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Thomas Palley comments below the fold (hit "read more") on the
subprime mortgage problem, and the Fed's bandaid responses.
Lowering interest rates will probably help, he says, but the deep
problem is the trade deficit which is hollowing out our economy.
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The Fed and America’s Distorted Expansion
Copyright Thomas I. Palley
The U.S. economy has been in expansion mode since November 2001. Though
of reasonable duration, the expansion has been persistently fragile and
unbalanced. That is now coming home to roost in the form of the
sub-prime mortgage crisis and the bursting house price bubble.
As part of the fallout, the Federal Reserve is being criticized for
keeping interest rates too low for too long, thereby promoting credit
and housing market excess. However, the reality is low rates were
needed to sustain the expansion. Instead, the root problem is a
distorted expansion caused by record trade deficits and manufacturing’s
failure to fully participate in the expansion.
If the Fed deserves criticism it is for endorsing the policy paradigm
that has made for this pattern. That paradigm rests on disregard of
manufacturing and neglect of the adverse real consequences of trade
deficits.
By almost every measure the current expansion has been fragile and
shallow compared to previous business cycles. Beginning with an
extended period of jobless recovery, private sector job growth has been
below par through most of the expansion. Though the headline
unemployment rate has fallen significantly, the percentage of the
working age population that is employed remains far below its previous
peak. Meanwhile, inflation-adjusted wages have barely changed despite
rising productivity.
This gloomy picture justified the Fed keeping interest rates low.
However, it begs the question of why the economic weakness despite
historically low interest rates, massive tax cuts in 2001 and huge
increases in military and security spending triggered by 9/11 and the
Iraq war?
The answer is the over-valued dollar and the trade deficit, which more
than doubled between 2001 and 2006 to $838 billion, equaling 6.5
percent of GDP. Increased imports have shifted spending away from
domestic manufacturers, which explains manufacturing’s weak
participation in the expansion. Some firms have closed permanently,
while others have grown less than they would have otherwise.
Additionally, many have reduced investment owing to weak demand or have
moved their investment to China and elsewhere. These effects have then
multiplied through the economy, with lost manufacturing jobs and
reduced investment causing lost incomes that have further weakened job
creation.
The evidence is clear. Manufacturing has lost 1.8 million jobs during
the expansion, which is unprecedented. Before 1980 manufacturing
employment hit new peaks every expansion. Since 1980 it has trended
down, but it at least recovered somewhat during expansions. This
business cycle it has fallen during the expansion. The business
investment numbers tell a similar dismal story, with spending being
much weaker than in previous cycles.
These conditions compelled the Fed to keep interest rates low to
maintain the expansion. That policy worked, but by stimulating loose
credit and a house price bubble that triggered a construction boom.
Thus, residential investment never fell during the recession and has
been stronger than normal during the expansion. Construction, which
accounted for 5 percent of total employment, has provided over twelve
percent of job growth. Meanwhile, higher house prices have fuelled a
borrowing boom that has enabled consumption spending to grow despite
stagnant wages. This explains both increased imports and job growth in
the service sector.
The overall picture is one of a distorted expansion in which
manufacturing continued shriveling while imports and services expanded.
This pattern was carried by an unsustainable house price bubble and
rising consumer debt burdens, and that contradiction has surfaced with
the implosion of the sub-prime mortgage market and deflation of the
house price bubble.
The Fed is now trying to assuage markets to keep credit flowing, and it
will likely soon lower interest rates. On one level that is the right
response and it may even work again – though it does increasingly seem
like sticking fingers in the dyke to prevent the flood. However, the
deeper problem is the policy paradigm behind the distorted expansion,
which is where the Fed is at fault and where it deserves criticism.
The ideological and partisan Alan Greenspan wholeheartedly endorsed
corporate globalization and promoted the White House and Treasury’s
unbalanced expansion policies. The Fed’s professional economics staff
also seems to have dismissed domestic manufacturing’s significance and
endorsed corporate globalization in the name of free trade.
Consequently, the Fed has tacitly supported the underlying policy
paradigm that has given rise to America’s distorted expansion. Despite
talk about reducing global financial imbalances, the Bernanke Fed still
seems locked in to this paradigm and that is where constructive
criticism should now be directed.
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