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September 20, 2007

How Virtuous Was Our Virtuous Cycle?

Friedrich von Blowhard writes:

Dear Blowhards,

As the captain of a small business boat trying to paddle through today's stormy economic seas, I have been spending a lot of time over the last month or so reading financial news online. This has led to my becoming acquainted with some interesting economic blogs. If you have an interest in such matters, you might find Econobrowser, The Big Picture, Calculated Risk, Alphaville and Naked Capitalism entertaining reads. You would even find some wit, I think; for example, Barry Ritholtz of The Big Picture had this to say in the wake of the Fed's recent 50 basis point (0.5% ) rate cut:

The Fed now has a third problem to deal with: They have become Wall Street's bitch. They may find that's a difficult condition to wriggle out from . . .[emphasis original]

The whole posting was entitled 'Bernanke Blinks' and you can read it here.

But mostly I'd like to call your attention to a point that I didn't appreciate about our current economic situation. To wit, that our various economic crises are all closely intertwined. Although from the press coverage one would think that our main problem is a credit crunch caused by loose lending in subprime mortgages, I suspect it would be just as accurate to describe our problem as stemming from our tendency to import a whole lot more than we import, i.e., that we have a large negative current account balance.

Okay, okay, I'm sure all you economic sophisticates already knew that, and I am obviously many years late to the party. Better late than never, I hope; I can only say that I woke up abruptly to the interconnectedness of things when I looked at a graph I discovered that compared the increase in mortgage debt outstanding (basically, the amount of new money loaned against real estate) with our trade deficit.


Note the similarity in the two trends? You can say all you want about correlation not being causation, but I think it's safe to say that people have been using home equity loans and refinancings to treat their houses as ATM machines, and spending the money they take out of them on goodies, a significant and stable fraction of which are imported. This graph comes to you courtesy of Calculated Risk; you can read the whole posting from March 2005 here. (See what I mean about being years late to the party? Sigh.)

The unity of our economic issues is explained quite a bit more eloquently than I could by Calculated Risk in another posting from September 18, 2007 called Fed Funds Rate Cut: Watch Long Rates.

The money quote of this insightful piece is as follows:

Lower interest rates led to an increase in housing prices. And those higher housing prices led to ever increasing mortgage equity withdrawal (MEW) by homeowners.

A large percentage of this equity withdrawal flowed to consumption, increasing both GDP and imports during the boom years. There is a strong correlation between the trade deficit and mortgage equity withdrawal, and although correlation doesn't imply causation, it appears mortgage equity withdrawal was a meaningful contributor to the widening trade and current account deficits during the housing boom.

To finance the current account deficit, foreign Central Banks (CBs) invested heavily in dollar denominated securities. Some analysts have suggested that these investments lowered interest rates by between 40 bps [0.4%] and 200 bps [2.0%] (Roubini and Setser: "Will the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006")

If these analysts are correct, and foreign CB intervention lowered treasury yields, then this also lowered mortgage interest rates ... and the cycle repeated. The result: a Virtuous Cycle with higher housing prices, more consumption and lower interest rates. [emphasis original]

Mr. Calculated Risk is primarily concerned with the fact that falling real estate values may reverse this process, creating a vicious cycle of lower consumption and higher interest rates.

Which would not be a good thing, of course.

But it turns out that another trend is part of this overall picture as well. I refer to the lack of a recovery in manufacturing employment after the job losses of the early years of this decade. Yves Smith at Naked Capitalism raised this point back on September 12. Mr. Smith wrote a post spotlighting the views of economist Thomas Palley.

Mr. Smith ends up quoting Palley at length, and I see no better way to proceed than to follow his approach. Thus, quoting Thomas 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.


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.


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 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.

And so to the headline of this post, How Virtuous Was Our Virtuous Cycle? One might think, kind of iffy, despite the significant GDP growth of the past six years. And note that in Palley's remarks yet another major economic trend slips into place:

Meanwhile, inflation-adjusted wages have barely changed despite rising productivity.

I pointed out in a previous postthat most of the gains of the past 40 years have largely been harvested by roughly 10% of the population, flowing largely to senior corporate executives, professionals such as lawyers and doctors, bureaucrats and financiers (or as they are known to sociology, the New Class).

One might note that the professional economists of the Federal Reserve and the rest of the government bureaucracy that manages much of our economy are also members of the New Class. Gee, you wouldn't think that our whole shebang was being managed for the benefit of the guys doing the managing, would you?

That might make the idea of the Fed being Wall Street's bitch a bit more understandable, no?



posted by Friedrich at September 20, 2007


Its how you gut a fish. You slice it open (free trade), open it up (artificially levitate the dollar index, keep interest rates low), and then scoop out the guts (export manufacturing base, hugely indebt the population and government). This is all a coordinated plan. The fallout is just beginning.

Posted by: BIOH on September 20, 2007 4:55 PM

Sigh indeed. Watching the New Class (and others, I suppose) help itself to whatever goodies it covets is quite a spectacle. How far would you say the New Class extends, anyway? CEOs and board members? Real estate sharks? Beats me.

Luckily for me, I wouldn't have any idea how to borrow money against my mortage. Er, do people really do that kind of thing? Amazin'. So ignorance has kept me in line, knock on wood. The Wife and I are so ignorant we went ahead and paid off our mortage as quickly as we could. I wonder if that makes us losers in the new economy ...

Posted by: Michael Blowhard on September 20, 2007 6:27 PM

Is it a conspiracy or is it simply the inability to bite the bullet?

Ben Bernanke, 20 days ago: "It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions."

Would that he had had the guts to stick to that stance.

As an admittedly economic babe in the woods I nevertheless sense the common sense in Bernanke's statement (which he has just contradicted by lowering the Fed Fund rate). As I read that statement, he is saying, "Do nothing, let fools and knaves pay the price for being fools and knaves." That would entail what is called a hard landing: a lot of economic pain endured, but endured for a short period of time as the market system self-corrects.

Anyhow, I think we would have been much better off if he had stuck to his guns and done nothing.

Posted by: ricpic on September 20, 2007 8:46 PM

"Anyhow, I think we would have been much better off if he had stuck to his guns and done nothing."

Really? And risk finanical industry dysfunction and a consequent recession? Bernanke is weighing the pros and cons of each decision, the con being an economic slowdown, perhaps of some magnitude. The least one can do is appreciate what he is afraid of - and that what he is afraid of is bad for Main St as well as Wall Street.

Posted by: jult52 on September 21, 2007 5:32 AM

Paint me a cynical on the recent Countrywide Loan situation, home ownership, and all All Things Fed?

Doesn't some of this go back to those life lessons we supposedly learned from our parents, school, etc.? You buy a house after you've saved some bucks for a down-payment. You buy a house when you can afford monthly mortgage payments that don't increase by factors of 2 or 3. You don't buy a house if you don't meet these 2 simple rules. Should everybody own a house? I don't think so. Should everyone have the opportunity to won a house? Absolutely.

While I agree with jult52 in principle, as a person who practices self-control with financial issues I can't help but be steamed by the "help" the govt. is giving to people who need the instant gratification of owning a house they're not ready for and the companies, like Countrywide, that prey on these short-sighted desires. I'm working hard enough to pay my own mortgage; I'm not in the mood to help pay someone else's.

And, Michael, congrats on paying off your mortgage. That is true ownership; not the joint ownership most of us have with our mortgage-reselling financial institutions.

Posted by: DarkoV on September 21, 2007 8:53 AM

Even at the peak of the housing boom, it has seemed to me that the rise in home proces and the attendant "virtuous cycle" are unsustainable. That's because the whole thing would have to correct itself when new home-buyers would be unable to purchase a new home.

I imagined that either the prices would drop, young workers (blue and white collar) would leave the area, or inflation woudl bring incomes closer to home prices.

Whatever the scenario, I was stunned by how many of my smart friends completely destroyed the advantage of having bought their homes pre-boom by maxing out on equity borrowing.

Posted by: PA on September 21, 2007 8:59 AM

Here's another angle on the sub-prime meltdown that many of you probably had not thought of...

Posted by: Bob Grier on September 21, 2007 11:27 AM

Actually, I think sociology refers to them as the upper and upper-middle classes. Bureaucrats aren't nearly as powerful here as they are in Europe.

Posted by: SFG on September 23, 2007 2:39 PM

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