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The wrong medicine is being applied to America’s economy. Having misdiagnosed the ailment,policymakers have prescribed untested experimental medicine with potentiallygrave side effects.
The patient is the American consumer – the world’s biggest by far, but nowin the throes of the worst funk since the Great Depression. Recent data onconsumer spending in the United States have been terrible. Growth ininflation-adjusted USpersonal consumption expenditures has just been revised down to 1.5% in thesecond quarter of 2012, and appears to be on track for a similarly anemic increase in the third quarter.
Worse, these numbers are just the latest in what has now been afour-and-a-half-year-old trend. From thefirst quarter of 2008 through the secondquarter of 2012, annualized growth in real consumption spending has averaged amere 0.7% – all the more extraordinary when compared with the pre-crisis trendof 3.6% in the decade ending in 2007.
The disease is a protractedbalance-sheet recession that has turned a generation of America’s consumers into zombies – the economicwalking dead. Think Japan,and its corporate zombies of the 1990’s.Just as they wrote the script for the first of Japan’slost decades, their counterparts are now doing the same for the US economy.
Two bubbles – property and credit –enabled a decade of excessive consumption. Since their collapse in 2007, UShouseholds have understandably become fixatedon repairing the damage. That means paying downdebt and rebuilding savings, leaving consumer demand mired in protractedweakness.
Yet the treatment prescribed for this maladyhas compounded the problem. Steeped in denial,the Federal Reserve is treating the disease as a cyclicalproblem – deploying the full force of monetary accommodation tocompensate for what it believes to be a temporary shortfall in aggregatedemand.
The convoluted logic behind thisstrategy is quite disturbing – not only for the US, but also for the globaleconomy. There is nothing cyclical about the lasting aftershocks of abalance-sheet recession that have now been evident for nearly five years.Indeed, balance-sheet repair has barely begun forUS households. The personal-savingrate stood at just 3.7% in August 2012 – up from the 1.5% low of 2005, buthalf the 7.5% average recorded in the last three decades of the twentiethcentury.
Moreover, the debt overhang remainsmassive. The overall level of household indebtednessstood at 113% of disposable personal income in mid-2012 – down 21 percentagepoints from its pre-crisis peak of 134% in 2007, but still well above the1970-1999 norm of around 75%. In other words, Americans have much farther to goon the road to balance-sheet repair – which hardly suggests a temporary, orcyclical, shortfall in consumer demand.
Moreover, the Fed’s approach is severely compromised by the so-called zero bound on interest rates. Having run out of basis points to cut from interestrates, the Fed has turned to the quantity dimension of the credit cycle –injecting massive doses of liquidity into the collapsed veins of zombieconsumers.
To rationalize the efficacy of thisapproach, the Fed has rewritten the script on the transmissionmechanism of discretionary monetary policy. Unlike the days of yore, when cutting the price of credit could boostborrowing, “quantitative easing” purportedlyworks by stimulating asset and credit markets. The wealth effects generated by frothy financial markets are then presumed to rejuvenate long-dormant“animal spirits” and get consumers spending again, irrespective of lingeringbalance-sheet strains.
There is more: Once the demand problem is cured, according to thisargument, companies will start hiring again. And then, presto– an unconventional fix magically satisfies the Fed’s long-neglected mandate tofight unemployment.
But the Fed’s policy gambit has takenthe USdown the wrong road. Indeed, the Fed has doubled down on an approach aimed atrecreating the madness of an asset- and credit-dependent consumption model –precisely the mistake that pushed the US economy toward the abyss in 2003-2006.
Just as two previous rounds of quantitative easing failed to accelerate UShouseholds’ balance-sheet repair, there is little reason to believe that “QE3” will do the trick. Quantitative easing isa blunt instrument, at best, and operatesthrough highly circuitous – and thus dubious– channels. Significantly, it does next to nothingto alleviate the twin problems of excess leverageand inadequate saving. Policies aimed directly at debt forgiveness andenhanced saving incentives – contentious, tobe sure – would at least address zombieconsumers’ balance-sheet problems.
Moreover, the side effects of quantitative easing are significant. Manyworry about an upsurge in inflation, though,given the outsize slackin the global economy – and the likelihood that it will persist for years tocome – that is not high on my watch list.
Far more disconcerting is thewillingness of major central banks – not just the Fed, but also the EuropeanCentral Bank, the Bank of England, and the Bank of Japan – to inject massiveamounts of excess liquidity into asset markets – excesses that cannot beabsorbed by sluggish real economies. Thatputs central banks in the destabilizingposition of abdicating control overfinancial markets. For a world beset byseemingly endemic financial instability,this could prove to be the most destructive development of all.
The developing world is up in arms overthe major central banks’ reckless tactics.Emerging economies’ leaders fear spillover effectsin commodity markets and distortions of exchangerates and capital flows that may compromise their own focus on financialstability. While it is difficult to track the cross-border flows fueled byquantitative easing in the so-called advanced world, these fears are far from groundless. Liquidity injections into a zero-interest-rate developed world send return-starved investors scrambling for growthopportunities elsewhere.
As the global economy has gone from crisis to crisis in recent years, the cure has become part of the disease. In an era of zero interest rates and quantitative easing,macroeconomic policy has become unhingedfrom a tough post-crisis reality. Untested medicine is being used to treat thewrong ailment – and the chronically ill patient continues to be neglected.
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