It's Still The Economy, Stupid

Wednesday, February 11, 2004  

Greenspan and Responsible Monetary Policy

Greenspan was blathering on to Congress today. Needless to say, I've vented a lot of against the Mr. Magoo of monetary policy, but the one consistent beef is, much like our President, the constant willingness to bend statistics to his narrow view of policy.

Case in point is his reiteration that the Fed "beat" inflation during the Reagan Administration. While inflation declined during the 1980s, there is no evidence that this was coincident with Federal Reserve policy.

The Fed had to start to lower interest rates in late-1981, as the world economy becan to collapse under Chairman Volcker. The collapse was engineered by a combination of extremely high interest rates in the developed world (up to 20% in the U.S.) with a bursting bubble in lending to developing nations. The latter had borrowed heavily during the 1970s to finance development. They were still heavily reliant on commodity exports to generate income to pay those debts. In 1982, when world commodity prices began to collapse, Mexico and several other countries nearly defaulted on its obligations.

Meanwhile inflation was still running at nearly double-digit levels. As mentioned before, the Fed had started to reduce rates, which are supposed to increase inflation, far in advance of any appreciable "price stability". This does not prove in any way the fed "licked" inflation. In fact it shows the Fed was licked before inflation was even at reasonable levels, and forced to expand monetary policy regardless of the consequences. That inflation continued to decline during the 1980s was more due to the policies developing nations had to adopt to receive favorable terms on renegotiating their debts, a consequence of Volcker bursting their bubble rather than later Fed policy.

In fact, the goal of "price stability" is not really an achievable or desirable goal of monetary policy. First, price stability is in the eyes of the beholder. If the CPI or the PCE deflator in GDP figures (the Fed's definition), are low and stable, other prices (like houses, natural gas, health care, pharmaceuticals) could be wildly inflating or unstable and this would still meet the narrow definition the Fed has set for itself. Similarly, the Bush administration defines Afghanistan as "stable", based on its definition of Afghanistan as the Kabul city limits. While this kind of delusion helps sell talking points, it has no effect on the efficacy of policy.

Genuine targets for monetary policy should have two dimensions: depth and breadth. Depth meaning the statistic actually measures what it is supposed to measure, and that there are reasonably direct and provable effects that manipulating factor A will affect the statistic B. Breadth means that there are actually a group of related statistics, such that if factor A does not affect B (with some good excuse), it will affect C, D, E, et cetera so that the predicted policy effect can be proven. If price stability were honestly desired as a goal, we'd have lots of bundles of "prices" (not just CPI), and if certain prices (houses, medical care, etc) were inflating due to monetary policy, we could find reasons why CPI was not, and it would keep our basic economic relationship, that expansionary policy leads to inflation, valid. Many people believe that CPI is deliberately understating inflation, so if the Fed is using CPI to determine "price stability" without any breadth, they will come to incorrect conclusions about how effective their policy is.

My preferred monetary target is to keep consumption growth stable. Both tools of Fed policy, money growth and interest rates, have a more direct effect on consumption demand than on prices. A Fed policy that increased demand could still result in lower prices, if supply increased more than the policy increased demand. Obviously, there are other things besides Fed policy that affect demand, but the point is that analyzing a more direct relationship reduces the time lag of policy, as well as the number of things that can offset the policy.

If the Fed lowers interest rates, they change the relative price of consumption versus savings. Future consumption is worth less because of the lower interest rate, so consumers spend now rather than save. That our national savings rate has come down steeply since interest rates began to decline in 1982 is an established fact, and though there are plenty of other variables that affect savings and consumption, interest rate policy will affect consumption more quickly and more directly than it will affect prices. Likewise, expanding the money supply and lending gives consumers more credit and increases the amount they are able to spend. Once again, consumption is affected before, more directly, and more consistently by monetary policy than the price level.

While consumption is easy to measure by counting up receipts, we have to estimate prices by measuring both the quantity and quality of goods consumed. Measures of consumption are much more accurate than measures of prices because there are fewer intermediary variables to account for.

Finally, using consumption instead of prices will accommodate the overriding goal of policy: to moderate the business cycle. There have been periods of high growth with low inflation and periods of low growth with high inflation. If we are using inflation to gauge whether the economy is "overheating", we're more likely to make errors in applying policy fighting inflation rather than overconsumption. Using consumption rates, we can moderate a variable that is directly linked to output, rather than a variable that is indirectly linked.

We can measure a virtual boatload of alternate and related economic variables to give us a breadth of analysis on consumption. Saving reacts inversely with consumption, because in economic accounts all income is either consumed or saved. Credit growth is also related to consumption, as it is the purchasing power available to consume goods at any price. We can also look at our trade balance to see how much we're consuming vis-a-vis other countries to determine whether policy is too tight or too lax. Consumption growth and all the related indicators would overwhelmingly show Fed policy has been the most lenient for the longest period in history, and though nominally GDP continues to grow, it is a very unhealthy type of growth, dependent solely on the ability to overborrow and overconsume that the policy fosters.

It's pretty clear that if the Fed regulated consumption, they'd have done a lot more during the 1990s to prevent the economic bubble that popped with the stock market in 2000. They would also have left enough policy ammunition to allow what Steve Roach calls "reloading the cannon". Should the economy start to struggle, the Fed only has 1% of interest rates to cut, and very little pent-up demand to extract.

Likewise, the Federal Government cannot initiate their own stimulus while running a $500 billion deficit. At least nowhere near what they could have done by maintaining a surplus. The Bush policy has been the equivalent of a deer hunter who, not seeing any deer to shoot, starts unloading against birds, squirrels, trees, and so on. Should an incipient recession require a pickup in spending, there is very little money left to draw from.

There may not have been an asset bubble to pop if Greenspan had been serious with his "irrational exuberance" speech of 1996. If Greenspan is to be judged sheerly on the number of crash/bubble dynamics of the global economy during his reign, he's the worst central banker ever. He has presided over the largest number of crises ever seen by a central banker. Moreover, he continues to be dishonest with his assessment that we are experiencing a standard and strong recovery which has been anything but, nor honest with his blanket assessment that the Fed is powerless to diagnose bubbles before they pop when the lack of foresight has been due rather to the blinders he keeps on to avoid examining alternative measures of demand and prices.

A responsible monetary policy would have rates about where they were in 1996 - 4.5% percent higher than the current rate. In addition, Greenspan and the Fed would have acted to restrict credit growth, particularly by working with regulators like OFHEO to regulate lending outside the banking system. It goes without saying that rates should have increased far earlier than they did during the 1990s. But such is Greenspan's "asymmetric" policy, which only fights busts and does nothing to hinder the booms that precede them. It's a recipe for disaster.

posted by Teddy | 11:37 AM |

Hey Reggie! Is that rhinocerous around?

Risk is slowly coming back into financial markets as the U.S. economy slows. Argentina's MerVal fell nearly 8% on rumors the country will not make a payment to the IMF in March. Brazil had a similar rumble in their financial markets a couple weeks back involving payments on their enormous debt, and Thailand (the origin of the 1997 East Asian crisis)markets fell in response to the initial reports of the avian flu.

I think my fellow bloggers have thoroughly deconstructed both the joke that is the 2005 Bush budget as well as the ERP's silly employment predictions. I'll take a pass.

I never got a chance to look at fourth quarter 2003 GDP numbers, so I'll run through them. These were the major contributors to the 1% increase that converts to a 4% annual rate of growth. Personal consumption expenditures (1.84%), which were mostly nondurable goods (0.89%) and services (0.87%). The large decline in the contribution of consumption to GDP growth (-3.05% from third to fourth quarter), indicates the tax cut stimulus is done, and consumers must go back to meager wage increases and borrowing to fund consumption. Not surprisingly, the biggest individual contributor to consumption growth was medical care (0.53%), followed by furniture and household equipment (0.34%) and food (0.31%). There was also an "other" nondurable goods category that contributed 0.35%. That these categories are ones where inflation is a bit higher than the CPI average indicates this consumption is less than voluntary.

Gross private domestic investment also contributed 1.84% to GDP growth. Residential investment (go housing bubble go) contributed 0.54% to the gain in investment. Equipment and software contributed 0.76%, so here we go again measuring how much of this was actual dollar spending and how much was imputed. In current dollars, spending on information processing equipment and software increased by $11.9 billion (0.1% of GDP). Converted to "real", or constant dollars, the increase becomes $19.4 billion. Outside of information processing and residential investment, industrial equipment investment fell $2.3 billion, transportation equipment investment rose $1.9 billion, and "other" investment rose $4 billion. I would hardly call this a resurgence of investment spending. It looks just like last quarter, where the majority of "investment" was housing or imputed tech spending.

Government consumption expenditures contributed just 0.16% to GDP growth, as most Homeland Security, Iraq and Afghanistan spending was thrown into the second quarter of 2003. Net exports contributed 0.19% to GDP growth. This seems to be a function of the weak dollar, as both imports and exports increased, but exports added 1.69% to growth and imports subtracted 1.5%.

Going forward, consumption growth is being impinged by stagnant employment and wages. Consumers can always borrow, and have done so, but given private savings rates that are already negative there is little room for an increase in borrowing that would positively impact GDP. While residential and computer equipment investment seem to have endured through the first quarter, the economy reminds me of a car out of gas coasting downhill. As long as what brung us isn't impeded, the U.S. economy can continue to grow in the 2-4% range through at least the second quarter of 2004. But there are very few avenues to increase consumer spending unless we see a significant pickup in hiring. We won't see a significant pickup in hiring without a significant pickup in spending. Corporate and household borrowing rates remain low in the meantime, allowing cost reductions via refinancing, but that doesn't improve the outlook going forward. Predictions I'm seeing for 4-5% growth in the first quarter seem really high.

posted by Teddy | 6:43 AM |