Fed Governor Kevin Warsh spoke today at the Institute of International Bankers. His comments are a must read for investors and likely one of the best speeches a Fed Governor has ever given. Unlike Geithner and Bernanke, he is less more realistic and less optimistic about the economy going forward and has some fantastic comments on the long-term implications of current Fed actions. I’ve included some highlights, but I highly recommend taking a few minutes to read the entire speech (link above).
This most recent boom and bust is not, as they say, our country’s first rodeo, but it may turn out to be the most consequential since World War II. And, here, I am not just talking about the near-term peak-to-trough changes in growth and employment levels, which are likely to prove significant.
Policymakers are revealing new policy preferences and prescriptions–fiscal policy, trade policy, regulatory policy, and monetary policy, chiefly among them. Long after the official recession ends, the choices being made may significantly alter the contour of the U.S. economy. The harder question that remains is whether these changes will prove beneficial.
The Panic of 2008
Has the experience of the last 20 months caused the findings of the vaunted growth experiment to be fundamentally revised? During this recent period of turmoil, the imponderable, or what was previously thought to be virtually impossible, happened with great speed and force and frequency.9 Asset prices plummeted, and market volatility reached its highest level in decades. Financial market functioning was deeply impaired across most asset classes and geographies. As a result, the U.S. economy endured a sudden stop. In the final quarter of last year and the first quarter of this year, private employment registered the largest two-quarter percent decline since the mid-1970s, and real GDP saw the most dramatic decline in a half-century.
These data are clearly indicative of significant deviance, and justifiably raise questions about the success of the growth experiment. Policymakers are rightly disposed to react, respond, and revisit the presumed record of accomplishment. In revising the historical record, however, we should not too hastily discount the preceding period of prosperity. We must avoid a classic case of what behavioral economists term “availability bias,” when decisions made are influenced disproportionately by more recent events.
Ultimately, I will leave it to economic historians to assess whether the Panic of 2008 was more anomalous than the period of prosperity that preceded it. I believe that the categorization of recent events as deviant, ultimately, will depend on what happens next. That is, if policy changes cause future economic performance to suffer, then the boom of the last generation may, regrettably, turn out to be more exceptional than the bust.
The Stability Experiment
That new policies are being implemented during a period of economic turmoil is no coincidence. These new preferences reveal much about the type of economy to which policymakers aspire. And to be clear, the stability experiment appears well intended. It aspires to manage the economy with greater care and more expansive and effective regulation, as well as a larger and more persistent role for government action, and an increase in home bias in global commerce.
Advocates of the stability experiment–each guided by their own compass–seem all too inclined to announce that the growth experiment has ended, and to conclude that the results are deeply disappointing. They seem to prefer to define deviancy up, wishing to assure an uncertain citizenry. If government policies are corrected, and private practices are made more prescriptive, they argue, the ship of state can ensure that the real economy avoids rough seas altogether. The political economy confirms the policy response: Policymakers may pay greater attention to insuring against rare bad events–to which they could be held to account–than to allowing scores of great things to flourish.
I describe this mix of new pro-stability policies as an experiment for good reason. It might deliver on its promise of lower volatility, lower unemployment, and higher growth over the course of a generation. But, it might not. The costs of the stability experiment might turn out to be large. Necessarily and hastily crafted when the financial crisis began, the stability experiment is likely to survive far longer than the panic that preceded it. It is surging in popularity and is likely to grow in application, particularly if, as I suspect, the economic picture disappoints.
Since mid-March of this year, financial conditions have continued to improve. Panic conditions are showing signs of retreat. Asset prices are rebounding, searching for a new equilibrium from their panic-induced depths–both in the United States and across the vast majority of our trading partners. And this improvement in markets coincided with the arrival of the proverbial green shoots of spring. This gloss of recovery is appealing, of course, and not only to central bankers.
I, like you, am rooting for the positive trend to continue. But, in my estimation, the rather indiscriminate bounce off the bottom–across virtually all assets and geographies–may be more indicative of a one-time reset, which may or may not be complete. I would be more comfortable going forward if we observe more dispersion in the valuations of particular assets and greater differentiation across asset classes and geographies.
The panic’s hasty retreat should not be confused with robust recovery. For economic performance will turn ultimately on the force of private final demand; and for now, it remains weak. Real consumer spending rose only modestly in the first quarter of this year, after dropping sharply in the second half of last year. Businesses reduced real spending at an annual rate of more than 35 percent and continued to cut their workforces. Real exports fell at an annual rate of close to 30 percent.
The trauma experienced by businesses and consumers coming out of the panic should not be underestimated. Notwithstanding recent encouraging signs that the contraction is abating, I would expect business capital expenditures and consumer spending to continue to disappoint for the next several quarters. Even if, as I expect, the United States emerges from this recession sooner than our advanced foreign trading partners, I am still very cautious about predicting a sustained run-up in net exports so soon after the virtual collapse of global trade.
On balance, I would not be surprised if these countervailing forces–unprecedented public support and underwhelming private demand–fight to a draw by the fourth quarter. But the scale of stimulus and the recent blow to the real economy are both lacking precedent, so predicting the victor is tough business. Of course, the extraordinary monetary and fiscal support may prove more efficacious in the near term than I expect, leading to a continued easing in credit conditions, a slowdown in the rate of deleveraging, improved inventory levels, and better quarterly economic statistics. Even so, the benefits of stimulus are likely to wane. More important, unemployment rates, in my judgment, are likely to remain higher and linger longer than in recent recessions. The “jobless recovery” may prove to be a familiar and vexing refrain. As a wise Stanford mentor of mine coined many years ago, “The economist’s lag is a politician’s nightmare.”
The rebalancing of U.S. GDP and global demand is likely to require some patience. During the transition, there may well be political impetus for still more-aggressive macroeconomic policies. In evaluating new measures, however, policymakers’ predominant interest should be ensuring the credibility of their fiscal and monetary frameworks. For, if macroeconomic policies were to become unanchored, or misunderstood by markets, continued government aggressiveness could prove counterproductive.
The global economy runs the risk of being mired in a period of slower growth for several years to come. Some portion of the subpar economic performance may be owed to the normal capital and labor reallocations that take place during recoveries. And given the serious misallocations that marked the onset of this recession, there is good reason to believe that the period of reallocation will be deeper and last longer. A reduction in the size of the finance and housing industries, for example, is well under way. Efforts to forestall those changes, in my judgment, are unlikely to succeed as promisingly as advertised. But perhaps a larger risk is that changes in public policies may, in the pursuit of stability, hold down the growth of the U.S. economy over this period.
Looking ahead, I could well imagine that the natural rate of unemployment trends higher. Historically, small businesses have tended to be the largest drivers of new job creation. But how they will respond if macroeconomic policies favor stability over growth is difficult to predict. The answer may ultimately depend on their access to growth capital and liquidity given the changing mix of public policies and private practices.
Ironically, the longer that output and employment disappoint, the more attractive the gloss of stability may become. As a result, we should evaluate the benefits and costs of the stability experiment with a keen eye to guard against downside risks for the real economy.
I have not lost confidence in the inherent innovation, creativity, and dynamism in the U.S. economy. Nor have I lost confidence in the inherent good sense of our citizens. If the stability experiment fails to deliver on its promise of higher employment and better economic performance, then policymakers ultimately will change their prescriptions yet again. And so, in the long term, after the final results of the U.S. experiments with growth and stability are finally tabulated, the broader U.S. experiment in democratic capitalism will endure–and our economy will emerge stronger than ever.