3 December 2008

Only higher interest rates will do

The US dollar must fall 50% and real rates (inflation adjusted) must be about 5%, only if the US starts saving can the world economy recover. Savings and investment in new capital goods and the abandonment on the demand of the worlds savings.

Funny how interested individuals can see through the fog even though the professionals, esp. the X-Gens can't see past the default setting, the status quo. Boomers at least knew people who had experienced the Great Depression and WW2. Boomers can even recall the bear market of 72-80.

Most professional economists are prisioners of the assumptions of their models.

This is the essentials of that argument:

Should the Fed intervene to reduce interest rates at the long end of the curve? Fed Chairman Bernanke’s intimation today that the might do this got the market’s undivided attention.

The answer depends on whether the policy objective is to get Americans to consumer again, or to get them to save.

Edmund Phelps,the 2006 Nobelist in economics, reminds me of a warning he issued in a March 14, 2008 op-ed in The Wall Street Journal:

The Fed’s view seems to be that the natural interest rate has decreased with the business downturn. But this too is uncertain.

We should consider Hayek’s argument that the upheavals in a boom may change the natural rate of interest. If the boom left it elevated, failure by the central bank to raise its interest rate correspondingly would cause inflation to begin rising. Something like that may be happening now.

I would add another possibility. Consider the sharp decline over the past year in Americans’ stock market wealth. This means, at unchanged interest rates, a decrease in their income from wealth.

For households to be willing in such straitened circumstances to save as much as before — cutting their consumption by the whole amount of the drop in their income from wealth — they would have to be compensated with a higher interest rate. At unchanged interest rates, people will not want to leave consumption in the present so pinched. So natural interest rates are driven up.

There may be other mechanisms at work. Uncertainty reigns. But if the above scenario comes to pass, the Fed cannot keep interest rates as low as now for very long. We may see in the near future higher interest rates and higher unemployment than have prevailed in the recent past.

Prof. Phelps is exactly correct, in my humble opinion. As Francesco Sisci and I wrote recently,

In the rush to prop up America’s financial institutions, foreign economic policy seems remote from Washington’s agenda. America wants to revive the mortgage market and consumer spending. The effort is doomed to failure. For a quarter of a century the American consumer has been the locomotive of the world economy, and now the locomotive has derailed and taken the rest of the world economy with it.

Recovery requires a great change in direction of capital flows. For the past decade, poor people in the developing world have financed the consumption of rich people in America. America has borrowed nearly $1 trillion a year, mostly from the developing world, and used these funds to import consumer goods and buy homes at low interest rates. The result is a solvency crisis of the American household, which shows up as a solvency crisis for financial institutions. If we reckon the retirement needs of households as a liability, the household sector is as good as bankrupt.

No recovery is possible unless American households can save, and they cannot save in an economic contraction when incomes spiral downwards. To save, Americans must sell goods and services to someone else, and a glance at the globe makes clear who that must be: nearly half the world’s population, and most of the world’s capacity for economic growth, is concentrated in China and the Pacific Littoral.

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