Jeffrey Sachs Communes with His Inner Hayek

Jeff writes:

The roots of crisis | Comment is free: The US federal reserve's desperate attempts to keep America's economy from sinking... do not seem to be effective. Although interest rates have been slashed and the Fed has lavished liquidity on cash-strapped banks, the crisis is deepening. 

To a large extent, the US crisis was actually made by the Fed.... [I]n 2001... the Fed turned on the monetary spigots to try to combat an economic slowdown... pumped money into the US economy and slashed its main interest rate.... The Fed held this rate too low for too long....

What was distinctive this time was that the new borrowing was concentrated in housing... commercial and investment banks created new financial mechanisms to expand housing credit to borrowers with little creditworthiness. The Fed declined to regulate these dubious practices....

[T]he home-lending boom... became self-reinforcing... buying pushed up housing prices, which made banks feel that it was safe to lend money to non-creditworthy borrowers.... [T]he Fed, under Greenspan's leadership, stood by as the credit boom gathered steam.... At a crucial moment in 2005... Bernanke described the housing boom as reflecting a prudent and well-regulated financial system, not a dangerous bubble. He argued that vast amounts of foreign capital flowed through US banks to the housing sector because international investors appreciated "the depth and sophistication of the country's financial markets (which among other things have allowed households easy access to housing wealth)."...

The housing bubble was bursting by last fall, and banks with large mortgage holdings started reporting huge losses, sometimes big enough to destroy the bank itself, as in the case of Bear Stearns.... [T]he Fed... has been cutting interest rates.... But... credit expansion is... flowing into... commodity speculation and foreign currency. The Fed's easy money policy is now stoking US inflation rather than a recovery....

Having stoked a boom, now the Fed can't prevent at least a short-term decline in the US economy, and maybe worse. If it pushes too hard on continued monetary expansion, it won't prevent a bust but instead could create stagflation - inflation and economic contraction...

I confess, I don't see why the Fed can't prevent a recession. Push the value of the dollar down far enough and export and import-competing manufacturing will grow fast enough to prevent a recession. The Fed may not like the inflation that this generates. But I don't see why monetary expansion will necessarily be ineffective in boosting output and employment.

Comments

[Paul J. Reber]

If the recession is not so long, but ends up associated with some inflation as things steady out, given the reasonable likelihood of a Democratic president in 2008, isn't this going to exactly continue the Bartels' effect? We'll end up with yet another Democratic president presiding over relatively stronger growth and slightly higher inflation.

It's funny to think you can see it coming a few years off. I guess that even though history doesn't repeat itself exactly, it really does kind of rhyme.

[roublen]

I wonder what economists think of Humphrey-Hawkins type full-employment schemes (the original one, not the watered-down version that eventually passed).

http://en.wikipedia.org/wiki/Hubert_Humphrey

It seems to me that to avoid the worst of a downturn, you'd want some way to transfer some purchasing power from (perhaps temporarily) risk-averse, cash-hoarding rentiers, to people in need of a paycheck, while doing as little damage possible to free enterprise, flexible markets, private property and the rest of it.

[ottnott]

Brad wrote:
"I confess, I don't see why the Fed can't prevent a recession."

The Fed CAN prevent a recession. The Fed can make us all millionaires, too, but it isn't a goal worthy of the cost.

How far do you think the Fed should go to prevent a recession?

[Ken Houghton]

"But I don't see why monetary expansion will necessarily be ineffective in boosting output and employment."

I don't, either, from the standard models. But it notably hasn't worked yet, unless you could creating a bunch of inventory this quarter, in a JIT world.

Fortunately, the Bush tax rebate is similar to helicoptering, so the next President will be able to blame his predecessor for the recession that starts his term.

Too bad neither of the candidates has the cojones to do so.

[mlnberger]

I do not know the chances, but I imagine they are above nil: what are the consequences if the rest of the world and / or the bond vigilantes (wherever they may be) decide that inflation and a declining dollar are inevitable and (long-term) interest rates start to rise? One of the not-discussed consequences of a rise in interest rates would be the lethal damage it would do to our federal budget deficit; of course it would slow business / consumer activity to a crawl. Would these stop or counter the Fed's ability to avoid a recession?

[Matt]

"Push the value of the dollar down far enough "

until

"import-competing manufacturing will grow fast enough"

If you mean, let us all now agree to a set of production contracts for the future in order to meet a production timeline.

If you give us the growth value/timeline, we will produce the future production contracts.

But if you want us to be accurate, then are rate of production will go up power law, if we use the current production model. I tell you, that is the minimum number additional inventory operations over your planning period that you need to get the next bit of precision.

So you get reconstruction, a new production model; then you get what you want, a few people exchange jobs.

You ask why doesn't reconstruction happen in small differential amounts. Why do business cycles pile up.

It is because we have an aggregate view, we know the long moves. Behind your back, we are refusing to make differential moves, because we are waiting for the bigger auction.

It makes sense. It is saying, hey, this production system won't work for long, I can see that the next round of growth will reorganize my factory floor totally. So, I wait until my suppliers see similar problem, so we can time our move, reduce mutual down time. In the meanwhile, I operate with supply shocks.

We are deliberately quantum, we time our jumps.

[Measure for Measure]

"I confess, I don't see why the Fed can't prevent a recession. Push the value of the dollar down far enough and export and import-competing manufacturing will grow fast enough to prevent a recession."

Wha?

Let me quote from my macro textbook:

"The J-Curve: Some Details
Trade links across countries take time to create, time to modify, and time to destroy. So while a depreciation of the US real exchange rate causes an increase in foreign purchases of US goods, a year or more will pass before we see the change in the volume of trade."
-- DeLong (2002), p. 172

Sure, the Fed can prevent a depression or end a recession given enough time. But I would think that the long and variable lags in monetary policy might make avoiding recessions a more difficult task for the FRB.

[christofay]

Here we are watching the Fed trying to avoid a recession brought on by its last efforts to avoid a recession.

Banana republics are good places to buy stuff cause they're cheap. The middle class is kept in line by inflation when you're worried about paying for food and schooling, you run out of time to protest.

The bond vigilantes, the Chinese, the Saudis, are starting to show up.

From http://goldnews.bullionvault.com/greenspan_conundrum_bond_yields_treasury_US_debt_050520082

What to do? Thirty-year US bonds now yield fully 3% more than short-term Treasuries. Last time this premium for long-term borrowing got so high, the US government decided to stop issuing 30-year bonds altogether. It only re-introduced them in late 2006, taking advantage of Greenspan's Conundrum to lock in 30-year loans at below-short-term rates.

Put another way, "Just what will the Fed do if 10-year Treasury yields keep rising?" as we asked here at BullionVault at the start of June 2007.

"Well if Washington and the US consumer can't borrow cheap at the long end," we guessed in Gold & the Bond Market Panic, "then they'll just have to go to the short end for cheap money instead. The Fed can take care of that.

"By slashing the price of overnight money, it will let the US government shift the weight of its obligations out of 10-year and long-dated bonds into shorter-term debt – the classic structure of borrowing for any banana republic."

And now – surprise, surprise! – the US Treasury says it's bringing back one-year T-bills, last seen at the end of 2001. "The administration said [Wednesday] it would begin selling the one-year bill, also referred to as a 52-week bill, at an initial auction in June," reports the Associated Press.

"New one-year securities will be auctioned every four weeks [because] the government will need to cover a budget deficit expected to jump to an all-time high this year, surpassing the old mark of $413 billion set in 2004. A big part of the increased borrowing reflects the need to pay for economic-stimulus rebates to 130 million households."

[christofay]

It's floating around:

Market

Analyst Call
Weak data Fed eases, stocks rally.
Strong data Strong economy, stocks rally.
Consensus data Lower volatility, stocks rally.
Bank loses US$ 8 billion Bad news all out of the way, stocks rally.
Oil price up Good for energy producers, stocks rally.
Oil price down Good for consumers, stocks rally.
US$ down Good for exporters, stocks rally.
US$ up Lower inflation, stocks rally.
Inflation up Good for commodities and asset prices, stocks rally.
Inflation down Fed eases, stocks rally.
Climate change Soft commodities up, stocks rally.
World ends Good for disaster recovery companies, stocks rally.

So Mr Delong says we're in the US$ down, good for exporters, stocks rally, but we also get a push in the real economy. Our standard of living has fallen enough that factories start hiring again to produce for the European market. There will be a lag, factories have to be re-tooled, real investment for returns that run rate of inflation plus something, 3 to 20%, has to be created.

[christofay]

Or to put where are we now economically in another view, is the Bernanke Fed playing Cheney's end of term game of kicking the can down the road? The desperate moves are postponing when the start of the recession will be declared till the next administration?

[bigTom]

We've had 2 quarters of approx .5% growth, so we have been squeezing by just above the official definition. Of course GDP growth less than population growth (and not corrected by true inflation -i.e. food & fuel not core) is sortof recession lite. Perhaps this can continue for several more quarters. I am of the opinion that the increase in commodity prices is large enough -and permanet enough that we need to adjust to a smaller pie. We could either adjust quickly or by stagnating for a much longer period of time. Perhaps we are following the second course.

[christofay]

The entire Cheney administration has been stagnation.

What do you call stagnating for a much longer period of time?

[Noise Trader]

"I confess, I don't see why the Fed can't prevent a recession. Push the value of the dollar down far enough and export and import-competing manufacturing will grow fast enough to prevent a recession."

Devaluing the dollar does not instantaneously start the wheels of industry spinning faster. Over time, a cheap dollar will cause exporters to hire and train new workers, order new machinery and develop new sales channels. Unfortunately, these are slow processes, while the dislocations associated with a popped housing bubble, a damaged banking system and dampened animal spirits happen quickly. Adjustments don't happen overnight, and the lags matter!

[John Paul]

``I confess, I don't see why the Fed can't prevent a recession.''

The Fed cannot prevent a recession, Mr. Delong, because the rest of the world is tired of propping up an unsustainable model of American consumption. There will be a recession because Americans must learn to work without gas-guzzling 60-minute commutes, to eat without transporting excess calories over thousands of miles and to live within their means.

[a]

``I confess, I don't see why the Fed can't prevent a recession.''

This is the money quote! I guess this is pretty much the view of most American economists. Keep the consumer spending, to keep the economy moving.

For fifty years economists have espoused theories that have seen Americans go deeper and deeper into debt, always to keep the economy moving. It works, until it doesn't. It doesn't, when the people lending the money decide the borrower is a deadbeat, and won't lend anymore.

[Matt]

Here is another path to examine Brad's ultimate question,

Why can't we always use money technology to allow smooth adjustments to shocks?

Because we are not limited by money technology, there is another limit on our differentialness, another restriction outside of money that prevents us from making smooth transitions.

As time progresses, productivity locks into a specific lot size. So companies reach a point where they need to adjust lot sizes so the distribution of measuring units all the way down the chain yield a lot size set capable of making measurements that better match the shock.

When do we reach this point and what is our change mechanism?

We reach this point when the people next to us make differential moves equal to the actual cost of using money technology to measure the moves. The Jensen inequality breaks down. The financial system itself imposes a cost of usage. At that point, people say,"Forget about using money to make adjustments"

The uncertainty of money matches the uncertainty of getting the next bit of precision. That is the signal for the herd to flock.

Cows do this. When the lead cow discovers a water hole in the distance, then the future gains from the water hole in the distance exceed the gains from adjusting my relative position in the current pasture. I am better off stampeding, that is, running in the same relative position until the new configuration is reached.

Consider homeowners under water. Solos expects them to flock, to stampede because they are limited, ultimately, by their inability to make smooth transitions in housing, increasing the measuring effectiveness of money won't work, it is not money, it is the fact that the bubble in housing forced a particular "lot" size on the housing consumer. So Soros and Jim Gross at PIMCO know about flocking. They are betting that homeowners under water will aggregate into a mob, force government actions.

[Kelly]

I have to agree with "a". It seems that Prof DeLong is looking for a painless way out.
As to whether the devalued dollar will bring quick manufacturing to our shores maybe you should consider this from the LA Times;
http://www.latimes.com/news/printedition/front/la-fi-chinainvest5-2008may05,0,7440284,full.story

Chinese firms bargain hunting in U.S.
DONGGUAN, CHINA — Liu Keli couldn't tell you much about South Carolina, not even where it is in the United States. It's as obscure to him as his home region, Shanxi province, is to most Americans.

But Liu is investing $10 million in the Palmetto State, building a printing-plate factory that will open this fall and hire 120 workers. His main aim is to tap the large American market, but when his finance staff penciled out the costs, he was stunned to learn how they compared with those in China.

Liu spent about $500,000 for seven acres in Spartanburg -- less than one-fourth what it would cost to buy the same amount of land in Dongguan, a city in southeast China where he runs three plants. U.S. electricity rates are about 75% lower, and in South Carolina, Liu doesn't have to put up with frequent blackouts.

About the only major thing that's more expensive in Spartanburg is labor. Liu is looking to offer $12 to $13 an hour there, versus about $2 an hour in Dongguan, not including room and board. But Liu expects to offset some of the higher labor costs with a payroll tax credit of $1,500 per employee from South Carolina.

"I was surprised," said the 63-year-old president of Shanxi Yuncheng Plate-Making Group. "The gap's not as large as I thought."

Liu is part of a growing wave of Chinese entrepreneurs expanding into the U.S. From Spartanburg to Los Angeles they are building factories, buying companies and investing in business and real estate.
.
.
.....

[Massi De Santis]

``Push the value of the dollar down far enough and export and import-competing manufacturing will grow fast enough to prevent a recession."

There may be a limit to how fast export and import manufacturing can grow to offset a drop in domestic demand. Firms would have to think that the lower level of the dollar is permanent or it will stay low for a long time, before they invest more and hire more workers. Labor markets are still relatively tight, with unemployment at 5%, so an increase in the demand for manufacturing workers may result in wage inflation. This is quite likely given that the current inflationary pressures affect these types of workers more (lower income commuters with rising gasoline prices, lower income workers facing higher food prices).

Finally, to the extent that future higher inflation and inflation risk may deter current investment, higher expected inflation can lower AD even more.

--MD

[uberdave]

What Prof DeLong is saying is that he doesn't understand how Sachs comes up with his statement that too much monetary expansion would lead to a bust. Perhaps Sachs is thinking that Bernanke will opt for hyperinflation, which usually has made economies collapse (Austria 1920's, Brazil 1990's, Zimbabwe today).
However, DeLong should realize that while monetary policy should be able to keep unemployment from going too far above long-term 'equilibrium', to steady growth around population+productivity, in the short-term, a recession might occur. It depends on the starting point: if you're way above trend, to get back to normal will hurt. Getting from the recent 2005-2007 overheating (4.4% unemployment, 5% growth, huge capital inflows) to a more sustainable equilibrium (5.5% unemployment, the average for 1990-today, 2.5-3.0% growth, domestic demand which is weak enough to adjust the CA until exports catch up -- the J-curve that many have mentioned above). The Fed can and should do what it can to smooth the process, but the move from boom to no-boom is what is commonly referred to as a bust. If it happens slowly, it shows up in statistics as a soft landing; if it happens fast, it is a recession, and if compounded by policy errors (or, in many emerging markets, policymakers must hike rates or devalue), a crash and long recession or depression.

[Just a yob journalist]

All righty then. Brad seems to think the US can avoid recession by pushing down the value of the greenback and putting up with high inflation. But there are three things I don't get:

1) Will other countries stand by and let the US devalue its currency to boost exports? China, especially, doesn't seem likely to let that happen if it involves widespread unemployment among Chinese workers. Isn't there a danger of a race to the bottom as each manufacturing nation tries to beggar its neighbor?

2) Doesn't Brad's formula merely trade recession now for recession later? Won't the inflation that would follow Brad's recommendations eventually need to be tamed by crushing interest rates?

3) Why would foreigners want to hold debased greenbacks anyway? Aren't they likely to stop reinvesting their US dollar assets in Treasuries? Or at least to demand much higher interest rates? And won't that slow the economy even further?

I don't know the answer to any of these. But I'd love to find out.

[anonymiss]

export and import-competing manufacturing will grow fast enough to prevent a recession.

But will they really? I've driven through the rust belt, and it's really not clear to me how much of a manufacturing base we really have left. It's not like we can unwrap the factories and start them producing again--and even if we can for some, a lot of them that are structurally sound aren't environmentally sound. I just don't see people putting up with that for jobs they don't believe are going to stay.

There is an issue here of having to build the factories, and find and train the workers, which is made more difficult in an inflationary period, especially one where there's a credit crunch. Add to that the fact that most Americans don't want manufacturing jobs, because they've lived through the mills and the factories closing down. They don't want to bet their future on a horse they know is a loser, so selling these jobs to American workers, investors, local governments, and others is going to be a heck of a difficult thing.

We've spent 25 years ripping down factories and moving our society to one that's focused on finance, services, and consumption (mostly financed by the clever schemes developed by the financiers). I just don't see where the manufacturing comes from to see us through this dry spell--and certainly not enough to help the millions of median-wage Americans in debt or close to it who are going to get crushed by higher inflation.

I don't see this white horse really materializing.

[anonymiss]

export and import-competing manufacturing will grow fast enough to prevent a recession.

But will they really? I've driven through the rust belt, and it's really not clear to me how much of a manufacturing base we really have left. It's not like we can unwrap the factories and start them producing again--and even if we can for some, a lot of them that are structurally sound aren't environmentally sound. I just don't see people putting up with that for jobs they don't believe are going to stay.

There is an issue here of having to build the factories, and find and train the workers, which is made more difficult in an inflationary period, especially one where there's a credit crunch. Add to that the fact that most Americans don't want manufacturing jobs, because they've lived through the mills and the factories closing down. They don't want to bet their future on a horse they know is a loser, so selling these jobs to American workers, investors, local governments, and others is going to be a heck of a difficult thing.

We've spent 25 years ripping down factories and moving our society to one that's focused on finance, services, and consumption (mostly financed by the clever schemes developed by the financiers). I just don't see where the manufacturing comes from to see us through this dry spell--and certainly not enough to help the millions of median-wage Americans in debt or close to it who are going to get crushed by higher inflation.

I don't see this white horse really materializing.