Tim Duy: Not So Bad?

Tim Duy gives and answer to Brad DeLong's question:

Not So Bad?, by Tim Duy: Brad DeLong is puzzled. Earlier this week, defending Greenspan-era monetary policy,

Now we are not yet out of the woods. If the tide of financial distress sweeps the Fed and the Treasury away--if we find ourselves in a financial-meltdown world where unemployment or inflation kisses 10%--then I will unhappily concede, and say that Greenspanism was a mistake. But so far the real economy in which people make stuff and other people buy it has been remarkably well insulated from panic at 57th and Park and on Canary Wharf.

Today Delong adds:

I still do not understand why the real side of the economy is doing so well in relative terms. The worst financial distress since the Great Depression ought to trigger the worst downturn in demand, production, and employment since the Great Depression. It hasn't--at least not so far.

Good questions; I think economic activity has surpassed most peoples’ expectations. My answer to DeLong’s question comes in three parts:

1. The nature of the expansion defines the nature of the following contraction. The post-tech bubble expansion was anemic by most measures, and never gained much traction until the housing bubble arose. The primary channel through which housing supported the economy was via consumer spending, generating a tepid growth dynamic compared to the equipment and software investment boom of the 1990’s. The tepid upside suggests a tepid downside. I would be more worried if the chart for equipment and software:

looked like the chart for residential investment:

And given trends in new orders, I am hoping it won’t:

2. The impact of the consumer slowdown is partially offshored, a point which I think deserves greater attention. This shifts job destruction to an overseas producer. In fact, as spencer at Anger Bear shows, the recent improvement in the real trade balance has less to do with rising exports, which continue to follow recent trends, than the sharp slowdown in real import growth. Note too that exports are not falling as they were in the 2001 recession as the global economy has held up better than expected.

3. Perhaps most importantly, however, is the massive liquidity injections from the rest of the world, or what Brad Setser calls “the quiet bailout.” In the first half of this, global central banks accumulated $283.5 billion of Treasuries and Agencies, something around $1,000 per capita. This is real money – I outlined the likely implications in January. Foreign CBs are happily financing the first US stimulus package; will they be happy to finance a second? Do they have a choice? Their accumulation of Agency debt is also keeping the US mortgage market afloat. Do not underestimate the impact of these foreign capital inflows. If the rest of the world treated the US like we treated emerging Asia in 1997-1998, the US economy would experience a slowdown commensurate with the magnitude of the financial market crisis. The accumulation of US assets is also forcing an expansion of foreign CB’s balance sheets, creating global monetary stimulus that allows the rest of the world to decouple from the US economy, supporting continued US export growth (see point 2 above).

Ideally, the slowdown remains moderate, allowing for a rebalancing as we expand export and import competing industries domestically, narrowing the current account deficit and eliminating the necessity of foreign official financing. This means accepting a period of time with suboptimal domestic demand growth and structural adjustment. Excessive fiscal stimulus risks testing the willingness of foreign CBs to continue to accumulate US assets. Moreover, I believe that excessive stimulus will eventually foster a more damaging inflationary dynamic, but such a process would likely build over a long period of time – the seeds for the 1970s were planted in the 1960s.

In short: External dynamics play a significant role in explaining the relatively mild US downturn. As long as foreign CBs are willing to accumulate US debt, the US government is willing to issue debt, the Federal Reserve is willing to accommodate the debt with low interest rates, we will avoid the most dire deflationary predictions.