Friday, February 06, 2004

Reload The Cannon

Steven Roach

"Economic policy-making requires a touch of art as well as science. But it also needs a good deal of common sense. Like war, one of the basic principles of stabilization policy is never to run out of ammunition. Policy stimulus is to be used in bad times, but when circumstances improve, it is critical to "reload the cannon." Otherwise, there will be no ammo for the inevitable next battle.

As simple as this basic rule is, it has all but been forgotten in the current climate. The Bank of Japan's zero interest rate policy is the most obvious case in point - a central bank that has completely run out of basis points. But it's not as if the monetary authorities in America and Europe have vast stockpiles of arms either; their policy rates are only 1% and 2%, respectively. The same rule, of course, applies to fiscal policy - deficit spending in bad times should be followed by fiscal restraint in good times. The recent globalization of fiscal profligacy is not exactly comforting in that regard either. "

....Lacking in the traditional fuel of income support, consumers have had little choice but to extract purchasing power from yet another asset — this time, property. But such asset-driven growth spawns the lethal combination of debt and reduced saving. And America has willingly complied. Household debt outstanding has soared to a record 82% of GDP, while the net national saving rate plunged to a record low of less than 1% in 2003. Unfortunately, the shortfall of domestic saving has given rise to America’s massive current-account deficit — leaving the US economy with the worst confluence of macro imbalances in its modern history. All this and more is an outgrowth of the Fed’s asymmetrical strategy of coping with asset bubbles — holding its fire on the upside but then deploying maximum defenses on the downside.

Meanwhile, this approach has another worrisome by-product: It has become a breeding ground for a string of additional asset bubbles that have come on the scene in the aftermath of the burst equity bubble. That’s not just true of property but also of bonds, credit instruments, emerging market debt, and tech stocks (again). This multiple-bubble syndrome is strikingly reminiscent of the moral hazard play that became central to the Great Bubble of the late 1990s — the recognition on the part of investors and speculators that Fed accommodation was here to stay. As long as the Fed takes interest-rate risk out of the equation, one bubble begets another. ...Continued

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