An intriguing, if unpopular, thought
THE late Rudi Dornbusch, an economist at the Massachusetts Institute of Technology, once remarked: “None of the post-war expansions died of old age. They were all murdered by the Fed.” Every recession since 1945, with the exception of the one in 2001, was preceded by a sharp rise in inflation that forced the central bank to raise interest rates. But today's Federal Reserve is no serial killer. It seems keener on blood transfusions than on bloodletting.
When the Fed cut its discount rate on August 17th, it admitted for the first time that the credit crunch could hurt the economy. The markets are betting it will soon cut its main federal funds rate. Economists are arguing vigorously about how much damage falling house prices and the subprime mortgage crisis will do. But there is one question that is rarely asked: even if a downturn is in the offing, should the Fed try to prevent it?
Most people think the question smacks of madness. According to received wisdom, the Fed should not cut interest rates to bail out lenders and investors, because this creates moral hazard and encourages greater risk-taking; but if financial troubles harm spending and jobs the Fed should immediately ease policy so long as inflation remains modest. Central bankers should be guided by the “Taylor rule”—and set interest rates in response to deviations in both output and inflation from desired levels.
A necessary evil But should a central bank always try to avoid recessions? Some economists argue that this could create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession, consumers, firms, investors and borrowers will be encouraged to take bigger risks, borrowing more and saving less. During the past quarter century the American economy has been in recession for only 5% of the time, compared with 22% of the previous 25 years. Partly this is due to welcome structural changes that have made the economy more stable. But what if it is due to repeated injections of adrenaline every time the economy slows?
Many of America's current financial troubles can be blamed on the mildness of the 2001 recession after the dotcom bubble burst. After its longest unbroken expansion in history, GDP did not even fall for two consecutive quarters, the traditional definition of a recession. It is popularly argued that the tameness of the downturn was the benign result of the American economy's increased flexibility, better inventory control and the Fed's firmer grip on inflation. But the economy also received the biggest monetary and fiscal boost in its history. By slashing interest rates (by more than the Taylor rule prescribed), the Fed encouraged a house-price boom which offset equity losses and allowed households to take out bigger mortgages to prop up their spending. And by sheer luck, tax cuts, planned when the economy was still strong, inflated demand at exactly the right time.
Many hope that the Fed will now repeat the trick. Slashing interest rates would help to prop up house prices and encourage households to keep borrowing and spending. But after such a long binge, might the economy not benefit from a cold shower? Contrary to popular wisdom, it is not a central bank's job to prevent recession at any cost. Its task is to keep inflation down (helping smooth out the economic cycle), to protect the financial system, and to prevent a recession turning into a deep slump.
The economic and social costs of recession are painful: unemployment, lower wages and profits, and bankruptcy. These cannot be dismissed lightly. But there are also some purported benefits. Some economists believe that recessions are a necessary feature of economic growth. Joseph Schumpeter argued that recessions are a process of creative destruction in which inefficient firms are weeded out. Only by allowing the “winds of creative destruction” to blow freely could capital be released from dying firms to new industries. Some evidence from cross-country studies suggests that economies with higher output volatility tend to have slightly faster productivity growth. Japan's zero interest rates allowed “zombie” companies to survive in the 1990s. This depressed Japan's productivity growth, and the excess capacity undercut the profits of other firms.
Another “benefit” of a recession is that it purges the excesses of the previous boom, leaving the economy in a healthier state. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place. A recession now would reduce America's trade gap as consumers would at last be forced to trim their spending. Delaying the correction of past excesses by pumping in more money and encouraging more borrowing is likely to make the eventual correction more painful. The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be a choice between a mild recession now and a nastier one later.
This does not mean that the Fed should follow the advice of Andrew Mellon, the treasury secretary, after the 1929 crash: “liquidate labour, liquidate stocks, liquidate the farmers, and liquidate real estate...It will purge the rottenness out of the system.” America's output fell by 30% as the Fed sat on its hands. As a scholar of the Great Depression, Ben Bernanke, the Fed's chairman, will not make that mistake. Central banks must stop recessions from turning into deep depressions. But it may be wrong to prevent them altogether.
Of course, even if a recession were in America's long-term economic interest, it would be political suicide. A central banker who mentioned the idea might soon be out of a job. But that should not stop undiplomatic economists asking whether a recession once in a while might actually be a good thing.
* * * Editorial Dollars for Sale New York Times August 25, 2007
During the worst of the markets’ recent volatility, many investors moved their money into supersafe Treasury securities, temporarily boosting the dollar against the euro and the British pound. But of late, the dollar has resumed its downward trend of the past several years. And policy makers and currency traders are once again hypervigilant for signs that Asian central banks might redeploy part of their dollar-based debt holdings into non-American investments.
Such diversification — particularly by China, which is believed to have some $1 trillion — could further weaken the dollar, presaging higher interest rates and higher prices in the United States.
But Asian bankers, it turns out, are not the only ones to watch. According to a new study by Stephen Jen, a currency economist at Morgan Stanley, American investors may be a more powerful force than their foreign counterparts in driving the dollar down.
Mr. Jen notes that since 2003, American mutual funds have increased their allocation of overseas equities from 15 percent to 22.5 percent, a pace he describes as “gradual but determined.” If America’s other big institutional investors, such as pensions and insurance companies, have invested elsewhere at the same pace, he calculates that the outflow of dollars would now amount to $1.16 trillion, about the same as China’s total foreign reserves.
The outflow is not necessarily a thumbs down on the dollar’s prospects, says Mr. Jen. Instead, it may reflect an increased willingness to invest overseas in a prudent attempt at broad diversification.
But in a recent analysis of Mr. Jen’s study, the Economist magazine points out that a negative view about the dollar may underlie the urge to diversify. The Economist cites a Merrill Lynch survey showing that downbeat expectations for the dollar have been common among fund managers for the past five years. The push to diversify out of dollars was strongest three years ago, but persists today.
If dollar wariness among American investors were a recent phenomenon, it could be chalked up to temporary forces. But because the unease has been marked for many years, it must emanate from something more entrenched. One probable source is concern about America’s huge ongoing foreign indebtedness.
Currency markets generally punish heavily indebted nations by pushing down their currency. In the absence of policies to boost domestic savings — and thereby slow the build up of debt — a steady decline of the dollar implies a steady decline in American living standards. A sharply accelerating decline would imply severe economic distress. By diversifying out of dollars, American investors seem intent, at least in part, on reducing their exposure to either eventuality.
Policy makers should spend less time worrying about what foreign creditors could do to harm the dollar, and more time working to improve savings at home, both public and private. That way, the nation would be less reliant on imported capital and less vulnerable over all, come what may.