STephen Roach "Confession Time"

Stephen Roach (New York)
At long last, Federal Reserve Chairman Alan Greenspan has owned up to the central role he has played in sparking unprecedented global imbalances. His confession came in the form of a speech innocuously entitled, “Current Account” that was given in London at the Advancing Enterprise 2005 Conference on the eve of the 5 February G-7 meeting. In the narrow world of econo-speak, his prepared text contains the functional equivalent of a “smoking gun.”

Greenspan’s admission came when he finally made the connection between the excesses of America’s property market and its gaping current account deficit. To the best of my knowledge, this was the first time he ventured into this realm of the debate with such clarity. He starts by conceding “…the growth of home mortgage debt has been the major contributor to the decline in the personal saving rate in the United States from almost 6 percent in 1993 to its current level of 1 percent.” He then goes on to admit that the rapid growth in home mortgage debt over the past five years has been “driven largely by equity extraction” -- jargon for the withdrawal of asset appreciation from the consumer’s largest portfolio holding, the home. In addition, the Chairman cites survey data suggesting, “Approximately half of equity extraction shows up in additional household expenditures, reducing savings commensurately and thereby presumably contributing to the current account deficit.” In other words, he concedes that a debt-induced consumption boom has led to a massive current account deficit. That says it all, in my view.

The obvious and most important point is that rapid growth of US mortgage debt did not come out of thin air. It was, of course, a direct outgrowth of the Fed’s hyper-accommodation of the post-bubble era -- namely, short-term interest rates that have been negative in real terms for longer than at any point since the 1970s. As Greenspan’s dryly notes, “The fall in US interest rates since the early 1980s has supported home price increases.” That’s putting it mildly. Suffice it to say, were it not for the Fed’s aggressive monetary accommodation -- especially the post-bubble easing of some 550 bps in 2001-03 -- the home mortgage refinancing cycle would have been in a very different state. But it wasn’t just lower borrowing costs that spurred equity extraction. It was also the rapid rate of house price appreciation -- an outgrowth of what Greenspan notes has been the “unprecedented rate of existing home turnover” that he also attributes to sharply lower interest rates.

Equity extraction has been the pixie dust of America’s post-bubble recovery -- the newfound purchasing power that has fostered the biggest consumption binge in post-World War II history. Were it not for this wealth effect, consumers would have been constrained by an anemic pace of labor income generation -- long the most decisive variable in the macro consumption equation. Lacking in job creation and real wage growth, private sector real wage and salary disbursements have increased a mere 4% over the first 37 months of this recovery -- fully ten percentage points short of the average gains of more than 14% that occurred over the five preceding cyclical upturns. Yet consumers didn’t flinch in the face of what in the past would have been a major impediment to spending. Spurred on by home equity extraction and Bush Administration tax cuts, income-short households pushed the consumption share of US GDP up to a record 71.1% in early 2003 (and still 70.7% in 4Q04) -- an unprecedented breakout from the 67% norm that had prevailed over the 1975 to 2000 period.

These are the telltale footprints of what I have called the Asset Economy (see my 21 June 2004 dispatch, “The Asset Economy”). It’s a story that began in the latter half of the 1990s with the equity bubble. And it’s a story that involved the Federal Reserve as a key player at every subsequent twist and turn. Its role can be traced back to December 1996 with Alan

Greenspan’s famous “irrational exuberance” speech -- his first and only warning of the bubble-related perils to come. Unfortunately, the Chairman was quick to become a convert to the very excesses he warned of -- embracing the New Paradigm of rapid productivity growth as justification for why the central bank would be willing to stand by and tolerate faster than normal growth. That acquiescence -- putting the Fed Chairman in the dangerous role of a cheerleader insofar as the financial markets were concerned -- gave a green light to investors and speculators all the way to NASDAQ 5000.
Then when that bubble popped, the Fed went into its well-rehearsed “Japan drill” -- unleashing the aggressive easing that gave rise to the excesses of the home mortgage equity extraction cycle. This is the grand continuum of the Asset Economy -- wealth effects that morphed seamlessly from the stock market into the property market.
Aided and abetted by the conscious policy tactics of the Fed, Alan Greenspan can hardly profess innocence in assessing the current state of global imbalances. By warmly embracing asset appreciation and the debt binge it fostered, the central bank has encouraged consumers to all but abandon traditional income-based saving strategies. Instead asset-based saving has become the “new new” thing of the Asset Economy -- as has the debt-induced equity extraction that has driven US consumption to unprecedented excess. This shortfall of income-based personal saving, in conjunction with outsize government budget deficits, has created the very shortfall of national saving that makes ever-widening current-account deficits unavoidable. And that, of course, puts extraordinary pressure on the rest of the world to fund America’s profligate ways.

At long last, Chairman Greenspan owns up to the central role he and his colleagues at the Federal Reserve have played in fostering these developments.
Alas, he offers a hopeful prognosis as to how this all works out. Greenspan’s basic argument as set forth in his London speech is that we can all relax -- that “market pressures” are likely to play a key role in the coming US current account adjustment and in the global rebalancing that adjustment would spawn. In particular, he is optimistic both on the outlook for public and private sector saving. Undaunted by his mis-diagnosis of the fiscal outlook in 2001 -- he argued that tax cuts would be the wisest way to spend the government’s budget surplus -- Greenspan offers hope that the “voices of fiscal restraint” will finally prevail in Washington.

We’ll know more on the fiscal policy front soon enough as the Bush Administration prepares to release its new budget. Suffice it say, a credible program of significant deficit reduction will be tough to pull off as the White House rules out tax increases and focuses, instead, on the 18% of federal expenditures that can be classified as nondefense discretionary spending (excluding homeland security).

Moreover, Greenspan also expresses the belief that “An increase in household saving should also act to diminish borrowing from abroad.” This is a key assertion. What he is saying implicitly is that the Fed will need to withdraw support from the Asset Economy by restoring some semblance of normalcy to America’s real interest rate structure. What he is also implying is the hope that the US labor market will now provide increased support to the American consumer -- in essence, spurring the long-awaited “hand-off” from the new asset economy back to the more traditional income economy. January’s disappointing employment survey -- just the latest in a long string of subpar gains on the hiring front -- underscores how difficult it will be to execute this hand-off.

This may be the toughest nut of all to crack for the US central bank. It underscores the delicate tradeoff between real interest rates and saving as the Fed attempts to wean the American consumer from the excesses of the Asset Economy. Financial markets are presuming that the central bank will err on the side of caution in executing this delicate transition back to the income-based economy of yesteryear. The broad consensus of investors believes that the Fed wouldn’t dare flirt with a meaningful shortfall of economic growth. Futures markets are quite explicit in validating this perception by now pricing in only two and a half measured tightenings of 25 basis points each, between now and midyear. That’s hardly a move that would spur a spontaneous revival of personal saving, in my view. Nor would it be enough of a move to take away what I have called the “candy” of the carry trade that has spawned speculative excesses in a variety of risky assets -- including emerging-market, high-yield, and even investment-grade corporate debt. I continue to believe that it will take more Fed tightening than the markets are expecting -- in conjunction with a long overdue backup in long-term interest rates -- to spur a shift from asset- to income-based saving.

The Federal Reserve is trapped in a moral-hazard dilemma of its own making. It dates back to the Great Bubble of the late 1990s and the central bank’s unwillingness to take away the proverbial punch bowl just when the party was getting good. The close brush with deflation that then ensued was a painfully classic post-bubble aftershock. That experience underscores the greatest shortcoming of modern-day central banking -- the inability of monetary policy to cope successfully with asset bubbles and the deflationary perils they engender. The history of the 1930s and Japan in the 1990s are grim reminders of that shortcoming. Alan Greenspan’s confession finally sets the record straight on how he got us into this mess.

But it is a confession that is still steeped in denial. The presumption that natural market forces can cure all ignores the lingering perils of an all-too treacherous endgame. Let’s not forget that nearly five years after the equity bubble popped, America’s imbalances -- to say nothing of the world’s imbalances -- remain in uncharted territory.