How the US should prevent a global meltdown
The IMF urges the Fed to keep its finger on the interest rate trigger - to shoot first, ask questions later
Monday 27 September 1999
As the International Monetary Fund pointed out in its World Economic Outlook last week, there have been two significant global recessions in less than 10 years, from 1991-93 and 1998-99. The average growth rate of global output has been just 3 per cent, down from 3.5 per cent in the 1980s and 4.5 per cent during what we think of as the hard times of the 1970s. There has also, of course, been a succession of financial crises, mainly in emerging markets.
The US economic performance appears to be another example of American exceptionalism. By contrast there has been nothing but good news on inflation. It has been lower and more stable during the past five years than any time since the early 1960s. So why has there been such slow growth and financial instability at a time when governments and central banks have painstakingly and steadily improved their macroeconomic policies? Why has the payoff to a return to stable prices thanks to these policies been so limited? After all, there is no doubt in theory that low and stable inflation ought to permit high and stable growth. In the OECD countries generally there has been a small decline in structural government deficits - made up of a big decline in the US, a smaller decline in Europe driven by the Maastricht conditions for monetary union, and a big deterioration in Japan where the government has had to deliver more and more fiscal stimulus to the ailing economy.
In addition, inflation has everywhere become lower and less variable. There have also been widespread structural reforms, with deregulation of jobs and goods markets and generally tougher competition policies. Luckily for economic orthodoxy, the best performing country, the US, is the one which has been characterised by the best and most orthodox policies this decade. The government - federal plus state and local - has switched from being 3.6 per cent of GDP in the red in 1993 to 1.6 per cent of GDP in the black this year. It is a stunning turnaround, and the US position relative to other countries is even stronger when its relatively youthful demographic profile is taken into account - America is greying less rapidly than other OECD nations so it will not face the same pensions bill.
On the monetary side, there has been universal acclaim for Alan Greenspan's sure touch with interest rates, which has kept inflation low while sustaining the expansion and continuing increases in employment. The Fed has made the most of the credibility it has built up as an inflation-buster under Mr Greenspan and his predecessor, Paul Volcker. But it is fair to ask whether the American economy too will fall victim soon to a bout of instability and recession. After all, even if potential US output growth has accelerated, as the IMF concluded, on any measure the economy has been growing above potential for three years. It will have to slow down to a more sustainable pace. And there are good reasons to think a soft landing will be harder to achieve than a crash landing - the main one being the danger of a steep fall in share prices.
In its report the IMF urges the Fed to keep its finger on the interest rate trigger - in fact, to shoot first, ask questions later. Or, as the Fund's economists put it in slightly more measured terms: "It will be important for the Federal Reserve to continue to be forward looking in its conduct of policy, to respond again promptly if domestic demand growth fails to abate..., to be particularly alert to repercussions in the economy of the rise in the stock market." Firm pre-emptive action will minimise the danger of a hard landing, it advises. However, it might already be too late to correct the excess demand in the US economy. One signal is the chasm that is the American trade deficit, likely to equal 3.5 per cent of GDP this year. The sound of cheap imports being sucked in is a classic sign of pent-up inflationary pressure, and will continue undermining the dollar, allowing the inflation to emerge through increasing import prices. The deficit is testament to the role American consumers have played helping the rest of the world through the crisis of the past two years, but in a different environment it might have prompted a different Fed policy.
The other signal is the over-valuation of share prices. Indeed, the bull market on Wall Street is the mechanism through which the expansion has sown the seeds of its own end. For sustained low inflation and steady growth - good times - breed overconfidence. Investors believe it will last for ever and fling money at shares. They start to argue there is a new paradigm or an economic miracle. There is a good case for the central bank responding to such excesses by tightening monetary policy in response to excessive gains in share prices. After all, monetary policy can very successfully react to sharp falls in share prices, as the 1987 experience shows. The initial fall in shares then was as bad as it had been in 1929, but rapid cuts in interest rates ensured there was hardly any dip in output. On the contrary, it paved the way for the late 1980s boom. So should the Fed not have behaved in a symmetric way and raised rates as soon as it became clear Wall Street had gone too far? It was in December 1996 that Mr Greenspan first warned of "irrational exuberance". The wider share price index has climbed nearly 80 per cent since, and the $12 trillion market capitalisation of the US stockmarket is an unprecedented 140 per cent of GDP. One difficulty in arguing, however, that the Fed should have reacted to the stockmarket bubble is that it is probably true there has been a step improvement in the productivity and potential output of corporate America, thanks to technological progress.
The fundamentals have improved but it is impossible to know how much higher a level of share prices this ought to justify. This is something that can only be resolved with hindsight. What's more, to set monetary policy on the basis of asset prices without being more sure than the market about where asset prices ought to be could be destabilising in practice. The potential for making mistakes is at least as great as the potential for error in ignoring the inflationary warnings being flashed by a soaring stockmarket.
In short, Mr Greenspan would have been sticking his neck out if he had tried to save the US and the world from the instability that could yet result from a Wall Street crash by raising interest rates more aggressively. And of course if he had tried, the long American boom would have been that much less spectacular. That expansion, the best economic performance in the developed world since the mid-19th century, is still the best advertisement for sound macroeconomic policies.
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