The text below has been linked to by Atrios, but I’d like to bring it to your attention again.
The author, Stephen Roach, is the chief economist at Morgan Stanley, so he is one of the top economists in the world in terms of who is listened to, and he has extra credibility in that his bank presumably invests and lends after having taking his advice into consideration.
He is a known pessimist, but I cannot find good arguments against his. His message, like mine (See my previous diaries on this topic:Greenspan’s bubbles – more graphs and Greenspan’s bubbles – a graph) is simple:
We are in a runaway train, heading for the big crash, and it is mostly Greenspan’s fault
The US Federal Reserve is behind the curve and scrambling to catch up. Inflation risks seem to be mounting at precisely the moment when America’s current-account deficit is out of control. Higher real interest rates are the only answer for these twin macro problems. For an unbalanced world that has become a levered play on low real interest rates, the long-awaited test could finally be at hand.
In an era of fiscal profligacy, real interest rates are the only effective control lever of macro management.
It’s all there in a few sentences:
- fiscal profligacy: unrestrained government spending at the same time as taxes are brought down
- current-account deficit out of control: the US consumer is gorging on imports
- unbalanced world: everybody is living off that US consumer spending
- low real interest rates: cheap money allow everybody to borrow and spend like crazy
- inflation is picking up again (from a combination of higher asset prices and higher commodity prices, and despite the China deflationary effect)
Roach then goes on to explain that interest rates will have to increase significantly – just to get back to a neutral policy stance, and as it is “real” interest rates (i.e. those after taking into consideration inflation) that need to increase, the interest rates need to increase significantly faster than they have.
So what needs to be done? And can it be done?
So far, so good. After all, the US economy is picking up again, it has a good growth rate, and there is indeed some threat from imported inflation. A little tightening will help it go through this rough patch and maintain its amazing performance, right?
Well, except for one thing…
<u>The current apparent health of the US economy is not coming from “labor income generation”, i.e. middle class working and getting paid for that work, but from cheap money, i.e. from debt.</u> The wealth is an illusion, created by Greenspan, and encouraged by Asian central banks who initially thought that they could ride that tiger to their own wealth.
Even before interest rates have gone up, the market feels that the debt burden of a number of borrowers is unsustainable, with real life consequences on industrial actors (see bonddad’s recent diaries on that topic: GM Near Junk Status after GE cancels 2 billion credit line and Ford, GM and Chrysler “Lumbering Toward Failure”)
What Roach is saying is that (i) interest rates need to go up by a lot more than most people still expect, and (ii) even small interest rates will have nasty consequences. Not pretty indeed. And his conclusion is quite direct: it IS Greenspan’s fault:
Largely for that reason, I still don’t think America’s central bank is up to the task at hand. In the face of disruptive markets or growth disappointments, this Fed has repeatedly opted to err on the side of accommodation. I suspect that deep in its heart, the Federal Reserve knows what’s at stake for the US — and for the world — if the asset-dependent American consumer were to throw in the towel. Unfortunately, that takes us to the ultimate trap of global rebalancing — a realignment of the world that requires both higher US real interest rates and a weaker dollar. Should the Fed fail to deliver on the interest rate front, I believe that the US current-account correction would then be forced increasingly through the dollar. And that would redirect the onus of global rebalancing away from the American consumer onto the backs of Europe, Japan, and China. Call it a “beggar-thy-neighbor” monetary policy defense — pushing the burden of adjustment onto someone else.
It didn’t have to be this way. The big mistake, in my view, came when the Fed condoned the equity bubble in the late 1990s. It has been playing post-bubble defense ever since, fostering an unusually low real interest rate climate that has led to one bubble after another. And that has given rise to the real monster — the asset-dependent American consumer and a co-dependent global economy that can’t live without excess US consumption. The real test was always the exit strategy.
Read that again:
GREENSPAN’S MONSTER — the asset-dependent American consumer and a co-dependent global economy that can’t live without excess US consumption.
History will not be kind to him.