June 27, 2003

Out of Gas

Stephen Roach meditates on the gap between what the Federal Reserve wants the American economy to do--grow at 4 percent per year for a couple of years or so--and the tools at the Federal Reserve's disposal:

Morgan Stanley: ...Since the equity bubble popped in early 2000, the US economy has been on an anemic 1.7% annualized growth path. That includes a mild recession in the first three quarters of 2001 and an unusually subpar recovery in the subsequent seven quarters. Significantly, the post-bubble growth pace has been well below America?s productivity-driven potential growth rate that most put in the 3.25% to 3.75% zone. The result is the emergence of a wide margin of slack between aggregate supply and demand. For a US economy that entered this post-bubble business cycle at a 2.25% inflation rate, this slack has been sufficient to push the US dangerously close to the deflation threshold; in the first five months of 2003, annualized core CPI inflation has averaged just 1.2%. Little wonder the most common complaint heard from US businesses pertains to the lack of pricing leverage. In this context, the Fed?s goal is simple -- to get the economic growth rate back above its long term potential and hold it there for a sustained period of time. Only then will the gap between aggregate supply and demand start to narrow and deflationary pressures be arrested. At the liberty of being overly precise, I would translate the Fed?s anti-deflation objective as pushing the economy from a 1.7% growth path to a 4% trajectory -- and keeping it there for at least a couple of years.

The Fed has been unusually aggressive in attempting to achieve that objective. Thirteen easings over the past 30 months and 550 basis points later, however, the central bank has little to show for its noble efforts. It?s not the lags, in my view. By now, all conventional macro models would have expected the ?policy multipliers? to have delivered -- not just on the basis of monetary stimulus but also in response to the Bush Administration?s first round of fiscal stimulus implemented in early 2001. Sure, there were several special circumstances that temporarily got in the way -- namely, the terrorist attacks of September 11, 2001 and the more recent war in Iraq. But in the aftermath of each of those disruptions, the US economy has failed to spring back. If policy stimulus was achieving the traction that traditional macro called for, there should have been a powerful post-shock snapback in each instance. But there wasn?t...

Posted by DeLong at June 27, 2003 06:17 AM | TrackBack


We are in an interesting economic pickle. Coming off a stock market bubble, we experience a major terrorist attack and two wars. This puts a lot of strain on our monetary policy to maintain growth. Then long term political expediency probably removes the potential short term benefit of our fiscal policy.

On the export side, the U.S. has been the growth engine for the world economy over the last 15-20 years. Instead of using the time to fix their economic problems so that they can grow internally, most of the world's polticians have put off pain and simply exported to the U.S. for growth. In order to drive this export binge, the U.S. has to borrow tons of foreign money. These countries have to give us money to buy their products or else their currencies would appreciate making their exports less competitive.

The impact has been especially acute for our manufacturers since manufactures are largely tradable items. They are under severe price pressure. Unfortunately, if our currency declines enough to give them pricing power most of the major world economies will fall into the deflationary abyss.

Posted by: Stan on June 27, 2003 08:44 AM

Nice of them to credit the administration with pushing a "fiscal stimulus" in 2001, but from what I've read it wasn't terribly difficult to predict that the tax cuts enacted -- which went primarily to the upper-middle classes -- would have little effect.

I must admit to some surprise that they had essentially no effect at all. But I don't recall anyone respectable saying they thought the cuts would have a big impact, or that we couldn't get far more "bang for the buck" by doing other things with the money.

The big question, I think, is whether this will put to bed permanently claims that tax cuts are a cure-all for the economy, or even very useful as an economic stimulus. At the very least, "voodoo" supply-side economics should be dead and buried.

However, the capacity of the right wing to promote thoroughly discredited ideas is thus far unlimited, so I would imagine hope would be premature in this area...

Posted by: Jonathan on June 27, 2003 08:55 AM

So what's the solution? C is maxed out, capacity utilization is low and trending lower so I isn't going anywhere, and G isn't likely to do anything paticularly helpfull either. Plus with total debt now 300% of GDP, who's going to borrow? Popular songs from 1929: "Happy Days are Here Again" & "I'll Get By".

Posted by: brian on June 27, 2003 09:27 AM

I don't see how likely the Fed is to be able to solve this problem. To eat up all the excess capacity in the economy is going to take a real fiscal stimulus package to stimulate consumer spending. Instead the Presidents fiscal package of tax cuts seems tailored to try and spur investment (while lining the pockets of the wealthy) and in a case of excess capacity from the last expansion, I don't see how additional investment is going to help.

Posted by: Lorenzo on June 27, 2003 09:55 AM

Remember, Japan entered an extended period of slow growth with ample private savings. We are in a slow growth period with scant private savings, a balance of payments deficit, and a government deficit that will grwo about $400 billion yearly as long as can be envisioned.

The stock market is telling us all is well and a boom is anticipated, for stocks are amazingly pricey. The economy had better boom, but I am doubtful.

Posted by: anne on June 27, 2003 10:28 AM

"The Presidents fiscal package of tax cuts seems tailored to try and spur investment."

Wish I could agree. The investment incentive seems minimal. An additional small business write-off will have a small effect. What else? The dividend and capital gains tax cuts make stock holding in taxable accounts more attractive for the wealthiest investors. But, I do not find much investment incentive.

Posted by: lise on June 27, 2003 10:53 AM

Well, I meant the usual conservative line of tax cuts for the rich being good for the economy because they invest rather than consume.

Posted by: Lorenzo on June 27, 2003 11:37 AM

Please - I am not an economist.

Does increased saving mean increased investment? The rich household will have a large tax cut and is likely to save a larger percent of the cut than a middle income household. Does that mean this saving is investment? Suppose I buy shares of already issued stock or bonds with my tax cut, does that spur growth?

Posted by: emma on June 27, 2003 12:36 PM

Maybe I'm the ony one who thinks this, but considering the aftershocks of the March 2000 bursting of the bubble and extraordinary geopolitical risk since September 2001, it seems to me the performance of the economy isn't so bad at all. The policy mix has even been pretty decent, with interest sensitive sectors of the economy and government spending partially offsetting weak investment and an overly strong dollar for much of this period. And speaking of the dollar and our apparent current account weakness, what's so bad about having Europeans and Japanese finding no better place to invest than the United States?

Posted by: Jim Harris on June 27, 2003 12:39 PM

"The policy mix has even been pretty decent."

The fiscal policy mix has been terrible. With astonishing speed we went from an enviable suplus to deficits that will sorely strain all social service spending just when such spending is most needed as the baby boom generation turns past 60.

The tax cut of 2001 has been followed with a loss of 3 million private sector jobs, and the combined tax cuts have grossly favored those who least need tax cuts.

Fiscal policy has been terrible.

Posted by: dahl on June 27, 2003 01:15 PM

More dollars saved in a bank or put in the stock market would spur growth only if we didn't have enough such investment to begin with.

Unfortunately, the problem we're facing right now seems to be an overabundance of supply, and too little demand to make use of it.


Posted by: Jonathan on June 27, 2003 01:23 PM

For all those of you lamenting the dearth of investment opportunity, I could use a few million dollars to expand my booming business even faster. Just contact me and I'll tell you where to mail your checks.

Posted by: Patrick R. Sullivan on June 27, 2003 01:38 PM

Jim, growth may exist but we are really at risk if we have another shock. On the foreign investment front, Europeans and Japanese aren't sending money here because we are in great shape. Deficits do matter. We are just relatively less bad.

Posted by: Stan on June 27, 2003 02:03 PM

From what I can see the recently received tax
cuts by the rich are being funneled back into
the re-election campaign of aWol. Where's the
stimulous in that?

Posted by: Bart on June 27, 2003 07:06 PM

"Deficits do matter. We are just relatively less bad."

Deficits do matter, and we have a great balance of payments deficit that must be financed from abroad to support the dollar and continued American spending on imports. There has actually been a pronounced lessening of long term foreign investment in our economy. There is a financing of our imports however, from China to Germany. We can well envy the balance of payments situation in Japan and the Euro countries.

Posted by: anne on June 28, 2003 09:48 AM

Jim Harris is right when he remarks above that: "considering the aftershocks of the March 2000 bursting of the bubble and extraordinary geopolitical risk since September 2001, it seems to me the performance of the economy isn't so bad at all". Unfortunately Stan is also right when he replies: "Jim, growth may exist but we are really at risk if we have another shock."

Stock market valuations are still extremely high (i.e at what have historically been peak levels) and all of the Fed's ammunition (apart from very risky, possibly destabilising moves) has now been committed without restoring growth. In this context even one more shock is liable to produce a devastating downturn in confidence (a.k.a. a medium to large 'panic').

Shocks capable of triggering this occur quite routinely and not infrequently (recently 1-2X a year), and are usually overcome. Over the next year, or even two, I'm afraid this will not be so easy or so likely.

If you boil down Roach's "on the one hand, on the other hand economist-speak" to derive the residue, the implicitly projected most-likely outcome, it's starkly negative.

Posted by: JK on June 28, 2003 09:33 PM

Step up to the plate. Starting in January of 2001 what would have been the ideal blend of monetary and fiscal policy? What could have been the best outcome for July 2003? Please include deficit, employment rate and GDP growth rate numbers.

As a bonus, please suggest how best to increase median income or median hourly compensation.

Posted by: CMike on June 29, 2003 12:35 AM

Is there any economic mathematical truth in for every action there is an equal and opposite reaction? In other words, is the uncontrollable inflation of the early 70's through 80's corresponding to the baby boomer entry into the job market going to be reversed with an equal uncontrollable deflation beginning now as we have to send our kids to college and then go into retirement? How are we going to support our retirees without deflation if there is such a low worker/retiree ratio, no economic growth, nothing to invest in so you are using your principle almost from day one into retirement? How tough is it going to be for kids to go to college with rising college costs and an ever shrinking scholarship funds on 1-2% interest? Are we going to be working until we die? That's what it seems like. My Mom is working still, and she is 70 years old but this crashing of investment income from low interest rates has hit them hard.

I think a lot of people are not so worry-free about our ability to recover from disasters. I know the twin towers blowup was terrible but maybe one of its main effects was for people to realize vulnerablity. Besides the human cost, that was a heavy load on the insurance industry, and that was just a few buildings in a very big country. It doesn't have to just be terrorism, we could also ask ourselves how could the country absorb something like another big big hurricane like the one in 1960 pounding away at all those million dollar mansions and condos sitting on the Florida coastline. Do you think those people are going to accept anything less than full value for their property and if the insurance goes bankrupt, the government must pay them? I think that is why our house insurance has gone up so much, because they are trying to build up their reserves.

And then possibly are there some demographic/behavioral changes going on in respect to women that I wonder if they are significant in the economy. Someone told me that there are now more married women with children staying home with their families than since the 70's. Is this true? If so, doesn't this mean that the economy could shrink somewhat as there are fewer service jobs in day care and home services, and possibly restaurant meals?

Posted by: northernLights on June 29, 2003 01:20 AM

Question for you all: which of the following ways of spending a tax cut would be most economy-enhancing?

I could:
* Send it to Wall Street and invest it in a mutual fund or money market fund.

* Leave it in my checking account or savings account.

* Make a big-ticket purchase (spend it all on one thing: a used car, a TV, an air conditioner)

* Buy a large number of small things (books, CDs, dinners out).

* Spend it in the underground economy: panhandlers, cigarette smuggling, drugs, hookers, illegal immigrant babysitting or lawn care services, whatever.

* Maybe start a small business, like a lemonade stand or a bake sale? What about an illegal business-- a few hundred bucks smuggles a fair number of cigarettes from Virginia to NYC....

Posted by: Verbal on June 30, 2003 09:09 AM
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