Relax, central banks can still save us
Our situation is desperate but not serious, as the Viennese say.
Even if Europe and America slide back into recession with fiscal deficits already dangerously stretched and interest rates on the floor, financial authorities still have the means to prevent a spiral into debt-deflation.
Whether they have nerve to use those means if necessary, and whether they can overcome deep rifts to act in unison and with overwhelming force, is another matter. It would help if China and other reserve powers stopped sniping from their clay towers. They will suffer just as badly, or worse, if the damn breaks.
Perhaps oddly, I am not as uber-bearish as some at this juncture. It is far from clear to me that the US is crashing into a second slump. While the Philly Fed’s manufacturing index for August was catastrophic at minus 30.7, it is a twitchy index.
Paul Dales at Capital Economics says it flashed false warnings in 1995 and 1998. The US Conference Board’s leading indicators are more reliable. They are signalling sluggish growth.
Andrew Haldane, the Bank of England’s financial stability chief, says global banks have raised equity by $500bn since the bubble burst. They have slashed assets by $3 trillion, and halved leverage ratios from 40:1 to a long-run average of 20:1. “UK and US banks’ cash ratios are at their highest levels for several decades,” he said.
Citizens and firms on both sides of the Atlantic are running a “financial surplus” near 2.5pc of GDP, compared to a 1pc deficit five in 2006. US companies are sitting on $2 trillion in cash. The West is better cushioned this time.
There is much wreckage left, of course. A quarter of US mortgages are under water. A shadow inventory of unsold homes must still be cleared. Detox will be long and painful.
Yet it no longer makes sense to talk of a US housing bubble. The price to incomes ratio has halved to three, among the world’s lowest. Cleveland, Detroit, Cincinnati, and Atlanta are down to 2.4.
But let us concede - as a 'Gedanken Expirement' - that arch-bears are right to fear a full-blown global slump. Are we powerless?
The US cannot easily crank up fiscal stimulus with a deficit already at 10.8pc of GDP (IMF estimate). Much as I admire Nobel Laureate Paul Krugman – vindicated in his prediction that US 10-year bond yields would fall to historic lows – he misuses history to argue that spending on the scale of World War Two could safely lift America out of slump.
Yes, the US pushed public debt above 120pc of GDP to defeat Hitler, and Britain topped 200pc defeating Napoleon. Both countries marched on to greatness, but in each case they were the world’s paramount industrial power.
Who was going to threaten US Treasuries or the dollar in the late 1940s when Germany and Japan were under US occupation, and America accounted for half of global GDP?
Military demobilisation allowed an instant cut in the US budget deficit. Today the rot is structural, a failure to stop health care and ageing costs spiralling out of control.
So with fiscal policy exhausted, the burden must fall on monetary policy. Here we have barely begun to use our atomic arsenal even at zero rates. As Milton Friedman taught us – though nobody in Frankfurt -- it is a fallacy to think that low rates are loose. Zero can be extremely tight.
That may be the case now with US Treasury yields signalling deflation and M2 velocity collapsing as it did pre-Lehman.
To those who argue that the Fed is pushing on the proverbial string, David Beckworth from the University of Texas replies that the Fed showed between 1933 and 1936 that it could deliver blistering growth of 8pc a year despite debt deleveraging in the rest of the economy.
My own view is that Ben Bernanke has strayed from classic Friedman policy, blunting the effect of his two rounds of QE. Under his doctrine of “credit easing” he has steered bond purchases to banks. This has limited effect on the quantity of money.
A Friedmanite would argue that Bernanke has barely tried monetary stimulus. Yet he has greatly eroded his political capital in the process, especially by arguing that the purpose of QE2 was to push up inflation and help Wall Street. These were tone deaf justifications. “Treasonous” is the verdict of Governor Rick Perry of Texas. That was to be expected, but it does complicate matters.
The eurozone obviously needs looser money. M3 broad money is stagnant and real M1 deposits have turned negative, even in Germany and Holland. Real M1 is contracting at an alarming pace in Italy. EMU growth has wilted, five countries are spinning towards default, and the banking system is seizing up. This cries out for a change of course, yet the European Central Bank is still tightening.
The ECB’s Jean-Claude Trichet said “we do not do QE”. Indeed, Germany forbids it. Not only has the Bunde*****ank forgotten that the Bruning deflation of 1931 destroyed Weimar - not the hyperinflation of 1923 - it is imposing its policy blunder on the whole currency bloc. The visible result of piling monetary contraction on top of fiscal contraction is to push the Club Med over the edge.
The lesson of 2008-2010 is that further QE by the Fed alone risks a dollar slide and a further global crisis. A successful monetary blitz - if required - would need joint action by all major central banks in concert, including the ECB with no 'ifs’, 'buts’, and hostile body language. Some $6 trillion would suffice, or 10pc of global GDP.
We are not there yet. The August squall may pass. US growth may surprise, and China may avoid a hard landing. For all our squabbling, we still live in a benign world where ships and capital move freely and leaders talk to each other.
Remember what the world looked like when Franklin Roosevelt moved into the White House in March 1933 and shut down the US banking system.
The front page of the New York Times on his first Monday in office announced: "Hitler Bloc Wins A Reich Majority, Rules Prussia"; "Japanese Push On In Fierce Fighting, China Closes Wall, Nanking Admits Defeat"; "City Scrip To Replace Currency"; "President Takes Steps Under Sweeping Law of War Time"; "Prison For Gold Hoarders".
That was a serious situation.
