What should the Fed do to jump-start US economy?
Updated: 2012-08-17 06:48
By Lawrence J. Lau (HK Edition)
While the US economy is no longer contracting - the real rates of growth have been positive since the third quarter of 2009 - the economic recovery has been exceptionally slow, despite record low rates of interest. The unemployment rate has stayed stubbornly high above 8 percent and is unlikely to fall significantly in the near term. The effectiveness of an easy monetary policy is in serious doubt.
In fact, the real rate of interest, the difference between the nominal rate of interest and the rate of inflation (measured by the consumer price index, or CPI), has been negative since November 2009. The economy is in a classical "liquidity trap." As is well known, one can pull on a string but not push on a string. Further lowering the rate of interest and release of liquidity in the US is unlikely to increase domestic investment, especially given all the uncertainties of this presidential election year.
The problem is that expectations can be self-fulfilling in the absence of any clear signal of change. If firms and households expect the economy to do terribly and act accordingly by reducing investment and consumption, the economy will indeed turn out to be terrible, fulfilling their expectations. This may lead them to expect a further worsening of the economy, and act accordingly, resulting in an even further decline of the economy, creating a self-perpetuating downward spiral in which negative expectations lead to declines and declines feed into even more negative expectations.
This has been, unfortunately, the story of the Japanese economy since its property price bubble burst in 1990. In order for expectations to change, there must be some concrete action that can act as a signal to the firms and households that the economy will be improving soon.
The world economy has already experienced both "Quantitative Easing I (QE-I)" and "Quantitative Easing II (QE-II)" operations by the US Federal Reserve Board (Fed). However, these operations did not seem to have done the US real economy much good. Much of the excess liquidity generated went overseas, driving up exchange rates and asset prices elsewhere. If the US had some form of capital control, so that the excess liquidity had to be kept and used within the US, it might perhaps have driven up some US asset prices and led to some additional domestic investment. However, that has not been the case.
At this point, only an expansion of real aggregate demand can serve as an effective signal for a change in expectations. However, it does not appear likely that the US Congress will authorize a fiscal expansion, even though that is exactly what is needed. There is ample excess capacity in the US economy, especially in the construction sector and the building materials sector. What the US government should undertake is an expansion of capital expenditures focused on public infrastructure on the one hand and a reduction in recurrent expenditures on the other. It should be supporting growth and imposing austerity at the same time.
How can this be done, especially with a Congress that is unwilling to authorize any increase in expenditures, whether capital or recurrent?
One possibility is for the Fed, in its next round of bond buying, to purchase new long-term bonds, issued by the individual states and earmarked for public infrastructure in the respective states. For example, the Fed can offer to purchase a total of $600 billion worth of new state bonds from the individual states, roughly in proportion to the population of each state, with the proviso that the proceeds must be used for infrastructural projects - either new construction or maintenance and upgrading of existing infrastructure - and cannot be used to pay for the recurrent expenditures of the state (e.g., salaries of the state government employees) per se.
These infrastructural projects may include roads, highways, railroads, airports, seaports, bridges, dams, and even hospitals and schools, etc. This will increase aggregate demand, GDP, and employment in every state, and will be utilizing basically the excess capacity in the construction sector and the building materials sector and hence are unlikely to be inflationary. Moreover, such investments will turn out to be socially productive, given the current deteriorated state of US public infrastructure, by enhancing the rates of return of past, present and future private investment.
In addition, these expenditures on infrastructural projects will not increase the federal budget deficit; on the contrary, because of the GDP and employment that they will create in every state, they may actually help to reduce the federal as well as state budget deficits.
Of course, the individual states will have to pay the interest on the bonds and eventually repay the principal. However, the long-term rate of interest is at a record low and state revenues will benefit directly from the increased GDP and employment in the states. In addition, the states can take a long period, say 30 years, to repay the bonds, during which time the state economies will have recovered sufficiently. I believe all 50 states will support such a bond purchase plan. (In fact, a similar plan can be used for Greece, so that while Greece needs to reduce its recurrent government expenditures, it can still undertake some capital projects so as to maintain some economic growth and prevent unemployment from becoming too high.)
Another possibility is for the Fed to buy US mortgage loans or equivalently mortgage-backed securities at a discount. Owners of the mortgage loans or mortgage-backed securities can be asked to bid competitively the percentage discounts that they are willing to accept. The Fed will purchase those with the highest percentage discounts up to the maximum amount for that particular tranche of loan/bond purchases, say, $100 billion. Since these mortgage loans are purchased at a discount, there will be room for the negotiation of work-outs with the actual borrowers, especially those who are owner-occupants, through a reduction of their loan principals.
Moreover, the remainder of the loan, which may still be higher than the market value of the home, can be refinanced at the current lower rate of interest and perhaps even with an extended maturity, thus significantly lowering the monthly payments for the same home mortgage. In this way, it may become possible for many such borrowers to avoid default and loss of their homes. Once such mortgage loan default problems can be resolved satisfactorily, these households will have greater confidence as well as resources to start consuming normally again. The Fed can repeat the same exercise with successive tranches of such purchases of loans and bonds.
The Fed has a great deal of latitude in deciding what types of bonds and/or loans to buy. Another possibility for increasing aggregate demand is of course to increase net exports. If the US were any other country, its central bank could just undertake a significant one-off devaluation of its currency, leading to a significant increase in its net exports and resulting in an increase in both its GDP and employment.
However, for various ideological and technical reasons, a direct intervention in the foreign exchange market is not an option for the US or for the Fed. The Fed can offer to purchase new bonds to be issued by the Export-Import Bank of the US, thus enabling it to finance exports and export enterprises with super-low long-term interest rates. However, it is not clear that there is that much room there for Fed action.
Thus, the US is left with two imperfect instruments - "persuasion" and "flooding the World with liquidity" - to try to devalue the US dollar relative to other currencies. Neither instrument can work perfectly. The rate of interest in the US is already as low as it can be, so it is not possible to induce much additional net capital outflow (and hence a devaluation) through a lower interest rate differential with other countries and regions per se.
It is true that the Chinese yuan and the Japanese yen have actually appreciated significantly against the US dollar in the past couple of years and the respective bilateral trade balances seem to have narrowed. However, this strategy has not proven to be effective against the euro (in part because of the European sovereign debt problem and the US' position as a safe haven for capital). In fact, the euro/US dollar exchange rate has recently reached a 24-month new high.
Eurozone countries, Germany and France in particular, are major competitors of the US in the supply of capital and technology goods (e.g., airplanes, automobiles, machine tools, tractors, etc.), and their exporters remain extremely competitive with US exporters in the Chinese, Japanese and other markets. It is possible that the US dollar may fall yet again relative to the euro when the European sovereign debt crisis is finally resolved.
However, a significant, effective devaluation of the US dollar against major currencies, even if it can be engineered, risks kindling inflation in the US not only through a rise in the price of imports (the US has been importing most of its consumer goods), but also through a rise in the prices of the major commodities, including oil, and possibly also through a rise in the US asset prices due to increased foreign direct investment in the US. Unless US net exports can be increased significantly as a result of such devaluation, there may actually be some risk of stagflation.
We have discussed two possible bond-buying programs the Fed can launch, that can result in an increase in aggregate demand directly and indirectly and hence improve the US economy. There are also other possibilities. It does not have to be "Quantitative Easing III (QE-III)", or in any case QE-III can take a very different form from QE-I and QE-II. The world economy desperately needs a healthy US economy and the whole world wishes the Fed every success!
Professor Lawrence J. Lau is a Hong Kong economist and former vice-chancellor of the Chinese University of Hong Kong.
(HK Edition 08/17/2012 page3)