Fed Watch: Denying the Great Adjustment

Tim Duy's latest Fed Watch looks at growing international imbalances that have "US and emerging market policy makers on a collision course":

Denying the Great Adjustment, by Tim Duy: While not always the dominant force in my outlook, the external imbalance consistently lurks in the background of the US economy. I tell local audiences that the imbalance represents a very simple reality – the US consumes more than it produces, and the excessive consumption is provided by foreign producers. Eventually, maybe tomorrow, maybe years from now, those producers will desire to consume their own domestic output. At that point, US consumption and production will have to fall into line via a possibly painful restructuring. The more painful, the more policymakers will resist.

It is interesting to reference this framework in light of recent policy talk, kicked off by Federal Reserve Vice Chair Donald Kohn:

..in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability.

Next up was Lawrence Summers, former Secretary of the US Treasury:

Third, policymakers need to make a clear commitment to addressing the non-monetary factors causing inflation concerns. Though this could change rapidly and vigilance is necessary, it does not now appear that there are embedded expectations of a continuing wage price spiral. Rather, the primary source of inflation concern is increases in the price of oil, food and other commodities. Even if structural measures to address these issues do not have an immediate impact on commodity prices, they may serve to address medium-term inflation expectations. Appropriate steps include reform of misguided ethanol subsidies that distort grain markets to minimal environmental benefit, allowing farm land now being conserved to be planted; measures to promote the use of natural gas; and reform of Strategic Petroleum Reserve Policy to encourage swaps at times when the market is indicating short supply. Major importance should be attached to encouraging the reduction or elimination of energy subsidies in the developing world.

Unlike Kohn, Summers dances around the monetary causes of inflation, and engages in some domestic policy criticism, but puts “major” importance on reducing energy consumption in emerging markets. Finally (at least from the US), we have Federal Reserve Governor Frederic Mishkin:

One important factor behind developments in recent years has been the rapid growth in emerging market economies such as China. On the one hand, rapid growth in Asia has stimulated strong increases in import demand, cushioning the slowdowns in the United States, Europe and Japan, but on the other hand, the rapid growth in demand has pushed up prices for commodities that are in short supply. Thus, inflation rates in many emerging economies have risen sharply. The central banks in most parts of the world are at a crucial juncture: We must all be vigilant to keep inflation expectations anchored and inflation low.

Mishkin is a bit more charitable than Kohn, noting the benefits of strong growth abroad, but clearly lays the blame for inflation at the feet of emerging market economies. Notice, then, the dominant policy theme that lies at the heart of all three speakers: The rest of the world needs to grow at a slower pace so that the US can grow at a faster pace. This is not a surprise, as US policymakers are unwilling to accept what Yves Smith sees as the inevitable result of years of debt-supported consumption growth:

Perhaps I am lacking in imagination, but I see lower living standards for Americans an unavoidable outcome. We're seeing it now, via rising food and energy costs with stagnant wages. If you were to describe what ails this economy in its most fundamental terms, we have gone on a borrowing binge to support an unsustainable level of consumption. Merely having consumption fall to a healthier level would precipitate a slowdown. And that's before we get to the problem of "and what do we do with the debt hangover?"

Domestic policymakers are resisting, both via monetary and fiscal stimulus, and more will be coming. Interestingly, foreign policymakers continue to support US profligacy, making the comments of Kohn, Summers, and Miskin all the more ironic. As Brad Setser reports, it looks like foreign central banks are accumulating dollar reserves at a pace that more than finances the US current account deficit, even overflowing the US with money:

If most of the increase in dollar holdings finances the US (not foreigners borrowing in dollars), then the official sector provided enough money to the US not just to cover the current account deficit but to finance an outflow of private capital.

While Kohn et al., are bemoaning monetary policy abroad, that policy is keeping the US awash in capital at a critical juncture. Think of the asset boom that would occur should that capital actually gain some traction.

But wait – that capital is gaining traction, but in such a way that forces the inherit overconsumption of the US economy to light. Pick a channel, speculative investment, portfolio rebalancing, or fundamental demand, and you find financial markets trying to drive a rebalancing by forcing up the cost of key commodities. What US policymakers are unwilling to allow directly, the markets are forcing indirectly.

Consider that the current account deficit will need to correct by some mixture of import compression and export expansion. The weaker Dollar encourages that correction, but Dollar-pegs prevent the full adjustment. But where currency adjustment fails, commodity price adjustment steps in as, for example, higher transportation costs support import competing industries. Indeed, we are learning that cheap oil, not just cheap wages abroad, was the critical force supporting offshoring of US production.

On the consumption side, higher commodity prices reduce real demand growth. Note that this is likely a better adjustment mechanism that the alternative of abandoning all policy support and letting unemployment soar. Arguably, the pain of adjustment is spread throughout the economy rather than concentrated among the unemployed. But one should not forget the important distributional impacts of allowing higher commodity prices to force the consumption adjustment. In particular, lower income families are more energy intensive relative to high income families, so the adjustment is regressive, a point made by Robert Reich. And among manufacturers, the US auto industry suffers disproportionately.

I have long maintained that this adjustment should be characterized by weak consumption growth but better-than-expected business activity overall, particularly in export and import-competing industries. Effectively, the US is offshoring some of its weakness. The combination should be something that consumers clearly associate with recession, but with better than expected output, especially when policy stimulus is added to the mix. This is very much like the current environment, a recession that still lacks a single quarter of negative GDP growth. But the level of stimulus is starting to look excessive, and supporting a more inflationary environment than anticipated.

How long can this process continue? As long as global policymakers are willing to support it. Indeed, it is almost of a game of chicken, with US and emerging market policy makers on a collision course, neither wanting to accept the adjustment, a greater reliance on internal balance, necessitated by excessive US consumption.

The US is not likely to back down soon. We are seeing increasing calls for additional stimulus packages, and Brad DeLong is even suggesting the Democrats abandon any pretense of fiscal responsibility. The Federal Reserve is stuck, afraid to counter inflation via a rate hike themselves, instead exhorting foreign central banks – the very banks keeping the US afloat – to provide space for greater US growth at the expense of their own. In the meantime, the Dollar turns lower and oil sets a new record seemingly each month. Breakeven on the 10 year TIPS tested 260bp today, settling at 259. With US policy stuck in place, I suspect that emerging markets will take only baby steps toward changing the current dynamic. That leaves the ECB as the force most obviously leaning against the wind. Indeed, until inflation becomes sufficiently uncomfortable that a broader swath of nations finds meaningful policy tightening a necessity, I expect current financial trends to continue.

Comments

[robertdfeinman]

The false assumption is that economic "growth" has to be based upon "stuff". The biggest successes in the US over the past 30 years or so have been in producing non-material items and industries.

Microsoft sells software, which at most requires delivery of a CD, or, increasingly, bits over the internet. Google sells a service which also only requires transmission of information. Compare how well they have done, both in terms of growth and in terms of how many people they employ with GM or any maker of consumer electronics.

Other areas where the US has been a leader include pharmaceuticals and other bio-medical products. There has also been much economic activity (and favorable balance of trade) generated by the entertainment industries, especially video and music.

People in the US can have the same per capita GDP in the future as long as it is spent on services and intangibles. What needs to be changed is the idea that over capacity by factories must be catered to by a combination of forced obsolescence and shoddy construction. A piano can last 100 years, but after ten an automobile is considered scrap.

Coupled with a move away from traditional manufacturing there needs to be a refocusing on other satisfactions in life. Other societies (even advanced ones in Europe) do with much less stuff, they spend their time on activities instead of accumulation. Could Americans be convinced that sitting with friends in a bistro for several hours a night was better than vegging out in front of the TV or Xbox?

The ideas bandied around not only don't look at the 21st Century, they hearken back to the 19th. The days of the mill are over, stop trying to bring them back. We don't have to steal from the rest of the world, we can make our own fun.

[bob mcmanus]

"Perhaps I am lacking in imagination, but I see lower living standards for Americans an unavoidable outcome."

If the top 1-10% of Americans, the ones who gave seen the wealth increases I haven't seen for thirty years, take say a 50% decrease in living standards/wealth I think the economy would be ok, and the rest of us needn't starved in the dark so they can have their East Hampton and Aspen getaways.

If the rich resist, guillotines. I am starting to realize which side, rich or struggling, capital or labor, almost every economist is on. But y'all aren't rich. I just don't understand you.

[TigerPaw]

Maybe it takes a mind that grew up outside the US to notice it, but so much of what they're saying sounds rather like the parent telling the child not to smoke cigarettes who then goes out with his buddies to a bar to smoke cigarettes.

Why should anyone listen to the shaking finger of the US when clearly they can't get their own house in order? Whatever standing they may have had at some point is long lost, and like the awakening awareness that happens to all young people we see the hypocrisy being peddled as virtue.

[JKH]

The emerging economies have fostered this disaster with their pegs - the primary source of the cumulative imbalances. And now they reap domestic inflation as a result. They need to tighten something, and much more so than the US.

The cure for high oil prices is high oil prices, and the cure for unsustainably high growth is unsustainably high growth. It defies physics otherwise.

Oil is a terms of trade shock for the US that saps purchasing power. The Fed will not raise rates. Their current position is about jawboning inflation expectations. It’s a required position that doesn’t imply required action.

Kohn may be premature in his decoupling judgment. The asset bubble in real estate is global, and it is a deflationary slow motion train wreck. Deflationary tidal waves will swamp the oil shock, force oil down, and drown inflation. It’s cyclical. The US current account will improve as a result.

Or maybe not.

[Debt]

"If you were to describe what ails this economy in its most fundamental terms, we have gone on a borrowing binge to support an unsustainable level of consumption."

Of course, that has been the goal of policy.

"On the consumption side, higher commodity prices reduce real demand growth."

Requiring even more borrowing to keep demand growing.

[Debt]

"...unsustainable level of consumption..."

Keep consumption growing no matter what. If a mistake is made on the upside, allowing consumption to grow beyond domestic output, keep consumption growing anyway from that base. Create as much money as necessary to entice borrowers to borrow ever more. If interest rates are already negative, make them even more negative. Consumption must grow at all costs.

[Bill Conerly]

Tim's comment that we consume more than we produce is not true. We consume plus invest more than we produce. One could just as easily argue that we invest too much as that we consume too much. And yet, we don't mind countries running a trade deficit in order to invest. The U.S. did that in much of the 19th century with pretty good results.

[Winslow R.]

"Requiring even more borrowing to keep demand growing."

Which is how the economy has worked for at least 100 years and I expect to continue for the next 100.

Debt load can be increased by
1) lowering interest rates (until they reach zero)
2) increasing income (to cover interest payments)

hmmm now that interest rates are near zero, what's next?

Answer: Incomes have to increase, which no person worth his weight in gold wants. Probably why our current economic situation is causing such turmoil politically. Of course the question where the wage gains will occur?

So far wage gains are accruing outside of America as inflationary wage-price spirals flares in developing countries.

Ives etc. would like to see Americans make less in real terms, politically we'll soon see if Americans agree.

Why isn't the debate shifting to who are the most productive workers in the world and if they are also the most highly paid?

[cm]

robertdfeinman: I think your picture of a Bohemian and digital utopia is a bit simplified. Even most service and leisure activities (except maybe giving each other amateur theater performances) consume resources. Those resources have to be extracted/provided by "physical" activities.

And who is using all those Microsoft cash cows? Google is selling ads and search result exposure, for what? (It's search engine, which clearly has intrinsic utility, couldn't exist without the ad business.)

Facebook, Myspace, Linked In, etc. are providing platforms for mutual back scratching ("networking") and social exhibitionism, with a not unsubstantial aspect of business-related networking (job referrals, (attempts at) "B2B" networking).

What I want to get at is that at the end of the day, all of these are largely "supporting activities" and not ends in themselves -- except the non-business "networking". They have to take place on top of a base of "real" economic activity. Note, by "real" I don't mean (just) "goods producing".

That is of course also quite simplistic.

[Inflation Expectations]

Tim Duy has captured our predicament well. The central banks are stuck in their doomed policies for a while. Inflation will get worse, and investors and the public will take actions to further accelerate inflation.

At some point many other central banks will wake up and let their currencies appreciate. The misery index here will not be pretty then. This slow motion train wreck will play out over many years, and Obama may be doomed to be another Carter.

[cm]

And in the past 30 years (or so), yes the US has produced great "non material" items, while the rest has shipped it the material "stuff" in exchange for its paper dollars and debt instruments.

Again, that's simplistic, and not the whole picture (the US has exported technology and know-how to its "trade partners", military equipment and "services" to its "allies", and entertainment titles and airplanes to pretty much everybody).

[argento]

And in the past 30 years (or so), yes the US has produced great "non material" items, while the rest has shipped it the material "stuff" in exchange for its paper dollars and debt instruments.

I would add that the value of America's paper dollars and debt instruments were mightily enhanced by its military prowess, especially during the Cold War. Without sounding like a conspiracy theorist, the last two countries (Iraq in 2000, Iran 2004) that challenged the dollar's reserve status aren't doing too well. Perhaps China is waiting for its double-digit military expenditures to bear fruit before decoupling?

[Great Comment]

There was this great comment on Calculated Risk that bears repeating here:

Nothing went wrong at Lehman. Ponzi finance always self-destructs in the end. That's a known outcome.

Lehman helped create wealth illusions via leverage and used that to transfer great amounts of wealth from those who invested in these illusions to those who created them.

Collapse was always inevitable.

What defines success or failure is how much the executives and star traders pocketed before the whole thing went bust.

Walk away with a fortune, and leave the shareholders, clients, and financial markets in ruins.

That was always the plan and the true measure of success in the finance culture we have today.

This is how they use money and resources.

And yet the economic orthodoxy says that we need to react to the collapse of these schemes by giving the same sort of people even more access to money through credit and investment so the can forumlate even bigger and better plans for profiting from social and economic destruction.

When people screw up or destroy things with the money they have and then lose it, we respond by giving them more money.

I can't think of a sufficiently derogatory word to describe the kind of thinking that formulates and promotes such a naive and demonstratably flawed policy.

Everytime the enemy starts running out of ammo we re-arm them because our policy assumes that this time they'll use it to do something good and productive.

That's how it works in the text books after all - the Utility Maximizing Automata that inhabit our fantasy world economy always do the most economically beneficial thing with the resources we give them.

In the real world we get shot in the head with the bullet we just gave them.

The problems we have cannot be solved by socially and culturally blind academics who've spent most of their life in an idealized envrionment working with idealized representations of the world we live in.

This isn't economics.

This is war.

[hari]

For once, Mark is not only cogent with his policy views and positions, but he's demanding structural adjustment and fiscal discipline to get the budget and household economics in balance, sooner than later, even if the medicine may have to be taken with fingers tightly gripping the nose!

America has lived for last two decades or more on credit from abroad...and this life of leisure cannot go on for ever. Clean up the mess before IMF or someone is asked to find a solution - Kohn's lecture in Franfurt last week was telling for its logic ie. emerging markets should clean up their mess and fight inflation! What about US Fed?

[Mark Thoma]

That's Tim.

[hari]

OK! Thanks Mark.

G-8 meeting this weekend, in Japan, may be a turning point on political economy and galloping global inflation endangered by globalization. Me thinks, not only Fed but US Treasury will come under tremendous pressure to *correct* the dollar rate with its major trading partners - as commodity prices get (more) spiked.

Today ECB will most likely up the rate by 25bp (4.25%) making the spread on rates part and parcel of the monetary gambling casino.

Sarkosy (in-chair EU - until end of year) - will raise the cry against ECB and fight EU monetary policy making in a vacccum - ie. disregarding EU-27 domestic fiscal problems.

All this spells more protectionism, for me, under Sarkosy.
He wants to kill the on-going reduction offer on agri-subsidies at Doha/WTO round - and bring it to an end also.

[hari]

*monetary gambling casino* refers to FX speculations which surely will make for great arbitrage....

[hari]

Yes - ECB raised its rate by 25bp today.

Now the betting is over to the Fed - growth declining and inflation upfront - and it must choose way forward or hide its head in the sand....while oil prices escalate.

[hari]

Underlying Fed Watch today is the policy assumption that WH/Beltway are not prepared or ready to ask the right question. What in the world are they waiting for...while mainland China and emerging Asia are securing their global market positions?

There is an element of economic history being replayed - I am thinking of how Great Britain's decline was setforth in concrete without Whitehall mandarins acknowledging it.

Pound Sterling was the reserve currency of the world...and overnight...it was gone! And even now they pretend, as if, Sterling can outlive the EMU and Euro.

Churchill said that there are times in life's of Statesman when they must deal with the unpleasant and real world....
(my paraphrase).

[Mark]

Regarding Microsoft, Google, and other information/technology producers, according to BEA, the information-communications-technology industries accounted for 22.3 percent of real economic growth in 2007. Still, despite their impressive growth over many years, these industries accounted for 3.9 percent of the economy.

http://www.bea.gov/newsreleases/industry/gdpindustry/gdpindnewsrelease.htm

[JRossi]

I agree with Robert Feinman that more activity and less accumulation makes for an easier and better life, sometimes a significantly better life, and that ethos in catching on to some extent. But it's still an alternative lifestyle in the US. Most people want to do what everyone else does, or they want to life the way they've always lived,or they're trapped in the work-overspend trap, or they enjoy their toys, or they want to show others all the stuff they've got. Insane really, but it's how we live. Banning television commercials would help.

[don]

TD - "...the US consumes more than it produces, and the excessive consumption is provided by foreign producers. Eventually, maybe tomorrow, maybe years from now, those producers will desire to consume their own domestic output. At that point, US consumption and production will have to fall into line via a possibly painful restructuring. The more painful, the more policymakers will resist."
Maybe adjustment will be forced by unemployed Americans who get tired of trying to compete against artifically low import prices set by pegged Asian central banks.
FM: "On the one hand, rapid growth in Asia has stimulated strong increases in import demand, cushioning the slowdowns in the United States, Europe and Japan, but on the other hand, the rapid growth in demand has pushed up prices for commodities that are in short supply."
And on a third hand, the Asian surpluses divert U.S. aggregated demand away from U.S. production, so that even with substantial excess demand, the U.S. is having trouble maintaining full employment. (To me, FM appears to deliberately mischaracterize the issue to take attention away from the problem of Asian currency policies stealing demand from developed countries - akin to the old 'devalue the currency and export unemployment' games played during the great depression.)
YS: "Perhaps I am lacking in imagination, but I see lower living standards for Americans an unavoidable outcome. We're seeing it now, via rising food and energy costs with stagnant wages."
I wonder. The effect of increased food prices may be to bring a windfall to the U.S. bigger than that currently enjoyed by oil exporters, as the U.S. has a disproportionate share of the world's potential agricultural output.
MT: "Consider that the current account deficit will need to correct by some mixture of import compression and export expansion. The weaker Dollar encourages that correction, but Dollar-pegs prevent the full adjustment. But where currency adjustment fails, commodity price adjustment steps in as, for example, higher transportation costs support import competing industries."
But what are the relative magnitudes of the effects on the trade balance? My guess is the effect of transport costs is quite small relative to that of the currency pegs. For one thing, transport costs work to discourage both exports and imports. For another, their relative price effects seem to be quite small relative to the price distortions caused by the currency pegs.

[Eric Dewey]

Great post, Mark - thanks for bringing us Tim's work on a regular basis.

What's fascinating in going thru the (many good)comments is that it almost seems possible to identify when the speaker has a global perspective, as opposed to a domestic one.

Makes me think that what is really happening here is a realignment of perspectives - that the simple fact that the emerging world is beginning to see how to play the capitalist game, and has the resources to compete, has begun to have an power-balancing effect.

The US doesn't like the change - but when has an elite ever been willing to accept that the rules have changed?

Yet the course of history will be determined by the US reaction to its new role. Tim's work is clear-sighted enough to give us a better sense of what's happening - like it or not.

[cm]

JRossi: It is pretty clear what you are arguing against, but I'm not sure what you are arguing for (but to make this clear, I'm not trying to defend (frivolous) consumption - for a reasonable definition of "frivolous", and in my opinion I'm not participating much in that).

We live in a society that is at least nominally based on "exchange" of goods and services (which is in some form or another needed to support any activity) that is mediated through money, which flows to participants mostly in the form of compensation for labor/production/services rendered (in those cases where their contribution or its value can be questioned there will be at least a nominal connection).

One of our "problems" is that a large part of income-earning activities falls in the "frivolous", "harmful" (or merely resource consuming), and "generally undesirable or overallocated" categories, or categories supportive of or attached to those (via the "job multiplier").

Short of subsistence farming (not a realistic option for most significant societies today), I think nobody has found a social/economic model that is sustainable (yet?) -- taking the reality of the human psyche and "path dependencies" into account (how do you get from here to there).

I'm not confident that our society could handle a substantially higher proportion of the populace being properly or effectively unemployed, and without (or too little) formal income and attachment to the legal economy. One could question whether it can handle (and is handling) the state of affairs right now.

I'm afraid cutting out the "frivolous" activities would achieve just that.