Why We Should Fear Easy Money

Cutting interest rates now could set the stage for a collapse in the financial markets.

To widespread applause in the markets and the news media, from conservatives and liberals alike, the Federal Reserve appears poised to cut interest rates for the first time since the global financial crisis a decade ago. Adjusted for inflation, the Fed’s benchmark rate is now just half a percent and the cost of borrowing has rarely been closer to free, but the clamor for more easy money keeps growing.

Everyone wants the recovery to last and more easy money seems like the obvious way to achieve that goal. With trade wars threatening the global economy, Federal Reserve officials say rate cuts are needed to keep the slowdown from spilling into the United States, and to prevent doggedly low inflation from sliding into outright deflation.

Few words are more dreaded among economists than “deflation.” For centuries, deflation was a common and mostly benign phenomenon, with prices falling because of technological innovations that lowered the cost of producing and distributing goods. But the widespread deflation of the 1930s and the more recent experience of Japan have given the word a uniquely bad name.

After Japan’s housing and stock market bubbles burst in the early 1990s, demand fell and prices started to decline, as heavily indebted consumers began to delay purchases of everything from TV sets to cars, waiting for prices to fall further. The economy slowed to a crawl. Hoping to jar consumers into spending again, the central bank pumped money into the economy, but to no avail. Critics said Japan took action too gradually, and so its economy remained stuck in a deflationary trap for years.

Yet, in this expansion, the United States economy has grown at half the pace of the postwar recoveries. Inflation has failed to rise to the Fed’s target of a sustained 2 percent. Meanwhile, every new hint of easy money inspires fresh optimism in the financial markets, which have swollen to three times the size of the real economy.

In this environment, cutting rates could hasten exactly the outcome that the Fed is trying to avoid. By further driving up the prices of stocks, bonds and real estate, and encouraging risky borrowing, more easy money could set the stage for a collapse in the financial markets. And that could be followed by an economic downturn and falling prices — much as in Japan in the 1990s. The more expensive these financial assets become, the more precarious the situation, and the more difficult it will be to defuse without setting off a downturn.

The key lesson from Japan was that central banks can print all the money they want, but can’t dictate where it will go. Easy credit could not force over-indebted Japanese consumers to borrow and spend, and much of it ended up going to wastefinancing “bridges to nowhere” and the rise of debt-laden “zombie companies that still weigh on the economy.

Today, politicians on the right and left have come to embrace easy money, each camp for its own reasons, both ignoring the risks. President Trump has been pushing the Fed for a large rate cut to help him bring back the postwar miracle growth rates of 3 percent to 4 percent.

At the same time, liberals like Bernie Sanders and Alexandria Ocasio-Cortez are turning to unconventional easy money theories as a way to pay for ambitious social programs. But they might want to take a closer look at who has benefited most after a decade of easy money: the wealthy, monopolies, corporate debtors. Not exactly liberal causes.

By fueling a record bull run in the financial markets, easy money is increasing inequality, since the wealthy own the bulk of stocks and bonds. Research also shows that very low interest rates have helped large corporations increase their dominance across United States industries, squeezing out small companies and start-ups. Once seen as a threat only in Japan, zombie firms — which don’t earn enough profit to cover their interest payments — have been rising in the United States, where they account for one in six publicly traded companies.

All these creatures of easy credit erode the economy’s long-term growth potential by undermining productivity, and raise the risk of a global recession emanating from debt-soaked financial and housing markets. A 2015 study of 17 major economies showed that before World War II, about one in four recessions followed a collapse in stock or home prices (or both). Since the war, that number has jumped to roughly two out of three, including the economic meltdowns in Japan after 1990, Asia after 1998 and the world after 2008.

Recessions tend to be longer and deeper when the preceding boom was fueled by borrowing, because after the boom goes bust, flattened debtors struggle for years to dig out from under their loans. And lately, easy money has been enabling debt binges all over the world, particularly in corporate sectors.

As the Fed prepares to announce a decision this week, growing bipartisan support for a rate cut is fraught with irony. Slashing rates to avoid deflation made sense in the crisis atmosphere of 2008, and cutting again may seem like a logical response to weakening global growth now. But with the price of borrowing already so low, more easy money will raise a more serious threat.

By further lifting stock and bond prices and encouraging people to take on more debt, lowering rates could set the stage for the kind of debt-fueled market collapse that has preceded the economic downturns of recent decades. Our economy is hooked on easy money — and it is a dangerous addiction.

Trump’s Art of the Spin

NEW HAVEN – Blinded by a surging stock market and a 50-year low in the unemployment rate, few dare to challenge the wisdom of US economic policy. Instant gratification has compromised the rigor of objective and disciplined analysis. Big mistake. The toxic combination of ill-timed fiscal stimulus, aggressive imposition of tariffs, and unprecedented attacks on the Federal Reserve demands a far more critical assessment of Trumponomics.

Politicians and pundits can always be counted on to spin the policy debate. For US President Donald Trump and his supporters, the art of the spin has been taken to a new level. Apparently, it doesn’t matter that federal deficits have been enlarged by an estimated $1.5 trillion over the next decade, or that government debt will reach a post-World War II record of 92% of GDP by 2029. The tax cuts driving these worrying trends are rationalized as what it takes to “Make America Great Again.”

Nor are tariffs viewed as taxes on consumers or impediments to global supply-chain efficiencies; instead, they are portrayed as “weaponized” negotiating levers to force trading partners to change their treatment of the United States. And attacks on the Fed’s independence are seen not as threats to the central bank’s dual mandate to maximize employment and ensure price stability, but rather as the president’s exercise of his prerogative to use the bully pulpit as he – and he alone – sees fit.

There are three basic flaws with Trump’s approach to economic policy.

  1. First, there is the disconnect between intent and impact. The political spin maintains that large corporate tax cuts boost US competitiveness. But that doesn’t mean deficits and debt don’t matter. Notwithstanding the hollow promises of supply-side economics, revenue-neutral fiscal initiatives that shifted the tax burden from one segment of the economy to another would have come much closer to real reform than the reduction of the overall revenue trajectory has. Moreover, the enactment of fiscal stimulus in late 2017, when the unemployment rate was then at a cyclical low of 4.1% (headed toward the current 3.6%), added froth to markets and the economy when it was least needed and foreclosed the option of additional stimulus should growth falter.

Similarly, Trump’s tariffs fly in the face of one of the twentieth century’s greatest policy blunders – the Smoot-Hawley Tariff of 1930, which sparked a 60% plunge in global trade by 1932. With foreign trade currently accounting for 28% of GDP, versus 11% in 1929, the US, as a debtor country today, is far more vulnerable to trade-related disruptions than it was as a net creditor back then.

Ignoring the cascading stream of direct and retaliatory taxes on consumers and businesses that stem from a tariff war, Trump extols the virtues of tariffs as “a beautiful thing.” That is painfully reminiscent of the 1928 Republican Party platform, which couched tariffs as “a fundamental and essential principle of the economic life of this nation … and essential for the continued prosperity of the country.” Trump ignores the lessons of the 1930s at great peril.

The same can be said of Trump’s recent Fed bashing. The political independence of central banking is widely regarded as the singular breakthrough needed to achieve price stability following the Great Inflation of the 1970s. In the US, passage of the so-called Humphrey-Hawkins Act of 1978 gave then-Fed Chairman Paul Volcker the political cover to squeeze double-digit inflation out of the system through a wrenching monetary tightening. Had Volcker lacked the freedom to act, he would have been constrained by elected leaders’ political calculus – precisely what Trump is doing in trying to dictate policy to current Fed Chair Jerome Powell.

2) The second critical flaw in Trump’s economic-policy package is its failure to appreciate the links between budget deficits, tariffs, and monetary policy. As the late Martin Feldstein , to the extent that budget deficits put downward pressure on already depressed domestic saving, larger trade deficits become the means to fill the void with surplus foreign saving. Denial of these linkages conveniently allows the US to  for self-inflicted trade deficits.

But with tariffs likely to divert trade and supply chains from low-cost Chinese producers to higher-cost alternatives, US consumers will be hit with the functional equivalent of tax hikes, raising the risk of higher inflation. The latter possibility, though seemingly remote today, could have important consequences for US monetary policy – provided, of course, the Fed has the political independence to act.

Finally, there are always the lags to keep in mind in assessing the impact of policy. While low interest rates temper short-term pressures on debt-service costs as budget deficits rise, there is no guarantee that such a trend will persist over the longer term, especially with the already-elevated federal debt overhang projected to increase by about 14 percentage points of GDP over the next ten years. Similarly, the disruptive effects of tariffs and shifts in monetary policy take about 12-18 months to be fully evident. So, rather than bask in today’s financial-market euphoria, politicians and investors should be thinking more about the state of the economy in late 2020 – a timeframe that happens to coincide with the upcoming presidential election cycle – in assessing how current policies are likely to play out.

There is nothing remarkable about a US president’s penchant for political spin. What is glaringly different this time is the lack of any pushback from those who know better. The National Economic Council, established in the early 1990s as an “honest broker” in the executive branch to convene and coordinate debate on key policy issues, is now basically dysfunctional. The NEC’s current head, Larry Kudlow, a long-standing advocate of free trade, is squirming to defend Trump’s tariffs and Fed bashing. The Republican Party, long a champion of trade liberalization, is equally complicit. Trump’s vindictive bluster has steamrolled economic-policy deliberations – ignoring the lessons of history, rejecting the analytics of modern economics, and undermining the institutional integrity of the policymaking process. Policy blunders of epic proportion have become the rule, not the exception. It won’t be nearly as easy to spin the looming consequences.

China Hardens Trade Stance as Talks Enter New Phase

Chinese negotiators emboldened by perception U.S. was willing to compromise

The hardened battle lines were prompted by Beijing’s decision to take a more aggressive stance in negotiations, according to the people following the talks. They said Beijing was emboldened by the perception that the U.S. was ready to compromise.

  1. In particular, these people said, Mr. Trump’s hectoring of Federal Reserve Chairman Jerome Powell to cut interest rates was seen in Beijing as evidence that the president thought the U.S. economy was more fragile than he claimed.
  2. Beijing was further encouraged by Mr. Trump’s frequent claim of friendship with Chinese President Xi Jinping and by Mr. Trump’s praise for Chinese Vice Premier Liu He for pledging to buy more U.S. soybeans.

An April 30 tweet, in which Mr. Trump coupled criticism of Mr. Powell with praise of Chinese economic policy, especially caught the eye of senior officials. “China is adding great stimulus to its economy while at the same time keeping interest rates low,” Mr. Trump tweeted. “Our Federal Reserve has incessantly lifted interest rates.”

Why would you be constantly asking the Fed to lower rates if your economy is not turning weak,” said Mei Xinyu, an analyst at a think tank affiliated with China’s Commerce Ministry. If the U.S.’s resolve was weakening, the thinking in Beijing went, the U.S. would be more willing to cut a deal, even if Beijing hardened its positions.

That assessment, however, flies in the face of a strong U.S. economy. Gross domestic product in the first quarter rebounded from the end of 2018, with growth clocking in at a seasonally adjusted annualized rate of 3.2%, up from 2.2% the prior quarter. The jobs report for April, released on Friday, showed the unemployment rate falling to 3.6%, the lowest in nearly 50 years.

But at the same time, China’s economy has stabilized this year following months of weakness. Although China’s exports dropped unexpectedly in April, its first-quarter growth came in at 6.4%, beating market expectations. The generally improving economic picture gave Beijing more confidence in trade talks, as did a recent conference on the country’s vast infrastructure-spending program, called the Belt and Road Initiative, which was attended by about 40 heads of government and state.

Chinese leaders saw the conference turnout “as China has more leverage to improve relations with other countries and with the U.S. business community,” said Brookings Institution China specialist Cheng Li. “It made them play hardball.”

If China misread the signals—and vice versa—it wouldn’t be the first time.

The history of U.S.-China trade negotiations is filled with misunderstandings, as the two nations, with very different political systems, struggle to figure out each other’s intentions.

.. In another apparent sign of mixed signals, Trump administration officials had thought they had made it clear that they were weary of negotiations and that it was time for Beijing to make specific commitments to change laws, including adding protections for intellectual property and barring the forced transfer of U.S. technology.

As talks resume Thursday, one big question mark is whether China will agree to U.S. demands for changes in Chinese law to implement the trade deal. Beijing maintains this would impinge on Chinese sovereignty and take too long to implement, but Beijing had made similar commitments in prior trade deals, including those it signed to join the WTO in 2001.

U.S. officials say Beijing has failed to make good on those commitments, while China has promised to further liberalize its economy.

“The U.S. is correct to seek a multiprong approach of not relying solely on commitments but also actually changes to the laws, so as to ensure Chinese leadership intentions are fully conveyed down to all local levels of government,” said Harvard Law Professor Mark Wu.

A Central Banking Domino Effect Is in Motion

Policy U-turns from the Fed and ECB are cascading around the world

Abrupt changes in the policies of the world’s largest central banks have rippled through smaller economies, leaving them with the prospect of low and even negative interest rates for years to come despite having mostly healthy economies.

The danger is that these easy-money policies could fuel destabilizing bubbles in real estate and other asset markets. They may also leave banks with little ammunition to respond to the next economic downturn.

Economies like Switzerland’s, whose central bank signaled no change in its negative-rate policies for years to come, are small compared with the U.S. and eurozone. Still, they are home to major global banks and companies that are sensitive to exchange rates and financial conditions. With financial markets so interconnected, problems in small countries can quickly spread to larger ones.

.. The Swiss National Bank said Thursday that it would keep its policy rate at minus 0.75%, where it has been since January 2015, and reduced its inflation forecast to 0.3% this year and 0.6% in 2020. The SNB cited weaker overseas growth and inflation and “the resulting reduction in expectations regarding policy rates in the major currency areas going forward.”

.. Here’s why Fed and ECB decisions matter for countries that don’t use the dollar or euro: Switzerland and countries near the eurozone but not part of it—like Sweden and Denmark—rely on the bloc for much of their exports and imports. That makes growth and inflation highly dependent on the exchange rate. Central-bank stimulus tends to weaken a country’s exchange rate, so when the ECB embraces easy-money policies as it did two weeks ago it tends to weaken the euro against other European currencies such as the Swiss franc. Because the ECB is so large, Switzerland and others can do little to offset it.

.. “They are hostage to the fortunes of what the ECB does,” said David Oxley, economist at Capital Economics.

.. “The gravity pull is very strong” from the Fed and ECB, said Sebastien Galy, macro strategist at Nordea Asset Management. “The consequence is [non-euro central banks in Europe] mostly end up importing policy from the ECB, so you end up with housing bubbles and a misallocation of capital.”

What Will Cause the Next US Recession?

Three of the last four US recessions stemmed from unforeseen shocks in financial markets. Most likely, the next downturn will be no different: the revelation of some underlying weakness will trigger a retrenchment of investment, and the government will fail to pursue counter-cyclical fiscal policy.

BERKELEY – Over the past 40 years, the US economy has experienced four recessions. Among the four, only the extended downturn of 1979-1982 had a conventional cause. The US Federal Reserve thought that inflation was too high, so it hit the economy on the head with the brick of interest-rate hikes. As a result, workers moderated their demands for wage increases, and firms cut back on planned price increases.
The other three recessions were each caused by derangements in financial markets. After the
  1. savings-and-loan crisis of 1991-1992
  2. came the bursting of the dot-com bubble in 2000-2002, followed by the
  3. collapse of the subprime mortgage market in 2007, which triggered the global financial crisis the following year

.. And one can infer from today’s macroeconomic big picture that the next recession most likely will not be due to a sudden shift by the Fed from a growth-nurturing to an inflation-fighting policy. Given that visible inflationary pressures probably will not build up by much over the next half-decade, it is more likely that something else will trigger the next downturn.

Specifically, the culprit will probably be a sudden, sharp “flight to safety” following the revelation of a fundamental weakness in financial markets. That, after all, is the pattern that has been generating downturns since at least 1825, when England’s canal-stock boom collapsed.

.. Needless to say, the particular nature and form of the next financial shock will be unanticipated. Investors, speculators, and financial institutions are generally hedged against the foreseeable shocks, but there will always be other contingencies that have been missed. For example, the death blow to the global economy in 2008-2009 came not from the collapse of the mid-2000s housing bubble, but from the concentration of ownership of mortgage-backed securities.

Likewise, the stubbornly long downturn of the early 1990s was not directly due to the deflation of the late-1980s commercial real-estate bubble. Rather, it was the result of failed regulatory oversight, which allowed insolvent savings and loan associations to continue speculating in financial markets. Similarly, it was not the deflation of the dot-com bubble, but rather the magnitude of overstated earnings in the tech and communications sector that triggered the recession in the early 2000s.

At any rate, today’s near-inverted yield curve, low nominal and real bond yields, and equity values all suggest that US financial markets have begun to price in the likelihood of a recession. Assuming that business investment committees are thinking like investors and speculators, all it will take now to bring on a recession is an event that triggers a retrenchment of investment spending.

If a recession comes anytime soon, the US government will not have the tools to fight it. The White House and Congress will once again prove inept at deploying fiscal policy as a counter-cyclical stabilizer; and the Fed will not have enough room to provide adequate stimulus through interest-rate cuts. As for more unconventional policies, the Fed most likely will not have the nerve, let alone the power, to pursue such measures.

As a result, for the first time in a decade, Americans and investors cannot rule out a downturn. At a minimum, they must prepare for the possibility of a deep and prolonged recession, which could arrive whenever the next financial shock comes.