Richard Alford: Counter-Cyclical Follies

Below is a piece from Dick Alford that continues the line of analysis in the item we published last week, "Dick Alford on the FOMC: Watch what they say."  We say watch what the members of the FOMC do, not what they say.  The former is an exercise in futility, while the latter is merely ridiculous.  One of the rights of a free people is to follow policies that make no sense at all.  Happy Independence Day.  --  Chris

The policy perspectives and stances of many economists and policy makers have evolved since the advent of the financial crisis and the great recession.  The downturn is increasingly viewed as “balance sheet recession”.  Given the supposed balance sheet aspect of the recession, monetary policy is increasingly viewed as incapable of providing the required stimulus.  Many proponents of the balance sheet perspective advocate the use of fiscal stimulus, which they argue remains effective despite the “balance sheet” aspects of the recession and the zero interest rate bound on monetary policy.

Recently, however, increasing numbers of economists, market participants and some members of the US policy establishment have come to a greater appreciation of the role of globalization on US economic performance.  They view globalization and the US policy response to it as the cause of the US asset price bubbles and hence the balance sheet nature of this “recession”.  This perspective also implies that counter-cyclical fiscal and monetary policies do not address the cause of the under-performance of the US economy and hence are not solutions.

Recognizing globalization as the source of the current economic and financial malaise does not replace the “balance sheet” view, but rather incorporates and expands on it.  While the balance sheet recession perspective suggests limits to the effectiveness of monetary policy, it neither explains the asset price bubbles which contributed to the “balance sheet” effect nor the concentration of job losses in the manufacturing/tradables sector.  On the other hand, the global perspective and the US policy response to it explains the asset price bubbles, and the “balance sheet” affect on economic performance both pre-and post-crisis and the pattern of job losses.  The focus on the international dimension also reveals limits to the effectiveness of both monetary and fiscal policies in promoting sustainable growth with full employment.  It implies that any return to sustainable growth will entail taking steps to actively promote the rebalancing of the US economy—increasing exports, investment and savings relative to income while decreasing consumption and imports relative to income.

Globalization and US Policy

Recent comments by William Dudley, Janet Yellen, Dean Baker, William Gross, and Nobel laureate Michael Spence among others present a compelling argument that can explain the evolution of the economy and policy since at least the mid-1990s. The argument can explain:

1.       1.the failure of all the expansionary monetary and policy since the mid 1990s to achieve sustained job and macro economic growth;

2.       2.the appearance of the current balance sheet recession in the US;

3.       3.the decline of the tradable goods sector and manufacturing jobs along with it.

In a recent speech, Dudley linked globalization and unsustainable patterns of trade to declines in US inflation and downward pressure on employment:

“…even before the crisis, it was evident that the relationship between developed and emerging economies was becoming strained and needed to be adjusted; the status quo would clearly be unsustainable. Consider, for example, the economic relationships between the United States and China that prevailed over the past decade or so.

Some experts have summarized the arrangements as follows. The United States bought Chinese exports at low prices, which bolstered U.S. living standards and held down U.S. inflation. The United States did not take extreme steps to try to force China to revalue the renminbi upward against the dollar, and China, in turn, invested its trade surplus and capital inflows into U.S. Treasuries in order to keep the renminbi from appreciating too rapidly. The U.S. terms of trade improved as the cost of imported goods dropped, and U.S. interest rates stayed relatively low as China recycled its trade surpluses back into U.S. financial assets. For China, the benefits included strong economic growth, technology transfer and the creation of many manufacturing jobs. These developments, in turn, helped foster rising living standards and political stability in China.”

Dudley links the global developments to the US policy response, which included “a sustained period of very low and stable yields”:

“Although the pre-crisis arrangements worked reasonably well for a while, the flaws became increasingly evident over time. Looked at from the lens of the developed world, the combination of rapid gains in production capacity and relatively repressed consumption in the EME world helped foster a global deficiency of demand relative to supply. In these circumstances, the United States and many other industrialized economies had to sustain domestic demand at elevated levels in order to achieve "full employment" and prevent deflation.”

He spells out the results of the “had to” policy response:

“For the United States, the consequence was elevated consumption facilitated by asset price inflation, easy underwriting standards for credit and structural budget deficits….”

In a recent speech, Yellen also linked sustained periods of low yields with financial imbalances and disorderly unwinds with negative implications for the real economy:

“..But may incent a phenomenon commonly referred to as "reaching for yield," in which investors seek higher returns by purchasing assets with greater duration or increased credit risk…

The shift toward riskier assets is a normal channel through which monetary policy supports economic activity. But taken too far, this dynamic has the potential to facilitate the emergence of financial imbalances. For example, with interest rates at very low levels for a long period of time, and in an environment of low volatility, investors, banks, and other market participants may become complacent about interest rate risk.  Similarly, in such an environment, investors holding assets which entail exposure to greater credit risk may not fully appreciate, or demand proper compensation for, potential losses. Finally, investors may seek to boost returns by employing additional leverage, which can amplify interest rate and credit risk as well as make exposures less transparent…

One of the lessons of the financial crisis was that the potential adverse effects of a rapid unwinding of financial imbalances, regardless of the causes, are significantly increased if market participants employ significant leverage..

… leverage had profound consequences when sentiment changed. Lenders who had financed securities, either directly in the repo market or through structured vehicles, were suddenly no longer comfortable with the collateral and were unsure of their potential exposure to losses…. the result was a rapid and disorderly unwinding, over just weeks or months, of a very complicated system that had taken years to evolve.

From this perspective, the asset price bubbles, the unsustainabilities in consumption and real estate investment, and the excessive use of credit and leverage were the result of globalization and the US policy response to it.  The interest rate stance and fiscal stimulus masked the immediate impact of globalization on US prices, incomes and overall employment but set the stage for the financial crisis, the secular decline of jobs in the tradables sector, and the current recession.

Returning to Dudley:

                “…It is clear that the pre-crisis formula for global growth was not sustainable. This is obvious in the case of industrialized nations where private consumption and fiscal deficits reached unsustainable levels and needed to be cut back.”

The asset price bubbles, the financial crisis and the” balance sheet” recession were not the inevitable result of globalization.  There were policy alternatives to the “had to” response.  Dudley expressed it this way:

“.. if the United States had adopted different policies, it might have shifted the composition of growth toward more business investment and less consumption and housing.”

Dudley cites the continued need to rebalance:

“Ultimately, the composition of economic activity in the United States needs to be rebalanced. There are two issues here. First, the consumption share of GDP may still be too high. Second, the need for U.S. fiscal consolidation implies that there will have to be offsetting increases in investment and the U.S. trade balance as the recovery proceeds.”

The unresolved international and domestic unsustainabilities imply that this is not a standard or “balance sheet” driven recession the cause for which can be corrected by stimulative measures.  Dudley again:

“On the U.S. side, the recovery remains distinctly subpar in spite of aggressive monetary and fiscal stimulus. On the monetary policy front, short-term rates remain near zero and the Federal Reserve is just about to complete its $600 billion Treasury purchase program. On the fiscal policy front, the U.S. government has engaged in large stimulus program. This supported demand and employment while the private sector shifted its saving balance into surplus in an effort to repair balance sheets.”

Dudley cites two problems with a fiscal policy response to the continuing under-performance of the economy.  First:

“…the large size of the fiscal deficit and the rapid increase in the country's federal debt-to-GDP ratio means that this is not sustainable for much longer.”

Second, offsetting the private sector shifting its balance into surplus by having the public balance sheet deteriorate does not restore external balance.   Once the necessity of rebalancing is recognized, it becomes apparent that stimulative counter-cyclical monetary and fiscal policies alone are not sufficient to restore sustainable growth at full employment in the face structural external deficits.  Dudley again:

“We, as a nation, have to take steps that facilitate the needed structural adjustment of U.S. economic activity that will position us to thrive in the next chapter of global economic transformation. We need to make sure the next business cycle will be more sustainable than the last, which was built on an unstable foundation of asset price gains, easy credit and outsized financial-sector profits.

This will require a shift in orientation from consumption to export and investment-led growth. As EMEs have shown us, comparative advantage and global competitiveness are not inevitable consequences of factor endowments—they are the result of the choices we make as nations.”

A number of economists and market participant outside of officialdom have also commented on the structural dimension of the current recession.  In a response to an Op-Ed by former President Clinton, Dean Baker points out the link between the trade sector and the secular decline of jobs in manufacturing.

First, it is true that the economy lost manufacturing jobs in the eight years after President Clinton left office, but the job loss began in his last three years in office… 

It is true that the pace of job loss picked up after Clinton left office, but this was due first and foremost to the recession caused by the collapse of the stock bubble… As a result of the collapse of the stock bubble, the country had at the time the longest period without job growth since the Great Depression. It only began to create jobs again once the housing bubble began to fuel a construction and consumption boom.

… if President Clinton paid attention to economic data he would have noticed that not only were we losing manufacturing jobs during his last three years in office, but the trade deficit was soaring. The trade deficit grew from just over 1 percent of GDP in 1996 to over 4.0 percent of GDP by the 4th quarter of 2000.”

In his July Investment Outlook, Bill Gross had this to say:

“Over the past 10 years under both Democratic and Republican administrations, only 1.8 million jobs have been created while the available labor force has grown by over 15 million. It is clear, however, that neither party has an awareness of the why or the wherefores of how to put America back to work again. Few economic advisors from either party ever mention structural long-term disconnects in employment – a recognition that cyclical influences will no longer dominate the U.S. labor market. Manufacturing and goods exports have ceded enormous ground to China and other developing labor markets, as America’s reliance on services and high tech innovation has exposed gaping holes in an historically successful model.

..The past several decades have witnessed an erosion of our manufacturing base in exchange for a reliance on wealth creation via financial assets. Now, as that road approaches a dead-end cul-de-sac via interest rates that can go no lower, we are left untrained, underinvested and overindebted relative to our global competitors. The precipitating cause of our structural employment break is both internal neglect and external competition. Blame us. Blame them. There’s plenty of blame to go around.”

Gross proposes a three-pronged response.  Two of Gross’s three proposed remedies address structural problems with the government providing short-term support to the labor market.  The development of a trade policy is one of the structural remedies:

“And how about at least an intelligent discussion on “trade policy” which incorporates more than just a symbolic bashing of Chinese currency relative to the dollar. Who, from either side of the aisle is willing to discuss the use of trade measures in order to help balance our $500 billion trade deficit? This is delicate territory, reawakening fears of Smoot-Hawley in the 1930s, but we are in delicate territory regarding our unemployment rate as well.”

In a recent WSJ OP-Ed piece Spence gets right to the point:

“To address the jobs challenge, we must stop pretending that this is only a difficult cyclical recovery. The root of the problem is structural.

… During the two decades before the crisis of 2008-09, the U.S. economy added 27 million jobs, primarily in government, health care, construction, retail and hospitality. This employment growth was almost all in the "nontradable" side of the economy—sectors generating goods and services that must be consumed where they are produced.

… The "tradable" side of the economy (which includes exportable goods and services) has its own set of issues. While finance, consulting, computer design and managing complex international businesses all fueled job growth for 20 years, these gains were matched by declines in the manufacturing jobs held by the middle class.….

Growth may be coming back slowly, but it is not bringing jobs with it.”

Spence focuses on the international aspect of the jobs challenge and the limitation of stimulus policy alone

“Nontradable job growth can’t mask the declines in the tradable sector any more. A stimulus package that temporarily restores elements of precrisis demand is unlikely to generate the escape velocity needed to get out of the jobs hole. The structural problem demands a structural answer.”

Spence and Gross share common ground.  They see the necessity of structural adjustment and near-term continuance of demand-maintaining stimulus with a planned return to fiscal balance.  Spence again:

“Can business, government, educators and labor come together to tackle the structural employment challenge head-on? Some will say that in the present political and fiscal climate, this is highly unlikely. They may be right. But it is a choice, a collective choice. We can invest in future growth and employment of an inclusive kind, or not. If we do, it will take significant shared sacrifice.

…These structural solutions won't work, of course, without a plan to restore fiscal balance. “

This brings us back to a point made by Dudley: the simultaneous existence of offsetting external and domestic imbalances did not arise by chance.  Given the continued existence of an external structural deficit, the US will be unable to achieve full employment without a corresponding large shortfall of public and or private savings.  Expansionary policy can generate offsetting imbalances, but cannot correct the external imbalances.  Furthermore, it is likely to encourage the growth of the external deficit absolutely and relative to GDP.


Monetary and fiscal policies, independently or in tandem, are not panaceas.  They have been oversold and over used.

The current economic malaise has both a cyclical and structural elements.  While there is a role for fiscal and monetary stimulus in addressing the malaise, stimulative policies alone cannot return the US to self-sustaining growth with full employment.  We cannot simply “spend” our way to full employment and then exercise fiscal discipline and remain at full employment.

Achieving full sustainable full employment and rebalancing the economy are intertwined.

Policymakers and elected officials must demonstrate leadership and institute policy responses aimed reducing the imbalances and unsustainabilities.  A partial list of required policy changes includes:

1.      effective Dollar and trade policies

2.       a tax code that a)does not discourage savings and investment relative to consumption  and  b) does not disadvantages US produced tradables relative to their competitors

3.       a political process in which at least the obvious and costly mistakes, e.g. ethanol subsidy, are corrected

4.       an energy policy that reduces dependency on foreign sources but allows US tradables to successfully compete.

5.       an effective system of financial regulation.