Bring Back the Punchbowl!
Martin Wolf says that the Federal Reserve must make sure that American households keep spending:
FT.com / Columnists / Martin Wolf - The Federal Reserve must prolong the party: Has the Federal Reserve been a serial bubble-blower? Or has it been responding to exceptional macroeconomic conditions? Not surprisingly, the implication of Ben Bernanke’s celebrated speech on the global “savings glut” implies the second view. Yet his self-exculpatory perspective is far from universally shared. So who is right? My answer is both. The Fed can indeed be accused of being a serial bubble-blower. But this is... because it has been managed by competent people responding to exceptional circumstances....
[There] is an excess of savings over investment (or income over spending) in much of the world, largely offset by an excess of investment over savings (or spending over income) in a limited number of countries among which the US is predominant.... The US has been the world’s spender and borrower of last resort.... [E]xcess savings elsewhere have been “crowding in” US spending. How has this worked?... [F]oreign governments did supply as much as 48 per cent of the net financing of the US current account deficit. This should be viewed as “vendor finance”, intended to provide the US with money needed to buy the exports.... If foreigners are net providers of funds, some groups in the US must be net users: they must be spending more than their incomes.... The US government moved massively from financial surplus into deficit.... Household spending grew considerably faster than incomes from the early 1990s to 2006. By then they ran an aggregate financial deficit of close to 4 per cent of GDP. Nothing comparable had happened since the second world war, if ever....
[T]he Fed has, willy nilly, pursued a monetary policy capable of inducing a huge and unprecedented financial deficit among US households... through... asset-backed borrowing and lending.... Nothing that has happened has been a product of Fed folly alone.... US households must spend more than their incomes. If they fail to do so, the economy will plunge into recession unless something else changes elsewhere.
This is why the Fed is sure to cut interest rates if today’s crisis seems likely to reduce the supply of credit (as surely it will).... Today’s credit crisis, then, is far more than a symptom of a defective financial system. It is also a symptom of an unbalanced global economy. The world economy may no longer be able to depend on the willingness of US households to spend more than they earn. Who will take their place?
I share Martin Wolf's belief that if housing prices start to collapse and thus credit and spending fall, the Fed will rapidly respond by lowering interest rates. It will do that as long as there is a sweet spot where it can do so without igniting inflation. But what will happen if it then turns out that inflation is ignited, and there is no sweet spot?
