Saturday, January 19, 2008

Who’s To Blame?


The Federal Reserve and the Bush administration are clear: They fear recession and have recommended the monetary (lower interest rate) and fiscal (tax rebate) policies designed to deal with that fear. But, no matter how swiftly they act, it’s doubtful that they can forestall recession. That cake is baked.

Why? Because the magnitude of the problem is far greater than the scope of the proposed remedies. In addition, acknowledging the extent of the problem exposes the Federal Reserve’s role in generating that problem.

To understand, recall the boom of the late 1990s. Capital expenditures soared. The chart below, which depicts business orders for new machinery, illustrates industry’s surge. Then the 2001 crash hit. Orders for new machinery plunged and the Federal Reserve came to the rescue by cutting interest rates. Business capital expenditures recovered sharply, but failed to grow beyond their 2000 peak. In earlier expansions business orders for new equipment doubled their value before the end of the business cycle.

Nondefense Capital Goods

(Click on chart to enlarge)

Recessions shaded

Low interest rates could not resurrect a hi-tech boom initiated by technological change and spurred onward by a stock-market bubble. The Fed’s remedy was not up to the task.

Instead the Fed’s medicine assisted a sector that was in no need of help. The chart below shows that real estate was already booming when it received the Fed’s easy-money blessing in 2001.

New-Home Sales

(Click on chart to enlarge)

Recessions shaded

For decades new-home sales had fluctuated in a range of 400,000 to 800,000 annually before reaching all-time highs in the late 90s. They barely suffered during the 2001 recession. Then, when the Fed depressed interest rates into the basement and held them there, real estate exploded. The new real-estate boom stood on the shoulders of the previous real-estate boom. It would eventually distort the economy.

You have to gaze at the chart above to appreciate the unprecedented nature and the enormity of what the Fed created. This was no ordinary cyclical upturn. This was the economic equivalent of a 100-year flood. To make matters worse, price-inflation did not surge to bring the boom to a timely halt. The Consumer Price Index (CPI) had climbed in the course of earlier building booms, and the Fed had boosted interest rates then to hasten those booms’ demise. The Fed let the latest real-estate boom run (just as it had let the boom run), despite this boom’s enormity, because price-inflation remained mild.

Unfortunately, stock-market and real-estate booms – known as asset inflations - don’t behave like ordinary price inflations. Buyers seek a capital gain and rush in to buy and re-sell. The faster prices rise, the greater the quantity demanded. As a result home prices – adjusted for inflation – recently rose at extraordinary rates to exceptional levels.

Eventually asset inflations collapse of their own accord because the asset’s price rises above any reasonable relationship to the asset’s ability to generate income. The bubble burst when stocks climbed beyond the underlying corporations’ ability to generate greater earnings. The recent real-estate boom began to collapse when home prices soared beyond any reasonable relationship to the rental income those homes could generate.

Now the chickens are coming home to roost. The powers-that-be hope that falling interest rates and tax rebates can encapsulate the outgoing tide. But the underlying distortions won’t just go away. The market is saddled with hundreds-of-thousands of homes that can’t be purchased at prevailing prices. A great asset deflation has begun. And just as asset inflations stimulate demand, asset deflations perversely discourage demand. Buyers will hang back, waiting for prices to fall further. There is a glut of homes and it will take time for the market to absorb that glut.

Unfortunately, many lives and livelihoods will face ruin on the way. Too bad, because Federal Reserve policy created this crisis. The skullduggery surrounding mortgage-lending practices was merely the superstructure of the problem. Skullduggery accompanies every great financial boom (think Enron). The Fed’s fundamental culpability is two-fold: (1) In response to a high-tech recession that falling interest rates could not alleviate, the Fed employed falling interest rates to stimulate a housing sector that was already enjoying boom conditions, and (2) The Fed’s protracted expansionary policy exacerbated an asset inflation whose demise will create a great deal of pain.

Yet this criticism is not directed at those responsible for the Fed’s actions. You can consult any economics text to see that the Fed’s policies were standard fare. It’s monetary policy itself that requires re-examination.

(The charts are taken from [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of Economic Indicators.)

© 2008 Michael B. Lehmann

No comments: