What
are the lessons from the Great Depression, from
stagflation in the 1970s, from deflation in Japan?
The bubbles that preceded these challenging times
should never have been allowed to happen. Yet even
today, the US Federal Reserve Bank is very
reluctant to pop bubbles.
Outgoing Fed
chairman Alan Greenspan talked about irrational
exuberance in the stock markets, but let the stock
market rise to
the
stratosphere in the late 1990s; he has also kept
interest rates low for an extended period despite
mounting consumer debt and steep home price
appreciation.
Central banks allow
excessive credit expansion to take place.
Partially, this may be because central bankers do
not recognize a bubble until it is reasonably well
developed. Partially, this may be out of fear of
political repercussions if they were to openly
target perceived bubbles in their infancy. To a
great extent it is also because some central
bankers believe they can mitigate the fallout from
the bursting of a bubble.
Richard Koo,
author of The Balance Sheet Recession, says
massive government spending must take the place of
corporate spending to keep an economy afloat when
corporations do not invest and consumers do not
spend. Koo considers himself to be a leading voice
for the "Japanese experiment". He argues that
corporations that come out of a bubble with
massive debt are more interested in repairing
their balance sheets, ie, paying down debt, rather
than investing. He rejects the notion that such
companies should be allowed to fail when the
problem is systemic, such that 95% of banks have a
negative net worth and there would not be any
buyers in the ensuing shakeout.
Consequently, the economy would
potentially suffer a meltdown. He has supported
the use of public funds to keep the Japanese
economy afloat and has encouraged a gradual and
cautious disposal of non-performing loans (NPLs)
for banks. Theoretically, government spending
should be curtailed once the economy is
self-sustaining again. We are skeptical that this
will succeed, as once the government has
authorized spending projects, they take on a life
of their own. As a result, we are growing
increasingly concerned about the yen as the
Japanese economy shows signs of strength.
Policy-makers have a choice whether to
bring an economy to its knees to eradicate any
excess or to provide the appropriate stimulus to
try to neutralize just about any potential crisis.
Ben Bernanke, during his confirmation hearing to
succeed Greenspan as head of the Fed, emphasized
that the experience of the Fed governors will help
to preserve prosperity. It goes without saying
that inducing a depression by choice is something
few central bankers are willing to do. When a
central bank takes a more active role in promoting
structural change before a bubble has evolved,
such as the European Central Bank (ECB) has done
over the past couple of years, critics are
abundant. Europe experienced hyperinflation twice
in the 20th century and is more concerned about
the fallout of excess credit than, for example,
the Fed or the Bank of Japan.
Bernanke
says that "to understand the Great Depression is
the Holy Grail of macro-economics". Fed
policy-makers have also been observing the
Japanese experiment very closely. During his
nomination hearing to succeed Greenspan, Bernanke
praised the depth of experience of the Fed
governors. He also said he saw the role of the Fed
as being to provide adequate liquidity during a
financial crisis. All of this suggests that when
we face a crisis, the Fed under Bernanke’s
leadership will seek to rectify any imbalance with
a stimulus.
We believe there is
substantial risk that central bankers will not
fully appreciate that the upcoming economic
slowdown we foresee is very different in nature.
Both in the 1930s in the US and in the 1990s in
Japan, the corporate sector was in turmoil. This
time around, with some notable exceptions (think
automotive sector), corporate America is in
reasonable shape. It is the consumer sector that
we are most concerned about. There may also be
significant fallout hitting the financial sector
should there be a collapse in housing prices.
The Fed has to be careful how it applies
its stimulus. The traditional stimulus will
encourage corporations to invest more. The problem
is that corporations are likely to be encouraged
to invest overseas in search of greater returns as
their traditional customers, the American
consumers, are exhausted. Any stimulus will
further increase pressures in producer prices as
raw material prices are likely to stay elevated.
Given the cheap imports from Asia and high
consumer debt, pricing power is likely to remain
disappointing. As a result, real wage growth is
likely to be lackluster at best as corporations
must minimize labor cost to remain competitive.
This year, car manufacturers gave
"employee discounts" to empty their lots. Right
after Thanksgiving, substantial discounts were
given to shoppers to lure them out to the stores.
As top line growth may be attained, few retailers
are likely to be satisfied with their margins. A
slowdown in the housing market and high winter
heating costs will put further pressure on
consumer spending. An already negative savings
rate cannot continue forever.
As consumers
realize that their real wages do not grow, that
they cannot rely on extracting equity out of their
homes, that competition from Asia may be a threat
to their standard of living, the rational reaction
will be to spend less. Given the dependence of the
world economy on consumer spending, we believe the
Fed will interpret the economic data as a warning
sign that deflation could set in and a recession
or even depression could follow unless the economy
is "saved" before a deflationary spiral is
initiated.
So far, inflation has been tame
because of Asia's willingness to flood the US
markets with cheap goods, subsidized by rigid
exchange rates. However, inflation is creeping
through the production chain, and it is only a
matter of time before it will become more widely
spread. Already, we see significant inflation on
any goods or services that cannot be imported from
Asia (most of us can relate to inflation in the
cost of healthcare and education). As the US
economy slows, foreigners may be less inclined to
acquire US assets, vital to support the dollar
given a current account deficit around 6% of gross
domestic product.
What if the Fed applies
the perceived lesson from the Great Depression and
the Japanese experiment to prop up the American
consumer? If Japan is any guide, rather than
allowing financial distress to happen among
households (in Japan it was corporations),
policies are likely to be put in place to allow
households to make ends meet. But if consumers
know that the government will come to their
rescue, they may not have a good incentive to
start saving. Whereas it used to be a virtue to
leave something for your heirs, the baby boomer
generation is likely to make it a virtue to
squeeze the last cent out of a reverse mortgage to
finance retirement. (A reverse mortgage provides a
steady income stream from a bank in return for
incremental increases in a mortgage.)
Inflation cannot be switched off like a
light. We are concerned that by the time the Fed
realizes that preserving the consumer’s financial
health may be a losing battle, inflationary
pressures will no longer be containable. Any
effect on the US economy will be amplified should
the dollar fall sharply under the weight of the
current account deficit.
