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The Great Deluder

For us, Mr. Greenspan is the great deluder of the American public, flatly deceiving it about the economy's true situation and prospects. His speeches always convey the impression of extraordinary sophistication, but the reality is that elementary knowledge of macroeconomic aggregates or processes, such as saving or wealth creation, obviously eludes him. It keeps amazing us how little critical response he finds.

One reason for this generally silent complacency, we presume, is an overwhelming desire among economists not to upset the prevailing bullishness of public opinion. Bear in mind that Wall Street economists dominate economic discussion in the United States. Their main concern is the stock market.

But we also note a widespread lack of knowledge or interest in macroeconomic matters even of crucial importance. Nobody cares about savings, nobody cares about a credit expansion that has gone completely out of control and nobody seems to realize that the huge trade deficit has been the greatest profit-killer in the U.S. economy for years. Rather, it is hailed as an emblem of economic strength.

The other looming danger in addition to the trade deficit, is, of course, the immense risk it poses to the dollar and in its wake to the whole financial system, both having become heavily hooked on incessant, immense capital inflows. It seems to us that this horrendous danger, too, is in general not at all appreciated.

Pointing to higher U.S. real GDP growth in America than in Europe and Japan, the bullish American consensus has been hailing Mr. Greenspan's aggressive monetary easing as a tremendous success. In our view, this comparison is heavily distorted by different calculations of inflation rates. Looking at the economic aggregates that truly matter for people and the economy, like employment, incomes, and production, the U.S. economy over the past three years has performed most miserably among the industrial nations.

What went wrong in the first place? Actually, it seems easier to first identify some factors that have plainly not been among its causes. It is the first economic downturn in postwar history that has not been precipitated by rising inflation and monetary tightening.

As aggregate domestic demand eventually outpaced aggregate domestic supply during past booms, inflation rates used to accelerate. The Fed then pulled the brakes, invariably culminating in recession. Monetary easing, starting about a year later, then promptly triggered the subsequent V-shaped upturn. Within just two years following the recession, the economic losses suffered during the recession were more than offset by very steep economic recoveries.

Periods of recession implicitly reflected the liquidation of the borrowing and spending excesses that had accumulated during the prior boom. In this way, businesses came out of recessions with strong balance sheets and great gains in efficiency.

The thing to see is that the borrowing and spending excesses that accumulate in the course of the boom essentially disrupt the economy's established pattern of demand, output, incomes, relative prices and profits. These distortions hamper economic growth directly over time, irrespective of the level of interest rates.

But manifestly, both the U.S. economy's and the stock market's sharp downturns in 2000 were not caused by tight money or credit. Nonfederal credit rocketed in the year's second quarter when the two began their plunge at an annual rate of $1,315 billion. The increase during the year as a whole was $1,148 billion, after $1,098 billion the year before. For comparison, during recession year 1991, the total nonfederal credit rose $188 billion, after $410 billion in 1990 and $632 billion in 1988.

Assessing the U.S. economy's prospects, we must be clear about the extraordinary causes of the downturn that started in mid-2000. In our view, the consumer borrowing and spending binge since 1997 is the U.S. economy's decisive primary maladjustment, certainly the one that brought about the downturn in 2000. It was crucial in generating the variety of dislocations and imbalances that broke the economy's vigor - the collapse of personal saving, the surge of the trade gap, the slump in business investment, the profit carnage, and exploding consumer and business debt loads.

In response, the Fed almost immediately began an unprecedented campaign of monetary easing. According to the American consensus economists, this campaign's success over the last three years has been remarkable. As a result, according to the general mantra, the U.S. economy did not suffer an economic slump of the kind that followed the stock market's crash in 1929. In one of his congressional testimonies, Mr. Greenspan actually emphasized that "imbalances in the economy had not festered in the past years."

But have the economic and financial maladjustments that precipitated the economy's downturn in 2000 really been significantly remedied? To repeat the key point in this respect: Since this downturn was definitely not caused by tight money or credit, loose money alone cannot be the solution.

What Mr. Greenspan has succeeded in doing is cushioning the impact of the bursting stock market bubble on consumer spending, by rapid and drastic rate cuts that promptly fuelled a housing and bond bubble instead. The former created the soaring collateral values that facilitated sharply higher borrowing, while the latter served to slash borrowing costs.

For many observers, this was an ingenious new monetary policy. For sure, it prevented for the time being a sharper economic downturn. But it raises the last and most important question of all: Has Greenspan's policy created the conditions that are requisite to put the U.S. economy on the road of lasting recovery?

The credit excesses of the late '90s bubble economy implicitly disrupted its underlying structures of demand, output, relative prices and profits in many ways. The thing to realize is that these bubble-related maladjustments depress the economy of their own accord, as happened in the United States in 2000-01. In the same vein, restoring sustainable economic growth requires liquidation of the distortions that have accumulated in the economy and its financial system.

We see absolutely no evidence of this having happened. Instead, Mr. Greenspan has merely diverted these distortions, turning them into even greater maladjustments elsewhere in the economy.

In the view of the bullish consensus, Mr. Greenspan has done a brilliant job in preventing a deeper and longer recession than might have been expected. This assessment, of course, ignores the protracted employment and income disaster. In our view, America's Great Deluder has done a miserable job: he has papered over existing maladjustments from the boom through even bigger, new bubbles and macroeconomic maladjustments, heralding much worse to come in the future.

The structural damage to the economy has become far too big to lend itself to a mild correction. The next downturn will not be pleasant.

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