibility, which have
all helped to reduce the prices of many goods, cheap money has not
spilled into traditional inflation, but into rising asset prices
instead--first equities and now housing. THE ECONOMIST has long
criticised Mr Greenspan for not trying to restrain the stockmarket
bubble in the late 1990s, and then, after it burst, for inflating a
housing bubble by holding interest rates low for so long (see
article[1]). The problem is not the rising asset prices themselves but
rather their effect on the economy. By borrowing against capital gains
on their homes, households have been able to consume more than they
earn. Robust consumer spending has boosted GDP growth, but at the cost
of a negative personal saving rate, a growing burden of household debt
and a huge current-account deficit. 

BURNING THE FURNITURE
Ben Bernanke, Mr Greenspan's successor, likes to explain America's
current-account deficit as the inevitable consequence of a saving glut
in the rest of the world. Yet a large part of the blame lies with the
Fed's own policies, which have allowed growth in domestic demand to
outstrip supply for no less than ten years on the trot. Part of
America's current prosperity is based not on genuine gains in income,
nor on high productivity growth, but on borrowing from the future. The
words of Ludwig von Mises, an Austrian economist of the early 20th
century, nicely sum up the illusion: "It may sometimes be expedient for
a man to heat the stove with his furniture. But he should not delude
himself by believing that he has discovered a wonderful new method of
heating his premises."

As a result of weaker job creation than usual and sluggish real wage
growth, American incomes have increased much more slowly than in
previous recoveries. According to Morgan Stanley, over the past four
years total private-sector labour compensation has risen by only 12% in
real terms, compared with an average gain of 20% over the comparable
period of the previous five expansions. Without strong gains in
incomes, the growth in consumer spending has to a large extent been
based on increases in house prices and credit. In recent months Mr
Greenspan himself has given warnings that house prices may fall, and
that this in turn could cause consumer spending to slow. In addition,
he suggests that foreigners will eventually become less eager to
finance the current-account deficit. Central banks in Asia and
oil-producing countries have so far been happy to buy dollar assets in
order to hold down their own currencies. However, there is a limit to
their willingness to keep accumulating dollar reserves. Chinese
officials last week offered hints that they are looking eventually to
diversify China's foreign-exchange reserves. Over the next couple of
years the dollar is likely to fall and bond yields rise as investors
demand higher compensation for risk. 

 When house-price rises flatten off, and therefore the room for further
equity withdrawal dries up, consumer spending will stumble. Given that
consumer spending and residential construction have accounted for 90%
of GDP growth in recent years, it is hard to see how this can occur
without a sharp slowdown in the economy.

Handovers to a new Fed chairman are always tricky moments. They have
often been followed by some sort of financial turmoil, such as the 1987
stockmarket crash, only two months after Mr Greenspan took over. This
handover takes place with the economy in an unusually vulnerable state,
thanks to its imbalances. The interest rates that Mr Bernanke will
inherit will be close to neutral, neither restraining nor stimulating
the economy. But America's domestic demand needs to grow more slowly in
order to bring the saving rate and the current-account deficit back to
sustainable levels. If demand fails to slow, he will need to push rates
higher. This will be risky, given households' heavy debts. After 13
increases in interest rates, the tide of easy money is now flowing out,
and many American households are going to be shockingly exposed. In the
words of Warren Buffett, "It's only when the tide goes out that you can
see who's swimming naked."

 How should Mr Bernanke respond to falling house prices and a sharp
economic slowdown when they come? While he is even more opposed than Mr
Greenspan to the idea of restraining asset-price bubbles, he seems just
as keen to slash interest rates when bubbles burst to prevent a
downturn. He is likely to continue the current asymmetric policy of
never raising interest rates to curb rising asset prices, but always
cutting rates after prices fall. This is dangerous as it encourages
excessive risk taking and allows the imbalances to grow ever larger,
making the eventual correction even worse. If the imbalances are to
unwind, America needs to accept a period in which domestic demand grows
more slowly than output.

 The big question is whether the rest of the world will slow too. The
good news is that growth is becoming more broadly based, as demand in
the euro area and Japan has been picking up, and fears about an
imminent hard landing in China have faded. America kept the world going
during troubled times. But now it is time for others to take the lead. 

-----
[1] http://www.economist.com/displayStory.cfm?story_ID=5381959

See this article with graphics and related items at http://www.economist.com/opinion/displaystory.cfm?story_id=5385434

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