The Fed and the US's distorted
expansion By Thomas Palley
The US economy has been in an expansion
mode since November 2001. Though of reasonable
duration, the expansion has been persistently
fragile and unbalanced. That is now coming home to
roost in the form of the subprime-mortgage crisis
and the bursting house-price bubble.
As
part of the fallout, the Federal Reserve is being
criticized for keeping interest rates too low for
too long, thereby promoting credit and
housing-market excess. However, the reality is
that low rates were needed to sustain the
expansion. Instead, the root
problem is a distorted
expansion caused by record trade deficits and
manufacturing's failure to participate fully in
the expansion.
If the Fed deserves
criticism, it is for endorsing the policy paradigm
that has created this pattern. That paradigm rests
on disregard of manufacturing and neglect of the
real adverse consequences of trade deficits.
By almost every measure, the current
expansion has been fragile and shallow compared
with previous business cycles. Beginning with an
extended period of jobless recovery,
private-sector job growth in the US has been below
par through most of the expansion. Though the
headline unemployment rate has fallen
significantly, the percentage of the working-age
population that is employed remains far below its
previous peak. Meanwhile, inflation-adjusted wages
have barely changed despite rising productivity.
This gloomy picture justified the Fed
keeping interest rates low. However, it raises the
question: Why the economic weakness, despite
historically low interest rates, massive tax cuts
in 2001, and huge increases in military and
security spending triggered by September 11, 2001,
and the Iraq war?
The answer is the
overvalued US dollar and the trade deficit, which
more than doubled between 2001 and 2006 to US$838
billion, equaling 6.5% of gross domestic product.
Increased imports have shifted spending away from
domestic manufacturers, which explains
manufacturing's weak participation in the
expansion.
Some firms have closed
permanently, while others have grown less than
they would have otherwise. Additionally, many have
reduced investment because of weak demand or have
moved their investment to China and elsewhere.
These effects have then multiplied through the
economy, with lost manufacturing jobs and reduced
investment causing lost incomes that have further
weakened job creation.
The evidence is
clear. US manufacturing lost 1.8 million jobs
during the expansion, which is unprecedented.
Before 1980, US manufacturing employment hit new
peaks during every expansion. Since 1980 it has
trended down, but it at least recovered somewhat
during expansions. This business cycle, it has
fallen during the expansion. The business
investment numbers tell a similar dismal story,
with spending much weaker than in previous cycles.
These conditions compelled the Fed to keep
interest rates low to maintain the expansion. That
policy worked, but by stimulating loose credit and
a house-price bubble that triggered a construction
boom. Thus residential investment never fell
during the recession and has been stronger than
normal during the expansion.
Construction,
which accounted for 5% of total employment in the
US, has provided more than 12% of job growth.
Meanwhile, higher house prices have fueled a
borrowing boom that has enabled consumption
spending to grow despite stagnant wages. This
explains both increased imports and job growth in
the service sector.
The overall picture is
one of a distorted expansion in which
manufacturing continued shriveling while imports
and services expanded. This pattern was carried by
an unsustainable house-price bubble and rising
consumer debt burdens, and that contradiction has
surfaced with the implosion of the
subprime-mortgage market and deflation of the
house-price bubble.
The Fed is now trying
to assuage markets to keep credit flowing, and it
will likely soon lower interest rates. On one
level that is the right response, and it may even
work again - though it does increasingly seem like
sticking fingers in the dike to prevent the flood.
However, the deeper problem is the policy paradigm
behind the distorted expansion, which is where the
Fed is at fault and where it deserves criticism.
The ideological and partisan former Fed
boss Alan Greenspan wholeheartedly endorsed
corporate globalization and promoted the White
House and Treasury's unbalanced expansion
policies. The Fed's professional economics staff
also seems to have dismissed domestic
manufacturing's significance and endorsed
corporate globalization in the name of free trade.
Consequently, the Fed has tacitly
supported the underlying policy paradigm that has
given rise to America's distorted expansion.
Despite talk about reducing global financial
imbalances, the Fed under current chairman Ben
Bernanke still seems locked into this paradigm,
and that is where constructive criticism should
now be directed.
Thomas Palley
is founder of the Economics for Democratic and
Open Societies Project.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
