And now, as promised, my e-mail from Gilles Saint-Paul of the Université des Sciences Sociales de Toulouse in response to my question about why economists outside the U.S. seem to think we need a recession while economists within argue that we need to do whatever we can to fight it.
The U.S. economy does not “need” a recession but it needs to cut consumption
by several percentage points to restore its trade balance. I also think it
needs to avoid bailing out those who gambled on risky loans and overpriced
houses. Otherwise, it will have another round of financial bubble which may
again sustain excess consumption, because market participants will reinforce
their presumption that buying the bubble is a one way bet since they will be
bailed out if things turn sour. And along with the bubble comes an imbalance
in the composition of investment (for example, a housing bubble may lead to
too much construction).
It would be nice to have these needed corrections without a recession, but I
doubt it can be avoided. Default on loans will worsen the balance sheet of
financial institutions and reduce the supply of credit to the economy. A
fall in consumption will reduce aggregated demand because it takes time for
nominal prices to adjust and for the composition of demand to be redirected
to the external sector (exports), as it should.
So why do we see this hysteria on the part of policy makers?
For one thing, you are right that there is some delusional aspect about
growth. The last ten years were exceptional and should not be taken as a
norm. A mature economy can consider itself happy if its GDP per capita grows
at 2% a year. This is what we can expect from the long-run trend in
technical progress. As material and import prices go up, which is the normal
by-product of emergent countries converging to western living standards, we
should expect some “stagflation” to happen: imported inflation will go up
and the higher import prices will be a drag on productivity growth, so one
should be prepared to live with lower growth rates. This is inevitable and
will contribute to a real depreciation of the US exchange rate which will
contribute to restoring the external balance.
One aspect of the 1995-2005 period I think is that excess stimulus to the
economy had little effect on inflation because of the greater openness of
the US economy and because of the moderating effect of import prices. So a
Fed which was looking only at inflation could think that it was safe to
reduce rates to very low level, while in fact this led to overborrowing by
consumers and asset bubbles, which created the current problem.
A second aspect is that some economists fear that financial fragility and
the deterioration of credit conditions could lead to a remake of the great
depression. In particular, Mr. Bernanke himself was famous as an academic
for studying the financial transmission mechanism in such episodes; I wonder
whether his own past work is not inducing him to take those risks too
seriously. Personally I would rather wait till the economy has deteriorated
for good before intervening. I think it is less risky than trying to fuel
the economy at any cost.
A third aspect which is important in my view is that there is a lobby in
favor of cutting interest rates: exposed financial institutions, insolvent
borrowers on variable rates, and so on. So we are being sold a recession
story so that these people avoid having losses and get the rate cut that
they want. With a 4% inflation rate and a 3% interest rate, short-term
interest rates are negative. Inflation may continue to increase since loose
fiscal and monetary policy compound the stagflation problem that I mention
above. With negative interest rates we may see again a burst in asset
prices, which was fueled by the very low interest rates of the years
2001-2003, and we will run into a similar problem a few years from now,
except that it will probably be worse. As Rudi Dornbusch used to say “it is
not speed that kills you, it is the sudden stop.”