The U.S. economy is showing signs of finally bottoming out: Americans are on the move again after record numbers had stayed put, more young adults are leaving their parents’ homes to take a chance with college or the job market, once-sharp declines in births are leveling off and poverty is slowing. But the economy is still frail. Growth is has sunk below 2% and unemployment is stuck above 8%. Wall Street is looking up and Consumer Confidence is improving. Central bankers are at their printing presses, improving the mood generally. The Federal Reserve is buying mortgage-backed securities; The ECB promised to buy as much sovereign debt as necessary to quiet fears of a euro break-up; the Bank of Japan extended and expanded its asset-purchasing program by over $125 billion. Fear of inflation is justifiably nil. There is still spare capacity. The Fed clearly can do nothing about a slowing world economy and Europe sliding into recession.
Any forces holding back the recovery should be weakening. The process of deleveraging is well advanced. The housing market is showing signs of healing and housing prices are rising moderately. Consumers are feeling better off and banks appear to be more willing to lend.
Our biggest problem is fiscal policy. The economy can easily tip back into recession, if politicians do not come up with a medium-term plan that both raises revenues by reforming taxes and arrests the long-run growth of spending on entitlements.
The former British Prime Minister, Gordon Brown, writes that Europe may go the way of Japan, not Greece. The ECB will act as a lender of last resort, but that is not enough to keep Europe afloat. “This puts three steps firmly on the agenda: a fiscal union, a European finance ministry, and some form of Eurobond – the very questions Germany has tried to side-step.”
The sluggish global economy has again caused central banks to act, first with last month’s ECB bond-buying program and now with the Fed’s third round of quantitative easing. How is the new financial order shaping up?
First: Central banks will be huge players in the asset markets for the foreseeable future. The Fed is buying mortgage bonds, not Treasuries, this time but both the ECB and the Bank of England are still in the bond-buying business. This suggests that in the long run they will unwind these purchases, either by selling the bonds or by not buying them when they mature. But clearly we are nowhere near the point at which these programs can be reversed and unless the economy does become a lot stronger, it is hard to see how they can be. So when we talk about the “market reaction” to economic news, we need to be clear that bond prices are not set in a free market; they are set, in large part, by a huge non-profit maximizing public sector buyer.
Second, nominal interest rates are going to be at historic lows for the foreseeable future as well; the Fed extended its outlook from 2014 to 2015. If you are a cautious saver, you will get a low nominal and a negative real return. If you are a retiree forced to buy an annuity or a pension fund hedging its liability with government bonds, you will need a much bigger pool of savings to meet your chosen retirement income target.
Since savings are necessary for long-term economic growth, the result of this policy has been to undermine the trend growth rate. Or, low real interest rates are a sign that the economic outlook is poor, something the equity bulls ought to reflect on.
The household savings rate is too low, but the corporate sector have been hoarding cash and not investing, one reason why the government has been forced into deficit. But, of course, corporates are not investing because they are worried about the growth outlook. Governments could invest in infrastructure to offset their reluctance, especially the US with its low funding rate, but there is no sign that Congress will let that happen.
Central banks were granted much greater independence in the 1980s and 1990s because the politicians realized that was the only way to combat inflation. The boom that resulted made a temporary secular saint out of Alan Greenspan; both parties basked in his reflective glory. But can central banks operate with such freedom when their role is so politically controversial? It is a question that faces the ECB as well as the Fed, and it could be one of the big constitutional battles of the coming years.