On Tuesday morning, I attended a breakfast with Joseph Stiglitz that was both fascinating and gloomy. Stiglitz, who was formerly the senior adviser to Bill Clinton, Chief Economist at the World Bank, and was awarded the Nobel prize for Economics in 2001, shared his views on the state of the US and global economy and discussed some of the key themes in his new book Freefall. Stiglitz’s views are mentioned in brief below.
Consumption forms the majority of economic growth in the US, and a sustainable recovery needs consumers to spend. However consumers can’t consume if they’re saddled with too much debt. There are three solutions to this:
1) Bankruptcy. Defaulting on outstanding debts would reduce the burden, thus allowing spending to rise. However banks clearly don’t want that, and most certainly can’t afford it.
2) Inflation. This is also not likely, as central banks won’t allow it. Plus, in practice, inflating your way out of debt problems doesn’t really work – countries typically have a lot of short term debt, and as soon as markets get a whiff of an inflationary policy, short term bond yields will rise, thus making the cost of debt more expensive. In fact the worst thing for central banks is if markets believe that there’s a risk of inflation even if the central bank has no desire to inflate its way out of a debt problem, since this results in the cost of debt rising without the accompanying benefit of inflation (no wonder, therefore, that US policy makers continue to stress the downside risk to inflation, whether they actually believe it or not)
3) Muddle through. This is the most likely outcome, is what the authorities seem to be doing now, and the implications are a low growth rate for a prolonged period.
In his view, the US unemployment rate is likely to remain elevated. The budget office doesn’t expect unemployment to return to normal levels until at least the middle of this decade, and that’s based on what some might argue is an overly optimistic real growth rate of 3% per annum. In addition, the official unemployment rate is underestimating the ‘true’ figure – if you add in all the Americans who actually want a job but can’t get one, the number is almost 20%. Furthermore, about 40% of people in the US have been unemployed for more than six months, which is something that Europe’s used to, but hasn’t been experienced in the US in modern times. The effects of the labour market crisis are likely to be exacerbated and long lasting because this financial crisis has come at a time when US labour is at a particularly vulnerable phase. Just as in the Great Depression, when the US economy was transitioning from one based on agriculture to one based on manufacturing, this crisis has hit as the US economy is transforming from one based on manufacturing to one based on the service industry.
Labour market aside, he believes that the US economy is facing two huge underlying macroeconomic problems, the first being a weakness in global aggregate demand brought about by a very high saving rate in the emerging countries, and the second being mounting inequality between the rich and the poor. The apparent solution to the latter problem was to encourage people on low incomes to spend more and save less, resulting in an unsustainable savings rate of zero, and which has clearly now backfired.
Stiglitz also touched on exit strategies. Something that’s very important but hasn’t yet received sufficient attention is the effect of Federal Reserve ending its purchase of mortgages. The Fed’s balance sheet has swelled from $800bn to about $2tn, and it has bought almost all mortgages issued in the US over the past year. The Fed will go from buying almost the whole market to buying none, and surely this will result in mortgage rates rising, which is clearly bad news for the housing market and for the already depressed commercial real estate market. The most likely outcome for the US economy is a ‘double dip’ – not necessarily one that returns the economy to recession outright, but a slowdown in US growth.
There were numerous additional pieces of information that warrant a mention. I wasn’t aware that (according to Stiglitz) Paul Volcker was fired by Ronald Reagan. Despite Volcker’s excellent track record in bringing inflation under control in the 1980s, the bankers wanted someone to repeal Glass-Steagall and ultimately the bankers had their way. Reagan turned to Alan Greenspan as someone who strongly believed in deregulation. Greenspan succeeded in controlling inflation, although in Stiglitz’s view it wasn’t particularly due to Greenspan’s policies – the main credit goes to China. Greenspan has been blamed for a lot of what has happened over the past couple of years, but it’s not solely Greenspan’s fault – if it hadn’t been Alan Greenspan, it would have been anyone else who believed in deregulation to meet the political will at the time when Greenspan was appointed.
Stiglitz also discussed a favourite topic of his, on how a lack of regulation led to inappropriate incentive structures in banks, which led to bad behaviour. The banks’ job is to efficiently allocate capital, manage risk, and reduce transaction costs, thus resulting in higher productivity. But 40% of corporate profits went to banks at a time when real wage growth was flat for a whole decade – banks stopped being the ‘means’, and became the ‘end’. Banks were allowed to become not only too big to fail, but too correlated to fail. Saving the banks has been a social cost, but a private gain. This isn’t acceptable – the cost should be carried by the financial sector.
So radical reforms are necessary, and greater stimulus is needed, not least to support the labour market. If you are keen to read more of Joseph Stiglitz’s thoughts, then I have a signed copy of his book Freefall. The person who is closest to guessing where Greece 5y CDS is at the close of Monday 15th February wins (we’re taking the GCDS page on Bloomberg). To give you a guide, it started this year at 283, mounting credit concerns meant that it closed at 426bps on Monday this week, before rumours of a bail out saw it close at 375 on Tuesday 9th February.
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