As commentators worldwide have noticed, the global recovery since 2009 has been exceptionally weak. Books such as Stephen King’s “When the money runs out” (Yale, 2013) are now suggesting that the era of Western affluence is over. This reflects considerable writing in this column over the last few years; indeed I first mooted the idea as far back as 2004. Yet I would argue that much (though not all) of the rich world’s underperformance is due to exceptionally poor policies: monetary madness, fiscal profligacy and regulatory overload. The question to answer therefore is whether those mistakes will be undone in the near future, and if so, whether the Western economies and the world in general will return to rapid growth.
U.S. monetary policy has been excessively lax in terms of money supply growth since February 1995, when Fed chairman Alan Greenspan took the brakes off and allowed the dot-com bubble to gather steam. Since 2008, short-term interest rates have been set at zero and the Fed has pumped increasing amounts of money into the system in the form of Treasury and housing agency bond purchases.
The housing agency bond purchases, justified as a special measure to allow the housing market to recover, look especially egregious this month, since the National Association of Homebuilders Confidence Index is now standing at 57, which isn’t as it seems a near-neutral reading but is equal to its level in January 2006 when the housing bubble was at its height. The federal government already through guarantees and tax benefits distorts the market for this economically unproductive asset, so goosing its financing through Fed purchases makes the subsidy even more excessive. Cheap real estate is a key competitive advantage that allows American businesses to run at much lower costs than their European competitors; by driving up house prices the Fed is making the economy less competitive, encouraging outsourcing and in the long run raising unemployment.
There however seems little likelihood of an early reversal of the Greenspan/Bernanke easy money policy. Even the most hawkish Federal Open Market Committee members see rates at maybe 1% by the middle of 2015. Given that inflation is running at around 2% and accelerating that offers little likelihood of a positive real short-term rate of interest anytime soon. With savers being salami-sliced out of their wealth, as they have been now for almost two decades, the destruction of the once overwhelmingly bountiful U.S. capital base must continue. Only a market crisis can cause a change of policy; I will discuss later the likelihood of such a crisis.
Fiscally, the last five years have introduced trillion dollar deficits, though the figure this year is likely to be a mere $600 billion or so. The “fiscal cliff” at the end of last year and the “sequester” in March have trimmed a little off the deficits, but there is currently no appetite whatever to continue the trimming process and every indication, from the latest House farm bill, for example, that the next year will be one of backsliding. Like current monetary policy, current fiscal policy has been immensely economically damaging, but only a crisis will reverse it.
Regulatory policy is the third and least noticed of the government-driven leeches that have suckled the blood out of the U.S. and global economies. For any given regulation, you can calculate its costs, and the numbers are often frighteningly large. The delay in the Keystone XL pipeline, for example, costs $8 million per day – the cost differential between U.S. and Canadian oil prices for its carrying capacity. The new EPA regulation that will force the closure of coal fired power stations will cost the U.S. economy about $27 billion a year – the differential between the cost of coal generated electricity and that of electricity from natural gas, the next cheapest source.
As I have written previously, it is not a coincidence that the surge in U.S. regulation in the early 1970s coincided with a fall in the country’s annual average productivity growth rate from 2.8% to 1.8%. On a more micro level, it is not a coincidence that the two most notable periods of U.S. economic underperformance were the Carter administration of 1977-81 and the Obama administration, the two periods when regulators were allowed to run most rampant. You can’t blame President Obama alone for the last five years’ monetary and fiscal failings; his execrable predecessor, who appointed Ben Bernanke to the Fed, had at least as much to do with them. However the regulatory sludge that has been inserted into the works of the U.S. economy can squarely be laid at the door of this President. Unlike the first two failings, this one won’t be reversed by any crisis; it will have to await a turn in the electoral cycle – and a deregulating President with the courage of his convictions thereafter.
Both in the U.S. and Europe, regulatory costs have been greatly exacerbated by global warming hysteria, which has allowed regulators and special interest groups free rein to extract rents from taxpayers and the economy in general. The U.S. ethanol mandate, which has caused ethanol permits to multiply in value 20-fold this year, the plethora of inefficient, hugely subsidized windmills, especially in the wind-mad U.K., and the explosion followed by collapse in the solar power sector (an example of malinvestment if ever there was one) have between them imposed immense costs on the U.S. and global economy, wrecking the German steel industry and numerous other productive sectors.
Fortunately for our long-term future, a market crisis is likely within the next 12-18 months, although I don’t think it is imminent. Bond yields have forced themselves upwards in the last few months from around 1.6% on 10-year Treasuries to around 2.6% before reversing themselves. I believe this is simply the first mild leg of a long upward movement, which will restore real yields to a level probably somewhat above the historic average of 2-2.5%, because of the drain of capital that has occurred over the last couple of decades. Ben Bernanke at his questioning last week was asked how he would stop a spike in interest rates; he responded “By communicating.” That won’t do it, Ben. Inflation is also showing signs of resurgence, which will itself cause bond yields to adjust.
The crisis will be triggered by a sharp rise in long-term interest rates, which Bernanke will be unable to prevent. This will cause a stock market crash, probably to below the 8300 Dow that is the equivalent of the Dow’s early 1995 level, adjusted for nominal GDP growth. In turn, these twin crashes will cause a rash of bankruptcies and a relapse in the housing market, which has recovered altogether too vigorously, having been given too much artificial “stimulus.” The triple crash in bonds, stocks and housing, together with a global liquidity crisis affecting emerging markets in particular, will cause a return to a fairly deep recession.
At that point there will be a decent chance of policy reversal. With long-term interest rates higher, a zero Federal Funds rate will no longer be tenable without a rapid increase in inflation. With any luck, a bond market crisis like that of 1979 will force out Bernanke or his soft-money successor, and force their replacement by a hard-money representative such as former Fed vice-Chairman Roger Ferguson. As for fiscal policy, a crash in the bond market will make the Federal deficit very difficult to finance, so austerity will be forced upon the political class.
In other words, the policies of Walter Bagehot (lend freely in a crisis, but at high rates) and Ludwig von Mises (liquidate malinvestment in a recession, and do not attempt to stimulate by further malinvestment) will be adopted willy-nilly. Alas, assuming the recession hits this side of 2016 the regulatory state will not be similarly reformed; instead the crisis is likely to be met by a further round of expensive and misguided regulation. However at least partial policy reform will probably occur.
Will it work? That’s a more difficult question. A combination of Andrew Mellon at Treasury, Paul Volcker at the Fed and Calvin Coolidge in the White House, bringing Vermont thrift and common sense to the regulators could, given ten years in power, doubtless rebuild the U.S. savings base, reduce the burdens of its public debt and deficits and liberate the economy from the kudzu of regulation that has strangled it. Even though the U.S. would still be competing with emerging markets with lower labor costs, substantial capital bases and excellent global communications, that would probably be enough to rebuild U.S. economic strength.
However the pre-condition of Mellon, Volcker and Coolidge with a decade of uninterrupted power indicates that success is pretty unlikely. Much more likely is a monetary policy that tightens only modestly, leaving interest rates still too low to rebuild U.S. savings. Also likely is a fiscal policy that raises taxes too much and does the bare minimum on spending (leaving the actuarial nightmare of entitlement programs to worsen the long-term picture). Finally we will at best get a regulatory environment that provides only temporary relief, leaving tens of thousands of dedicated regulators in place to continue their economic depredations, based on new half-baked theories, once the politicalpressure is off.
The collapse of the American Empire is not necessarily imminent – that of Rome took 300 years, after all. But at the very least, the U.S. Age of the Antonines is almost certainly behind us.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)