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Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.com
The first
quarter Gross Domestic Product rise of 0.6% was greeted with considerable
relief by most Wall Street commentators; they had expected the chaos in the
housing market and the banking system to have pushed the
US economy into
recession. This was unreasonable; the huge monetary stimulus currently being
hurled at the economy was always likely to prevent immediate recession, while
the fiscal stimulus of the $110bn rebate package is likely to prop it up
through July or so. Beyond that, the future becomes less clear: at some stage
the monetary and fiscal stimulus must run out.
As I have
frequently written, monetary conditions have been pretty lax since 1995. It had
been becoming difficult to determine how lax since March 2006, when the Federal
Reserve stopped reporting M3 money supply, the measure used in by the European
Central Bank and other monetarist organizations. However the
St.
Louis Fed, which for the decade until April was run by the monetarist William
Poole, has constructed its own measure of broad money, Money of Zero Maturity,
which is a reasonable proxy for M3; it consists of M2 plus institutional money
market funds minus small time deposits. Like M3, MZM began to expand
excessively in early 1995; in the 13 years to March 2008 it grew at an average
annual rate of 8.88%, compared with growth in nominal GDP during that period of
5.25%.
Thus
monetary policy, however measured, has been excessively expansionary since
1995, in the sense of expanding the money supply faster than output. As I have
written previously, the inflation-creating effect of this excessive monetary
expansion has been suppressed for a decade by the Internet, which has had a
similar deflationary effect through enabling outsourcing to cheap labor
countries that the railroads and refrigeration did in the 1880s through
allowing cheap agricultural produce from the Midwest, Canada, Australia and
Argentina to be shipped worldwide.
From the
beginning of 2008, however, monetary expansion has sharply accelerated. In the
three months to April 21, the latest data available, MZM expanded at an annual
rate of no less than 28.7%. This extra-rapid expansion is not surprising – the
Fed has been terrified that the
US
financial system was about to collapse, and has been making funding available
in large quantities in a variety of ways. Indeed on May 2 the Fed, concerned
about the credit card financing market, allowed banks to use credit-card-backed
AAA bonds as security for Fed loans – needless to say this involves yet more
monetary expansion and further risk to the taxpayer. Monetary stimulus of this
extraordinary magnitude will have an effect, it has to.
Other
countries have also been expanding their money supply excessively. The European
Central bank has allowed euro M3 to expand by 11.1% in the three months to
March 2008, following an increase of 11.5% during 2007. As in the
United States,
this increase is much faster than that of nominal GDP, and it had been continuing
for several years, with annual growth rates of 7.4% in 2005 and 10.0% in 2006.
Of the major emerging markets,
China
and
India
have both been operating expansionary monetary policies and now have
considerable inflation problems.
Vietnam too has been surprised in
spite of its rapid growth by inflation surging towards 25%. Only in
Japan, where
“broadly-defined liquidity” has been increasing at rates in the 3-4% range in
2006-08, has monetary policy been reasonably consistent with low inflation.
Monetary
stimulus generally works with a lag of several months at a minimum. Thus it is
likely that the extremely lax monetary conditions of the past few months have
not yet produced their full effect. Nevertheless it is remarkable how rapid has
been the advance of energy and commodity prices, with the Reuters CRB commodity
price index up 24% since the Fed began its misguided interest rate cutting
campaign on September 18 last year. It is also remarkable how feeble growth in
the
United States
has been. With the Fed essentially printing money as fast as it could, the
US
economy grew only 0.6% in each of the fourth and first quarters. Since the
US population
increases by around 1% per capita, the economy has thus been in a per capita
recession since September. In the first quarter indeed, even ignoring
population growth, the economy was only pushed above the flatline by increases
in inventory and government spending, both detrimental to economic output in
the long term.
Over the
next several months, it is likely that current trends of feebly advancing GDP
and soaring commodity prices will continue. Certainly the stock market seems to
think so; it has recovered nicely from its mid-March low and is now above the
levels when the crisis hit last August, even though earnings in the financial
sector, representing more than 40% of total
US earnings before crisis hit, have
essentially disappeared in the last two quarters. The Fed may not currently
intend to push interest rates down further, but it has already forced them more
than 2% below even the thoroughly fudged statistics of inflation produced by
the Bureau of Labor Statistics.
It is
perhaps disappointing for bears that a crisis may not occur immediately, but
there can be no question that the vigorous monetary and fiscal medicine
administered by the Bernanke Fed and the George W. Bush administration will
have its effect. Indeed, far from declining in the second quarter, as has been
confidently predicted, Gross Domestic Product may even tick up a bit, boosted
by monetary and fiscal stimulus, perhaps to around 2% or 1% after population
increase has been taken into account.
At some
point, a crisis will arrive. Inflation in the eurozone,
China and
India
is already at levels deemed unacceptable, while even
Japan has positive inflation for
the first time in many years. In the
United States, the producer price
index increased 6.9% in the year to March, while that for crude goods increased
more than 30%. Like a bowling ball swallowed by a python, that inflation will
move through the economic system and eventually be reflected in consumer
prices. Indeed, it may already be showing up there; the seasonally unadjusted
consumer price index for March was up 0.9% (an annual rate of around 11%) and
only a heroic seasonal adjustment of 0.6%, double the next largest seasonal
adjustment for any month in the last ten years, brought the figure down to an
acceptable 0.3%.
The Bureau
of Labor Statistics explains on its website that its seasonal adjustment
methodology changed in January; should it be the case that this is being used
to suppress consumer price inflation, even the dozier members of the media will
come to notice after another couple of months have passed. In any case, it is
likely that by the latter part of 2008, consumer price inflation in the
US will be
running at more than 10%, and that even the heroic mavens at the BLS will be
unable to suppress that information completely (though on past form they will
undoubtedly try.)
There will
come a point at which the irresistible force of gradually increasing GDP and
continually optimistic stock market will meet the immovable object of consumer
price figures that can no longer be ignored. At that point, the
US will suffer
not merely a monetary crisis but a political crisis. President George W. Bush,
with his refusal to see recession, Treasury Secretary Hank Paulson, with his
background in an institution, Goldman Sachs and a market, the Wall Street of
1995-2007 that together bear a very substantial responsibility for the problem,
and Bush’s appointee Ben Bernanke, with his continual insistence that inflation
is imminently about to disappear, will be discredited by reality and unable to
provide leadership. Awkwardly, it is more likely than not that the crisis point
will occur before November, so there will be no fresh-faced President-elect to
take control of the situation.
Almost
certainly, it will prove impossible to put the entire
US economy on
ice until January 20, 2009, so the financial markets themselves, probably the
Treasury bond market, will take control. With the US Treasury’s funding need in
the fiscal years 2008 and 2009 already around $500 billion in each year, hiccups
in the bond market have an almost immediate way of making themselves felt. To
avoid a collapse in the bond market and a catastrophic decline in the dollar as
foreign central banks withdraw their money, short term interest rates will have
to be raised very quickly to at least 3% above the then prevailing level of
inflation. That would imply a level of 7-8% today, but probably considerably
more by the time the crisis hits.
Once
interest rates have been raised, inflation will not decline immediately, but
nor will the
US
descend into a re-run of the Great Depression. There will be a lengthy and
grinding recession, probably persisting throughout 2009 and into 2010, with GDP
declining maybe 4-5% from top to bottom and inflation coming definitively under
control only towards the end of the period. On the other hand, the dollar will
stop being weak, since US interest rates will be internationally attractive,
and the US balance of payments position will swing back sharply towards balance
as US consumption and therefore imports decline sharply. The
US savings rate
will also increase, allowing the country to finance new capital investment from
domestic resources, and giving it once more a substantial capital cost
advantage over the emerging markets with lower labor costs.
The wild
card will be politics. It is not yet clear who will be the next President, and
it is abundantly clear that this pretty unpleasant economic environment will
dominate that President’s first two years in office. As happened to Herbert
Hoover, it will be possible for the new President and/or Congress, through
misguided protectionist or anti-capitalist policies, to make things
sufficiently worse that a Great Depression Mark II ensues.
Since none
of the three remaining Presidential potential candidates has a firm, well
thought-out commitment to economic policies that would alleviate or solve the
problem, and all have tendencies that might exacerbate it, the safest choice is
probably to go for raw intelligence, and hope that the new President can learn
on the job.
Which is as
close as this column is going to get to an endorsement!
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