This is the most important economic question in and for the world: Has the U.S. economy's rebound since 2001 been aborted, or is it only delayed? Our rigorous disagreement with the global optimistic consensus over this question begins with four observations that we regard as crucial:
1. In the past four years, the U.S. economy has received the most prodigious monetary and fiscal stimulus in history. Yet by any measure, its rebound from the 2001 recession is by far the weakest on record in the post-World War II period.
2. Record-low interest rates boosted asset prices and, in their wake, an unprecedented debt-and-spending binge on the part of the consumer.
3. What resulted was a badly structured economic recovery, which - due to grossly lacking growth in capital investment, employment and wage and salary income - never gained the necessary traction to become self-sustainable.
4. Sustained and sufficiently strong economic growth implicitly requires a return to strong business fixed capital spending. We see no chance of this happening. Above all, the outlook for business profits is dismal from the macro perspective.
This takes us to the enormous structural changes that the Fed's new monetary "bubble policy" has imparted to the U.S. economy over the years. While consumption, residential building and government spending soared, unprecedented imbalances developed in the economy - record-low saving; a record-high trade deficit; a vertical surge of household indebtedness; anemic employment and income growth from wages and salaries; outsized government deficits; and protracted, unusual weakness in business fixed investment.
None of these shortfalls is a typical feature of the business cycle. Instead, they are all of unusual structural nature. Yet the bullish U.S. consensus simply ignores them, bragging instead about the U.S. economy's resilience and its ability to outperform most industrialized countries.
To be sure, all these structural deformations tend to impede economic growth. Some, like the trade deficit and slumping investment, do so with immediate effect; others become repressive only gradually and in the longer run. Budget deficits stimulate demand as long as they rise. An existing budget deficit, however large, loses this effect. Rather, it tends to become a drag on the economy. In the past few years, clearly, the massive monetary and fiscal pump-priming policies have more than offset all these growth-impairing influences.
Assessing the U.S. economy's future performance, it is necessary to distinguish between two opposite macro forces: One is the drag on the economy exerted by the various structural distortions; the other is the enormous demand-pull fostered by the housing bubble and the associated rampant credit creation.
Measured by real GDP growth, the demand-pull driven by the housing bubble has, so far, overpowered the structural drags, provided you believe in the accuracy of the GDP numbers. We do not. Yet even by this measure, as repeatedly explained, it is actually by far the U.S. economy's weakest recovery on record in the postwar period. In fact, measuring the growth of employment and wage and salary income, there has been no recovery at all.
Our stance has always been and remains simple. Asset bubbles and their demand effects invariably fade over time; structural effects invariably worsen over time if not attended to. It is our strong assumption that the negative structural effects are overtaking the positive bubble effects.
We come to another feature of economic recoveries that American policymakers and economists flatly ignore. That is its pattern or composition.
Past cyclical recoveries were spearheaded by three demand components: durable consumer goods, residential building and business fixed investment, regularly following prior sharp downturns caused by tight money during the recession. Importantly, the tight money had always created pent-up demand in these three categories, which promptly catapulted the economy upward when monetary policy eased. For sure, the pent-up demand played a key role in the recovery dynamics.
With its rapid and drastic rate cuts, the Fed rewrote the rules of the traditional business cycle and related policies. It managed a seamless transition from equity bubble to housing bubble. Consumer spending on durable goods continued to forge ahead during the 2001 recession at an annual rate of 4.3%. Residential building never retreated, while business fixed investment took an unusual plunge.
From 2000-04, consumer spending soared by 27.3% on durable goods and 25.4% on residential building. Government spending, too, rose sharply, by 13.9%. Together, the three components accounted for 123% of real GDP growth.
But in the rest of the economy, it was all misery. Despite a modest rebound, business nonfinancial fixed investment in 2004 was still down 0.2% from 2000. Exports of goods posted a minimal gain of 0.1%, whereas imports of goods shot up by 16.5%.
Thanks to the sharp decline in interest rates over the last few years, sharply inflating house prices have been a rather common feature around the world. Still, there is one crucial difference among the countries concerned. There are countries in which the rising house prices have fueled borrowing-and-spending binges by private households, and there are others where these binges are completely absent. Typical for the first pattern are all Anglo-Saxon countries; typical for the latter are most eurozone countries.
Even among the Anglo-Saxon bubble economies - meaning countries where the house-price inflation led to borrowing-and-spending sprees - the United States is a unique case. It concerns the official and public attitude to such bubble-driven economic growth.
The United States is the one and only country in the world where monetary policy was systematically designed toward the goal of inflating the market value of assets - stocks, houses and bonds - virtually making wealth creation through inflating asset prices their explicit goal.
In Britain and Australia, the associated borrowing-and-spending binges are even worse than in the United States. Yet there is a general apparent reluctance to embrace this growth model as an unmixed blessing. Central bankers who celebrate this as "wealth creation" and even explicitly animate people to exploit the possibilities of easy credit to lift their spending on consumption are unique to America.
For generations of economists, it used to be a truism that "wealth creation" implies capital formation in terms of generating income-creating tangible assets. The emphasis was on capital formation and the associated income creation. To indiscriminately put this label of "wealth creation" on rising asset prices in the absence of any income creation is plainly a novel usurpation of this concept. It is in essence wealth creation through a stroke of the pen.
Measured by their net worth (market value of household assets minus debts), American households have amassed unprecedented riches in the past few years, despite spending in excess of their current income as never before.
The first question springing to mind in the face of this "wealth miracle" is its cause or causes, leading immediately to the next question: whether or not this drastic increase of house prices relative to the consumer price index has to be seen as a "bubble," which sooner or later have the habit of bursting.
In old textbooks, you would read that higher saving increases capital value. But in the U.S. case, capital values have soared while personal and national saving has collapsed. What else, then, has the power to lift asset prices?
Everybody knows the answer, but few want to admit it: Lured by artificially low interest rates and easily available credit, private households have stampeded as never before into the purchase of homes, boosting their prices. Artificially low interest rates and easily available credit are, actually, the key features that specifically qualify an asset bubble.
The growth of home mortgages exploded from an annual rate of $368.3 billion in 2000 to an annual rate of $884.9 billion in 2004, compared with a simultaneous increase in residential building from $446.9 billion to $662.3 billion. Altogether, the United States experienced a credit expansion of close to $10 trillion during these four years. This equates with simultaneous nominal GDP growth of $1.9 trillion. America's financial system is really one gigantic credit-and-debt bubble.
Our general misgivings about "wealth creation" simply through rising house prices has still another reason, however, and that is the way housing values are calculated. The conventional practice in America is to treat the whole existing housing stock as being worth the last trade. We do not think this makes sense, considering that current sales are always marginal to the whole capital stock.
This way of calculating wealth creation naturally explains the extraordinary rapidity with which it can deluge an economy, creating trillions of dollars of such wealth in no time. For sure, this contrasts wondrously with the tedious process of generating prosperity through saving, investment and production.
In earlier studies published by the International Monetary Fund about asset bubbles in general, and Japan's bubble economy in particular, the authors repeatedly asked why policymakers failed to recognize the rising prices in the asset markets as asset inflation. Their general answer was that the absence of conventional inflation in consumer and producer prices confused most people, traditionally accustomed to taking rises in the CPI as the decisive token for inflation.
It seems to us that today this very same confusion is blinding policymakers and citizens in the United States and other bubble economies, like England and Australia, to the unmistakable circumstance of existing rampant housing bubbles in their countries.
Thinking about inflation, it is necessary to separate its cause and its effects or symptoms. There is always one and the same cause, and that is credit creation in excess of current saving leading to demand growth in excess of output. But this common cause may produce an extremely different pattern of effects in the economy and its financial system. This pattern of effects is entirely contingent upon the use of the credit excess - whether it primarily finances consumption, investment, imports or asset purchases.
A credit expansion in the United States of close to $10 trillion - in relation to nominal GDP growth of barely $2 trillion over the last four years since 2000 - definitely represents more than the usual dose of inflationary credit excess. This is really hyperinflation in terms of credit creation.
In other words, there is tremendous inflationary pressure at work, but it has impacted the economy and the price system very unevenly. The credit deluge has three obvious main outlets: imports, housing and the carry trade in bonds. On the other hand, the absence of strong consumer price inflation is taken as evidence that inflationary pressures are generally absent. Everybody feels comfortable with this (mis)judgment.