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In Treating U.S. After Bubble,
Fed Helped Create New Threats.
Low Rates Bolstered Economy,
But Housing, Foreign Debt
Appear Out of Balance.
Greenspan's Legacy at Stake.
By Greg Ip
The Wall Street Journal
Thursday, June9,2005
By many yardsticks, the Federal Reserve's response to the bursting
of the stock and tech-spending bubbles in 2000 has been a remarkable
success. The 2001 recession was mild and economic growth since has
been brisk. Employment is up and inflation remains within the Fed's
hallowed zone of price stability.
But five years after the stock market's peak, the economy faces
other threatening imbalances: a potential housing bubble, rock-
bottom personal saving rates, and a gargantuan trade deficit. And
the Fed's post-bubble prescription bears some responsibility for all
three. Fed officials acknowledge as much but say the alternatives
were worse.
By slashing short-term interest rates to 45-year lows, the Fed
encouraged Americans to borrow more, gave them little reward for
saving, and helped ignite a surge in housing prices. President Bush
and Congress joined in with steep tax cuts that boosted household
purchasing power. All that spending contributed to a growing U.S.
economy, a steady increase in imports, and -- given that Americans
are so eager to borrow and foreigners so eager to lend -- a mountain
of foreign debt.
This is pleasant for Americans as long as it lasts. But Fed
officials, international financial watchdogs, and private economists
say it can't. At some point, American consumers must spend less,
save more, and rely less on foreigners' savings.
How that will happen puts the nation in uncharted territory: After
treating a bubble, how does the Fed manage the side effects of its
medicine?
"We have done what no other economy has done before, faced with an
asset bubble," Lawrence Lindsey, a former Fed governor and Bush
adviser, said at a recent panel discussion. Praising both the Fed's
rate cuts and Mr. Bush's tax cuts, he said, "This is the first time
in history the textbook economic policy ... was used and worked. The
problem is, once you finish that chapter of the economic texts, you
turn the page and the page is blank -- because no one has gone
through the process before."
The Fed is confident these imbalances will be resolved with little
pain. As it raises interest rates, consumers will slow their
spending and save more. Foreigners' appetite for U.S. goods will
rise. The engine of U.S. growth will shift smoothly from consumers
and government to business investment and exports. Fed Chairman Alan
Greenspan might address this when he testifies on the economic
outlook to Congress today.
But a minority of economists warn of a more damaging scenario. Some
say the Fed has simply replaced the stock-market bubble with one in
housing, which could burst. That would sap the consumer spending
that mortgage refinancing and home-equity loans have fueled. Or
foreign investors could stop buying U.S. stocks and bonds, sending
the dollar down and inflation up, prompting both the Fed and bond
market to jack up interest rates sharply. In either case, the U.S.
economy could slow sharply or fall into recession.
Faced with an asset bubble, a central bank has two choices: Prick it
early or wait for it to burst and try to contain the damage. The Fed
in 1929 and the Bank of Japan in 1989 tried the first route, raising
interest rates in response to rapidly rising asset prices. The
result in the U.S. in the 1930s was depression and deflation. In
Japan it was stagnation and deflation that continue today.
In the 1990s Mr. Greenspan chose the second route. As long as the
prices of goods and services were stable, he would leave the stock
market alone. When the stock bubble finally burst, the Fed cut short-
term rates aggressively beginning in 2001 and then held them at a 45-
year low of 1% through early 2004 until the Fed was sure the threat
of deflation had receded.
Mr. Greenspan knew his strategy carried risks. But he saw far
greater ones in responding timidly as the collapse of the biggest
asset bubble in history wiped out more than $5 trillion in
shareholder value, and terrorist attacks, war, and corporate scandal
rattled confidence. The economic expansion to date suggests he was
right, and the odds are that he will retire as scheduled next
January with his reputation for economic stewardship intact. But if
a collapse in housing prices or a run on the dollar triggers a new
recession, Mr. Greenspan's legacy may be different. The Fed is
conducting a "crucial experiment" in post-bubble monetary policy,
says Edward Chancellor, a financial historian. "We don't know what
the outcome is yet."
Lower interest rates normally operate through several channels. They
encourage consumers to buy things on credit today instead of saving
to buy the items later. They boost stock and home prices, which
makes the owners of those assets wealthier and more willing to
spend. They encourage businesses to borrow and invest. And they
depress the dollar, boosting exports.
But after 2001, some of these channels were blocked. Businesses,
burdened with a glut of unused equipment from the bubble years and
cowed by geopolitical and regulatory uncertainty, didn't borrow to
invest. And the dollar didn't fall initially, but rose because
foreign economies were in even worse shape than the U.S.'s. This
meant the economy relied disproportionately on the one channel that
did respond: consumers. They bought record numbers of houses and
cars, mostly on credit. They also borrowed against their houses'
appreciated values, allowing them to spend more still.
To Mr. Greenspan, who had studied housing and mortgage markets all
his life, this came as no surprise. "Households have been able with
increasing ease to extract equity from their homes, and this
doubtless has helped support consumer spending in recent years,
complementing the traditional effects of monetary policy," he
observed in August 2003.
Accused by some of fostering excess, Fed officials responded that
the alternative was worse: a deeper recession and the risk of
deflation -- a period of generally falling prices, which can worsen
a downturn by making it harder for workers and companies to repay
debts. In a February 2003 speech Fed Governor Donald Kohn, one of
the central bank's principal monetary-policy strategists, agreed low
interest rates had had an outsize impact on car sales, home
construction, and housing prices. But that "has kept more people
employed and reduced the risk of deflation," he said.
By January 2004 the expansion seemed entrenched enough for Mr.
Greenspan to declare victory: "Our strategy of addressing the
bubble's consequences rather than the bubble itself has been
successful." While "large residues" of household and foreign debt
remained, they would not be a barrier to growth; such imbalances, he
suggested, would dissipate with time.
Instead they have grown. "The magnitude of these imbalances is
increasingly moving into unfamiliar territory," Mr. Kohn said in
April. Since his February 2003 speech, house values have risen 25%
and total mortgage debt by 28% while after-tax incomes have expanded
just 13%. The household saving rate, a low 2% in 2000, has fallen to
0.9%. A growing share of mortgages has gone to speculators and
people making little or no down payment. House "prices have gone up
far enough since then -- relative to interest rates, rents and
incomes -- to raise questions," Mr. Kohn said in April.
Meanwhile, the current-account deficit, the broadest measure of the
shortfall on trade and investment income between the U.S. and the
rest of the world, has moved into a zone that many economists
consider dangerous. It stands today at 6% of gross domestic product,
the nation's total output of goods and services, up from 4% in 2000.
To finance it, the U.S. now borrows about $2 billion a day from
foreigners. As the foreign debt mounts, so does the risk that
investors will demand a higher interest rate or lower dollar to keep
on lending.
To be sure, a major cause of the U.S. current account deficit is
that weak European and Japanese growth reduces demand for U.S.
exports. And China's fixed exchange rate keeps the prices of Chinese
goods artificially low, giving its television sets, bicycles, and
barbecue grills an edge in the U.S. market.
But the U.S. saves so little that when the U.S. cuts taxes and
consumers take out mortgages, the money to finance both increasingly
comes from abroad, in particular from foreign central banks. Those
banks purchase U.S. dollars to keep the greenback high against their
own currencies, thereby supporting their exports to the U.S. They
then invest those dollars in U.S. bonds, in effect providing the
financing for Americans to buy those exports.
Since 2000, foreign-brand cars have surged to 43% of the U.S. market
from 35%, according to Motorintelligence.com. In the meantime,
foreign holdings of U.S. Treasury bonds and bonds backed by
Americans' home mortgages have jumped 80%.
In the first quarter of this year General Motors Corp. made more
money on mortgages than on cars or car loans. Since the beginning of
2001 the number of Americans employed in manufacturing has fallen by
2.8 million, or 16%, while the number in residential construction,
real estate, and banking has risen by 766,000, or 14%.
"If I were a biologist I'd call this a perfect example of
symbiosis," former Fed Chairman Paul Volcker mused in a February
speech at Stanford University. "Contented American consumers matched
against delighted foreign producers. Happy borrowers matched against
willing lenders. The difficulty is, the seemingly comfortable
pattern can't go on indefinitely."
Almost every economist agrees. The debate is over how, not whether,
the global economy rebalances: Will it be smooth, through some
combination of declining dollar and accelerating foreign demand? Or
will it be chaotic, with a dollar collapse, much higher U.S.
interest rates, and perhaps a global recession?
Mr. Volcker thinks a crisis is likely. Investor confidence could
fade "at some point," he said, with "damaging volatility in both
exchange markets and interest rates."
His successor is more sanguine. Capitalist economies, Mr. Greenspan
believes, always have imbalances but are also continuously
reallocating resources and capital to correct them. Thus, imbalances
seldom become crises. "The number of forecasts of crises ... is far
in excess of the number of crises that actually occur," Mr.
Greenspan told a recent audience in Chicago. "There is something
equivalent to an invisible hand which continuously is readdressing
market imbalances to reach equilibrium."
Fed staff research shows that in the past, when a big, rich country
has a large current account deficit, it usually narrows without
crisis. Homes may be overvalued but are much harder to trade than
stocks and thus unlikely to collapse abruptly. Fed officials expect
home prices to stagnate while incomes advance, bringing
affordability back to historic ranges.
Having helped create today's imbalances, Fed officials acknowledge
some responsibility to reduce them. By raising rates, Mr. Kohn
explained, the Fed will make saving more attractive, slow the rise
in housing prices, and "thereby lessen one of the significant
spending imbalances." And Mr. Greenspan adds, "An increase in
household saving should also act to diminish borrowing from abroad,"
narrowing the current account deficit.
That benign scenario has yet to unfold. Business investment is
growing but by less than the Fed had expected. And while the trade
deficit narrowed sharply in March, for the first quarter as a whole
it hit a record of $694 billion on an annualized basis, or 5.7% of
GDP. Meanwhile, even as the Fed raises short-term interest rates,
long-term interest rates, which are set on markets, have actually
declined, a development that baffles Mr. Greenspan. Since mortgage
rates are tied to long-term bond yields, home prices have advanced
at one of their fastest rates yet over the spring. Mr. Greenspan has
acknowledged "a little froth" in the housing market.
What should the Fed do? Mr. Volcker, focusing on the current account
deficit, thinks the Fed ought to put added weight on keeping
inflation under control. "I am worried about a tendency to relax our
guard," he said. It is critical foreigners remain confident
that "those trillions of dollars they are piling up are going to be
protected against inflation." Some of today's Fed leadership shares
this view: The Fed can minimize the odds of crisis by keeping
inflation down, which means erring on the side of higher interest
rates.
Mr. Lindsey, on the other hand, believes the Fed should worry less
about inflation and more about keeping the housing market from
sinking. "You don't want to collapse asset prices," he says. "You
want to give people time to adjust in a gradual way." He thinks the
Fed should slowly raise its target for short-term interest rates,
now at 3%, to 3.5%, and then stop.
Mr. Kohn, in his April speech, made it clear the Fed would not let
imbalances deter any necessary action to keep inflation down: "We
should not hesitate to raise interest rates to contain inflation
pressures just because it might set off a retrenchment in housing
prices, just as we were willing to keep rates unusually low as house
prices rose rapidly."
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