-Caveat Lector-
June 9, 2005
PAGE ONE
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Side Effects
In Treating U.S. After Bubble,
Fed Helped Create New Threats
Low Rates Bolstered Economy,
But Housing, Foreign Debt
Appear Out of Balance
Greenspan's Legacy at Stake
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
June 9, 2005; Page A1
By many yardsticks, the Federal Reserve's response to the bursting of
the stock and tech-spending bubbles in 2000 has been a remarkable success.
The 2001 recession was mild and economic growth since has been brisk.
Employment is up and inflation remains within the Fed's hallowed zone of
price stability.
But five years after the stock market's peak, the economy faces other
threatening imbalances: a potential housing bubble, rock-bottom personal
saving rates and a gargantuan trade deficit. And the Fed's post-bubble
prescription bears some responsibility for all three. Fed officials
acknowledge as much but say the alternatives were worse.
By slashing short-term interest rates to 45-year lows, the Fed
encouraged Americans to borrow more, gave them little reward for saving and
helped ignite a surge in housing prices. President Bush and Congress joined
in with steep tax cuts that boosted household purchasing power. All that
spending contributed to a growing U.S. economy, a steady increase in imports
and -- given that Americans are so eager to borrow and foreigners so eager
to lend -- a mountain of foreign debt.
This is pleasant for Americans as long as it lasts. But Fed officials,
international financial watchdogs and private economists say it can't. At
some point, American consumers must spend less, save more and rely less on
foreigners' savings.
How that will happen puts the nation in uncharted territory: After
treating a bubble, how does the Fed manage the side effects of its medicine?
"We have done what no other economy has done before, faced with an
asset bubble," Lawrence Lindsey, a former Fed governor and Bush adviser,
said at a recent panel discussion. Praising both the Fed's rate cuts and Mr.
Bush's tax cuts, he said, "This is the first time in history the textbook
economic policy... was used, and worked. The problem is, once you finish
that chapter of the economic texts, you turn the page and the page is
blank -- because no one has gone through the process before."
The Fed is confident these imbalances will be resolved with little
pain. As it raises interest rates, consumers will slow their spending and
save more. Foreigners' appetite for U.S. goods will rise. The engine of U.S.
growth will shift smoothly from consumers and government to business
investment and exports. Fed Chairman Alan Greenspan might address this when
he testifies on the economic outlook to Congress today.
But a minority of economists warn of a more damaging scenario. Some
say the Fed has simply replaced the stock-market bubble with one in housing,
which could burst. That would sap the consumer spending that mortgage
refinancing and home-equity loans have fueled. Or foreign investors could
stop buying U.S. stocks and bonds, sending the dollar down and inflation up,
prompting both the Fed and bond market to jack up interest rates sharply. In
either case, the U.S. economy could slow sharply or fall into recession.
Faced with an asset bubble, a central bank has two choices: Prick it
early or wait for it to burst and try to contain the damage. The Fed in 1929
and the Bank of Japan in 1989 tried the first route, raising interest rates
in response to rapidly rising asset prices. The result in the U.S. in the
1930s was depression and deflation. In Japan it was stagnation and deflation
that continues today.
In the 1990s, Mr. Greenspan chose the second route. As long as the
prices of goods and services were stable, he would leave the stock market
alone. When the stock bubble finally burst, the Fed cut short-term rates
aggressively beginning in 2001 and then held them at a 45-year low of 1%
through early 2004 until the Fed was sure the threat of deflation had
receded.
Mr. Greenspan knew his strategy carried risks. But he saw far greater
ones in responding timidly as the collapse of the biggest asset bubble in
history wiped out more than $5 trillion in shareholder value, and terrorist
attacks, war and corporate scandal rattled confidence. The economic
expansion to date suggests he was right, and the odds are that he will
retire as scheduled next January with his reputation for economic
stewardship intact. But if a collapse in housing prices or a run on the
dollar triggers a new recession, Mr. Greenspan's legacy may be different.
The Fed is conducting a "crucial experiment" in post-bubble monetary policy,
says Edward Chancellor, a financial historian. "We don't know what the
outcome is yet."
Lower interest rates normally operate through several channels. They
encourage consumers to buy things on credit today instead of saving to buy
the items later. They boost stock and home prices, which makes the owners of
those assets wealthier and more willing to spend. They encourage businesses
to borrow and invest. And they depress the dollar, boosting exports.
But after 2001, some of these channels were blocked. Businesses,
burdened with a glut of unused equipment from the bubble years and cowed by
geopolitical and regulatory uncertainty, didn't borrow to invest. And the
dollar didn't fall initially, but rose because foreign economies were in
even worse shape than the U.S.'s. This meant the economy relied
disproportionately on the one channel that did respond: consumers. They
bought record numbers of houses and cars, mostly on credit. They also
borrowed against their houses' appreciated values, allowing them to spend
more still.
To Mr. Greenspan, who had studied housing and mortgage markets all his
life, this came as no surprise. "Households have been able with increasing
ease to extract equity from their homes, and this doubtless has helped
support consumer spending in recent years, complementing the traditional
effects of monetary policy," he observed in August 2003.
A Worse Alternative
Accused by some of fostering excess, Fed officials responded that the
alternative was worse: a deeper recession and the risk of deflation -- a
period of generally falling prices, which can worsen a downturn by making it
harder for workers and companies to repay debts. In a February 2003 speech
Fed Governor Donald Kohn, one of the central bank's principal
monetary-policy strategists, agreed low interest rates had had an outsize
impact on car sales, home construction and housing prices. But that "has
kept more people employed and reduced the risk of deflation," he said.
By January 2004, the expansion seemed entrenched enough for Mr.
Greenspan to declare victory: "Our strategy of addressing the bubble's
consequences rather than the bubble itself has been successful." While
"large residues" of household and foreign debt remained, they would not be a
barrier to growth; such imbalances, he suggested, would dissipate with time.
Instead, they have grown. "The magnitude of these imbalances is
increasingly moving into unfamiliar territory," Mr. Kohn said in April.
Since his February 2003 speech, house values have risen 25% and total
mortgage debt by 28%, while after-tax incomes have expanded just 13%. The
household saving rate, a low 2% in 2000, has fallen to 0.9%. A growing share
of mortgages have gone to speculators and people making little or no down
payment. House "prices have gone up far enough since then -- relative to
interest rates, rents and incomes -- to raise questions," Mr. Kohn said in
April.
Dangerous Zone
Meanwhile, the current-account deficit, the broadest measure of the
shortfall on trade and investment income between the U.S. and the rest of
the world, has moved into a zone that many economists consider dangerous. It
stands today at 6% of gross domestic product, the nation's total output of
goods and services, up from 4% in 2000. To finance it, the U.S. now borrows
about $2 billion a day from foreigners. As the foreign debt mounts, so does
the risk that investors will demand a higher interest rate or lower dollar
to keep on lending.
To be sure, a major cause of the U.S. current account deficit is that
weak European and Japanese growth reduces demand for U.S. exports. And
China's fixed exchange rate keeps the prices of Chinese goods artificially
low, giving its television sets, bicycles and barbecue grills an edge in the
U.S. market.
But the U.S. saves so little that when the U.S. cuts taxes and
consumers take out mortgages, the money to finance both increasingly comes
from abroad, in particular, foreign central banks. Those banks purchase U.S.
dollars to keep the greenback high against their own currencies, thereby
supporting their exports to the U.S. They then invest those dollars in U.S.
bonds, in effect providing the financing for Americans to buy those exports.
Since 2000, foreign-brand cars have surged to 43% of the U.S. market
from 35%, according to Motorintelligence.com. In the meantime, foreign
holdings of U.S. Treasury bonds and bonds backed by Americans' home
mortgages have jumped 80%.
In the first quarter of this year, General Motors Corp. made more
money on mortgages than on cars or car loans. Since the beginning of 2001,
the number of Americans employed in manufacturing has fallen by 2.8 million,
or 16%, while the number in residential construction, real estate and
banking has risen by 766,000, or 14%.
"If I were a biologist I'd call this a perfect example of symbiosis,"
former Fed Chairman Paul Volcker mused in a February speech at Stanford
University. "Contented American consumers matched against delighted foreign
producers. Happy borrowers matched against willing lenders. The difficulty
is, the seemingly comfortable pattern can't go on indefinitely."
Almost every economist agrees. The debate is over how, not whether,
the global economy rebalances: Will it be smooth, through some combination
of declining dollar and accelerating foreign demand? Or will it be chaotic,
with a dollar collapse, much higher U.S. interest rates and perhaps a global
recession?
Mr. Volcker thinks a crisis is likely. Investor confidence could fade
"at some point," he said, with "damaging volatility in both exchange markets
and interest rates."
His successor is more sanguine. Capitalist economies, Mr. Greenspan
believes, always have imbalances but are also continuously reallocating
resources and capital to correct them. Thus, imbalances seldom become
crises. "The number of forecasts of crises...is far in excess of the number
of crises that actually occur," Mr. Greenspan told a recent audience in
Chicago. "There is something equivalent to an invisible hand which
continuously is readdressing market imbalances to reach equilibrium."
Fed staff research shows that in the past, when a big, rich country
has a large current account deficit, it usually narrows without crisis.
Homes may be overvalued but are much harder to trade than stocks and thus
unlikely to collapse abruptly. Fed officials expect home prices to stagnate
while incomes advance, bringing affordability back to historic ranges.
Having helped create today's imbalances, Fed officials acknowledge
some responsibility to reduce them. By raising rates, Mr. Kohn explained,
the Fed will make saving more attractive, slow the rise in housing prices,
and "thereby lessen one of the significant spending imbalances." And Mr.
Greenspan adds, "an increase in household saving should also act to diminish
borrowing from abroad," narrowing the current account deficit.
That benign scenario has yet to unfold. Business investment is growing
but by less than the Fed had expected. And while the trade deficit narrowed
sharply in March, for the first quarter as a whole it hit a record of $694
billion on an annualized basis, or 5.7% of GDP. Meanwhile, even as the Fed
raises short-term interest rates, long-term interest rates, which are set on
markets, have actually declined, a development that baffles Mr. Greenspan.
Since mortgage rates are tied to long-term bond yields, home prices have
advanced at one of their fastest rates yet over the spring. Mr. Greenspan
has acknowledged "a little froth" in the housing market.
Added Weight
What should the Fed do? Mr. Volcker, focusing on the current account
deficit, thinks the Fed ought to put added weight on keeping inflation under
control. "I am worried about a tendency to relax our guard," he said. It is
critical foreigners remain confident that "those trillions of dollars they
are piling up are going to be protected against inflation." Some of today's
Fed leadership shares this view: The Fed can minimize the odds of crisis by
keeping inflation down, which means erring on the side of higher interest
rates.
Mr. Lindsey, on the other hand, believes the Fed should worry less
about inflation and more about keeping the housing market from sinking. "You
don't want to collapse asset prices," he says. "You want to give people time
to adjust in a gradual way." He thinks the Fed should slowly raise its
target for short-term interest rates, now at 3%, to 3.5%, and then stop.
Mr. Kohn, in his April speech, made it clear the Fed would not let
imbalances deter any necessary action to keep inflation down: "We should not
hesitate to raise interest rates to contain inflation pressures just because
it might set off a retrenchment in housing prices, just as we were willing
to keep rates unusually low as house prices rose rapidly."
Write to Greg Ip at [EMAIL PROTECTED]
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