US recovery: are the Fed's hawks and doves fighting over a turkey?

Fed chairman Ben Bernanke is encouraged by economic improvements, but unconvinced over strength of US recovery


Larry Elliott,
economics editor
guardian.co.uk

Sunday 25 March 2012


It all started when stock markets around the world tumbled in October 1987. After seeing the Dow Jones index fall by more than 500 points in a single day, the-then chairman of the Federal Reserve cut interest rates to shore up the stock market. It did the trick. Confidence returned, Wall Street rallied and so was born the idea of the "Greenspan put" – when times got tough the Fed could always be relied upon to ride to the rescue.

The Greenspan put was deployed in a more serious crisis in 1998, when the hedge fund Long Term Capital Management went belly-up, a move that ensured that the wild dotcom boom of the late 1990s continued for a further two years. When the internet bubble collapsed under the weight of absurd valuations and falling profitability, Wall Street expected Greenspan to deliver, and once again he did not disappoint.

Interest rates were slashed to 1% and left there for a year, creating the conditions for a housing boom the like of which the United States had never seen. Eventually, the Fed did start to tighten policy, but too little too late.

Greenspan has long retired, but the Fed's policy has not changed. The biggest bubble in history led to the biggest bust in history and the biggest policy response in history. Zero interest rates, electronic money creation, manipulation of the money markets: you name it, the Fed under Greenspan's successor, Ben Bernanke, has tried it.

The strategy appears to be working, after a fashion. Activity in the world's biggest economy is picking up and unemployment has started to come down. Compared with Europe – which is not saying much, admittedly – the US is doing OK. In the financial markets, there is growing confidence that America's recovery is for real, and a lively debate about whether the Fed needs to start to thinking about withdrawing some of the stimulus it has provided. Bond yields – the interest rate paid on government bonds – have been rising in the past few weeks, an indication that financial markets believe stronger growth will force the Fed into taking pre-emptive action against inflation.

There are three schools of thought about the US economy. In the first there are the doves, who believe that policy should be kept ultra-loose for years to come. They are led by Bernanke, who, as a student of the Great Depression and Japan's "lost decade" in the 1990s, is alive to the risk that tightening too quickly and too aggressively can tip countries back into recession. That was what happened in the US in 1937 and on many occasions in Japan during the 1990s and early 2000s. As things stand, Bernanke would be happy to see the Fed's key policy rate remain at virtually zero for the next 2½ years.

The Fed chairman is modestly encouraged by recent developments in the US economy, which has seen jobs created, a floor put under the housing market and a pickup in factory output. But he remains unconvinced about the strength and the durability of this recovery, not least because something similar happened at the end of 2010 and the start of 2011. There remains a lot of slack in the US labour market. In the past five years participation rates have fallen, the number of discouraged workers has increased, and under-employment - those working part-time but want to work full time – stands at 15%.

For the time being, Bernanke commands a majority on the Fed's open market committee that sets policy. But a smaller faction – the hawks – believes the recovery is for real and that the Fed will regret its laid-back approach if inflation lets rip over the next few years. This group says it is worried about repeating Greenspan's mistakes.

A paper being presented to the UK Royal Economic Society annual conference this week argues that this policy error – mirrored elsewhere in the west – caused the global financial crisis, since it resulted in a search for investments that paid higher interest. This, in turn, led banks to soften the requirements for borrowers, the upshot of which was the sub-prime mortgage boom. The study by Manthos Delis and his colleagues at the Cass Business School at City University concludes: "Our results are all the more striking as the present stance of the Federal Reserve is to maintain ultra-low interest rates in an attempt to resurrect the sagging US economy. Central banks should consider the possible adverse effects of their loose monetary policies on bank risk-taking."

The doves and the hawks are also slugging it out over the US budget deficit. Doves want to delay action to repair America's public finances; indeed some, like Paul Krugman, say that Barack Obama's economic and political problems stem from his failure to provide a big enough stimulus. Hawks, like all the Republican candidates for the White House, say that too much government spending is "crowding out" the private sector, thus stifling recovery.

Where a dove like Bernanke would agree with a hawk like Mitt Romney is that the US can return to its former economic glory provided the right policies are used. This rests on a number of assumptions: that America remains a powerful economy, that it is a world leader in a number of sectors, and that it has a history of re-inventing itself, thereby confounding those who write it off. All of that is true. Yet there is a third way of looking at the US economy. Yes, it has bounced back from difficult periods, but the picture over the last few decades is that a bigger and bigger stimulus is required to produce a growth spurt. What's more, the upswings have been weaker than in the 25 years after the second world war, and have been accompanied by larger trade deficits and the relentless hollowing out of manufacturing. In his new book*, Thomas Palley notes that there has been a marked difference in the growth paradigms before and after 1980.

Prior to that date, when the economy grew so did the incomes of the American middle class. Everybody gained from productivity improvements, and in the good times manufacturing employment rose and the trade deficit was negligible. After 1980, the gains from productivity were monopolised by those at the top, manufacturing employment fell even during upswings, while the boom of 2001-07 was the weakest in postwar history. Palley notes that the post-1980 growth paradigm "involved squeezing worker incomes, squeezing household saving rates, raising debt levels, persistent asset price inflation in excess of consumer price inflation, and reliance on ever lower nominal (ie not adjusted for inflation) interest rates".

This is a sobering but accurate conclusion. For a while America's weaknesses were masked by asset price bubbles, cheap imports, financial innovation, and cheap money. But there are limits to how high debt levels can go and how low interest rates can go. The desperate attempts by the Fed to kick-start the economy show that these limits have been reached. In that sense, the debate between the doves and the hawks is irrelevant. A more interesting debate is whether America's growth model is a turkey.



*Thomas Palley: From Financial Crisis to Stagnation, Cambridge University Press