Subscribe to BrookesNews’ Bulletin
The US economy and the Fed’s credit binge: what does it mean for Americans?
Gerard Jackson
In January The Economist declared that the US economy was not as healthy as it looked and troubled times awaited it. The magazine argued that the country’s growth was driven by “a massive monetary stimulus” brought about by keeping “real interest rates negative for several years”. In other words, the Fed flooded the economy with cheap credit.
It went on to argue that Greenspan’s loose monetary policy encouraged Americans to borrow against the rising values of their homes and go on a consumption binge (incidentally, this is one of the reasons that the current trade deficit has blown out) and so consume more than they are earning.
This is all rather rich as well as superficial. It illbehoves The Keynesian Economist to criticise the Fed for implementing Keynesian policies. Putting that point to one side, however, it is still true that the Fed’s monetary policy has unleashed a rash of serious problems that must eventually be confronted.
When this finally happens, we will call it a recession. Nevertheless, the Bush tax cuts of 2003 still played a significant and beneficial role in driving the economy. By cutting capital gains taxes President Bush increased the supply of capital goods by reducing the cost of investing in them.
The Economist has it that when house prices rose this encouraged their owners to borrow, allowing them to consume more than they earned. What actually happened is that the Fed pushed down the rate of interest. This caused credit to expand which in turn drove up house prices and nominal incomes. American consumers took advantage of the artificially low interest rates to increase their own consumption. Therefore, the rise in house prices and personal consumption have the same cause — the Fed’s cheap money policy.
Failure to recognise this fact led The Economist to predict that when “house-price rises flatten off, and therefore the room for further equity withdrawal dries up, consumer spending will stumble”. On the contrary, consumer spending would continue to rise so long as the Fed made it attractive to borrow. A decline in borrowing should be expected when the Fed starts raising short-term rates in an effort to reduce the supply of credit. (I cannot say at which rate borrowing will fall).
The Economist believes that because “consumer spending and residential construction have accounted for 90 percent of GDP growth in recent years, it is hard to see how this can occur without a sharp slowdown in the economy”. What the magazine has done is confuse economic growth with GDP. Consumption is not growth. Every pre-Keynesian economist understood that economic growth consisted of capital accumulation,
They also understood, as did every classical economist, “that every increase in production [needs to be] distributed without miscalculation”. (John Stuart Mill, Of the Influence of Consumption on Production, 1829). In other words, equilibrium is needed. If equilibrium is disturbed by monetary policies, as the Austrian School argues, then malinvestments, or ‘disproportionalities’ as early economists called them, emerge. In common parlance these malinvestments are called “imbalances”.
Unfortunately for economic policy these issues are not being debated. So long as economists confuse GDP with growth, argue for a “stable price rule”, teach that money is neutral and that it is possible for central banks to calculate a “neutral rate of interest” economies will be plagued by the so-called boom-and-bust cycle.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 20 March 2006