There’s good growth and bad growth. The former is well supported by internal income generation and saving. The latter is driven by asset bubbles and debt. The United States, in my opinion, has been on a bad-growth binge for nearly a decade, but especially over the past five years. In a US-centric global economy, that means the rest of the world has also become overly dependent on bad growth as the sustenance of a false prosperity. The endgame is all about the transition from bad growth back to good growth. The key question is under what conditions that transition occurs.
With a saving-short US economy now hooked on an increasingly frothy property market, risks of the ultimate post-bubble shakeout are mounting. That’s because, unlike the equity bubble of the late 1990s, the housing bubble has been built on a mountain of debt (see my 24 June dispatch, “From Bubble to Bubble”). The history of asset bubbles tells us they almost always last for longer than we think. That was true with the dot-com mania and is most assuredly the case today. The bursting of bubbles remains a great mystery. Macro offers two leading possibilities -- rising interest rates or a shortfall of income growth. In my days as a bond bear, I used to think that rising interest rates would wean America from the excesses of asset bubbles once and for all -- not just piercing the housing bubble but also triggering an unwinding of “carry trades” that stoke ever-frothy fixed income markets. As a newly converted bond bull, I now believe the imminent threat of such a possibility has receded. While that buys time, it does so with one more slug of bad growth. By dodging the interest-rate bullet, the debt-intensive Asset Economy may well get another lease on life -- making for an ever more treacherous endgame.
The Fed is the swing factor in this outcome. And so far, it has swung its support repeatedly in favor the multiple bubbles of the Asset Economy. It set the stage in the late 1990s, with Alan Greenspan backtracking on his initial concerns over “irrational exuberance” and then going on to be a leading cheerleader of the New Economy and the monetary accommodation it “deserved.” The bursting of the equity bubble then forced the Fed into an aggressive mode aimed at preventing a repeat of Japan’s experience -- a 550 basis point slashing of the federal funds rate to a 46-year low of 1%. As the post-bubble US economy appeared to heal, the central bank belatedly began to normalize its policy rate. This normalization has been feeble, at best. During the five-year period since the equity bubble popped, the Fed has kept the real federal funds rate at, or below, the zero threshold. This extraordinary monetary accommodation has led to bubble after bubble. But this time, the “echo bubbles” had something the original bubble never had -- a monstrous debt wave.
The Fed remains steadfast in its insistence that all is well because it is on a “measured” path toward policy normalization. While this week’s widely expected 25 bp tightening may add some credence to that impression, it will be the policy statement that tells us if the central bank’s commitment is wavering. The latest musings of Fedspeak are more ambiguous than usual -- with one policymaker on record depicting the current monetary tightening campaign as being in the eighth inning of a nine-inning baseball game while others are suggesting there is still considerably more work to do. At present, financial markets are more supportive of the baseball analogy -- looking for only 2-3 more measured tightenings of 25 bp each, or a Fed that is basically done by this September. That would leave the nominal federal funds rate in the 3.6% to 3.7% zone -- only about 0.5 percentage point above the one-year ahead inflationary expectations of 3.2% as tallied by the May reading of the Michigan survey of consumer confidence. If the markets have it right -- and I must confess to being very sympathetic to this conclusion -- it’s hard to believe that a 0.5% real federal funds rate will do much of anything to end the madness of America’s bubble-prone Asset Economy.
Steeped in denial, the Fed is trying to deflect attention away from its role in this sad state of affairs -- choosing, instead, to focus the debate on the so-called interest rate conundrum. The central bank can only do so much, goes the plea -- it’s up to the markets to do the rest. So far, with the federal funds rate basically at zero in real terms when judged by forward-looking inflationary expectations, the Fed has hardly done much at all. But that hasn’t stopped Alan Greenspan from going on at length in considering and then dismissing many of the factors that may account for this puzzle -- namely, faltering growth prospects, subdued business credit demand, foreign central bank purchases of dollar-denominated fixed income assets, and reduced inflationary expectations. Interestingly enough, the excess policy accommodation of the Fed has been conveniently left out of this discourse -- a rather shocking omission given the key role played by the policy anchor at the short end of the yield curve in shaping intermediate to longer-term rates through the so-called term structure of interest rates. It may well be that the real conundrum lies with the Federal Reserve, itself.
While I would like to see the Fed stay the course of measured tightening and take the real federal funds rate up to at least 2% -- broadly consistent with policy neutrality -- I don’t think that will happen. The US central bank remains decidedly pro-growth, market-friendly, and fearful of political flak -- all considerations that suggest it is unwilling to play the role of the “heavy” in dealing with the increasingly worrisome imbalances of America’s Asset Economy. Moreover, I suspect the financial markets are beginning to sniff out a potentially serious global growth scare -- driven by the confluence of an oil shock and a China slowdown. In that context, there is ample room for a further reduction of inflationary expectations -- especially in the event of a China-induced shortfall of commodity demand and pricing.
If such a growth scare comes to pass, I continue to believe that long rates may well move lower, with yields on 10-year Treasuries even testing the 3.5% threshold. That would put the US central bank on the brink of triggering an inverted yield curve -- especially if it elects to take its measured tightening campaign beyond the 2-3 more policy moves that the markets are now expecting. That would lead to a squeeze on financing that would starve the property bubble and undoubtedly tip the US economy into yet another post-bubble recession. Despite all the special circumstances that the Fed has offered as explanation for the current yield-curve flattening, I suspect that this pro-growth central bank will do everything in its power to prevent the yield curve from inverting.
Largely for those reasons, I suspect the US interest rate climate is likely to remain surprisingly benign and, therefore, supportive of yet another wave of debt-intensive asset inflation. As a result, the housing and bond bubbles could well continue to expand, allowing asset-dependent American consumers to keep on spending. US economic growth, in that climate, may well remain surprisingly firm -- even in the face of $60 oil. All this would be a textbook example of another period of “bad growth” -- the last thing an unbalanced US and global economy needs. Likely by-products of another spate of bad growth include more debt, further reductions in income-based saving, and an ever-widening current account deficit. Eventually, the balance-of-payments constraint will take over -- triggering a renewed weakening of the dollar and a sharp back-up in real interest rates. But the emphasis, in this case, is on the word “eventually.” The bear case for rates that I now support is likely to come later rather than sooner -- and off lower levels of longer-term rates than I had previously thought possible. Because of that hiatus, there’s little to stop the Asset Economy for the time being.
Meanwhile, the excesses in the US property market are now starting to display all the classic symptoms of a mania -- underscoring the inherent vulnerability that Yale professor Robert Shiller has long warned of. It’s not just the growing profusion of exotic financing schemes -- the interest-only and negative-amortization mortgage loans that have become the rage in the hottest of real estate markets. Equally worrisome is evidence that “asset flipping” is now reaching Ponzi-like proportions. The latest rage is www.condoflip.com -- a website dedicated to creating an electronic market whereby “buyers of preconstruction condos resell or assign those condos to new buyers.” Debuting in Miami, expansion is set shortly for Las Vegas, Los Angeles, Dallas, Chicago, and New York. If you hurry, you may even be able to own a “Condo-Flip” franchise of your own. Five years later, this is nothing more than a reincarnation of the day-traders of the dot-com era.
As former Fed Chairman Paul Volcker noted recently, the saddest thing of all is that no one in a position of responsibility wants to put an end to this madness (see his 10 April 2005 op-ed in the Washington Post, “An Economy on Thin Ice”). Congress is focused on fiscal profligacy and China bashing. The White House is fixated on “transformational politics.” The Fed remains steeped in denial. And the rest of the US-centric world is begging for another spin around the track. Sadly, bad growth begets more bad growth -- until it’s too late. Following this week’s likely rate hike, the US central bank will have only 325 bp in its arsenal -- literally half the ammo it had five years ago when the first bubble popped. With the aftershocks of the property bubble likely to be far more worrisome than those of the equity bubble, this time the Fed may be ill equipped to face what is shaping up to be an increasingly treacherous endgame.
