The Magic of American Finance and Economic Growth

It seems economic growth in the United States is once again in a slowdown, probably reflecting temporary factors like the Japanese tsunami that disrupted supply chains and forced some factories to temporarily suspend work. High oil prices have also negatively affected disposable income after tax, leading to dampened growth and consumer demand, and hence a build up of stock and a fall in production.

Periods of economic recovery rarely proceed without going off course, especially when they are weak like the current phase of recovery. But regardless of whether the underlying factors of the recent slowdown are fleeting or permanent, calls demanding the Federal Reserve Bank to do something remain.

Some Americans see in Ben Bernanke, the Federal Reserve Bank’s head, a modern day magician able to reinvigorate the economy by simply waving his cash wand; making interest rates extremely low at first, then adding quantitative easing, and finally, printing money. If the inflation rate is low, Americans want the Federal Reserve Bank to use every mantra it knows to restore life to the economy. Like the First World War generals who responded to every massacre of their men by sending more of them into the trenches in a desperate attempt to confuse the enemy, supporters of ‘free money’ always want ‘more’ every time it becomes clear to them that their policies are unsuccessful.

Monetary policy is suffering, more than any other policy area, from feelings that it is a free meal to be consumed. But the interest rate also constitutes the savings rate which is passed on to spenders. As much as the Federal Reserve Bank can manage to push this price down (some economists may doubt the Bank’s ability to significantly push the interest rate down), it imposes taxes to the same extent on savers, and provides subsidies to those who spend their savings. Clearly, governments do not realize that pushing the price of any real commodity down is an effective way to stimulate the economy since any gains made by consumers are considered a loss for producers, and usually the losses outweigh the gains if the market price is fair. So then why are savings any different?

There is a point of view that claims that investment in companies falls due to labor market rigidity (since wages are too high). Moreover, the important social benefits- for example more cohesive families and societies - come from investment that can create job opportunities. Thus, lower interest rates would give companies the support necessary for investment.

Yet there is scant evidence to indicate that the real problem causing the decline in investment can be summed up by the paying of excessively high wages (many companies have cut overtime and social benefits, or even reduced wages themselves during the recession). Furthermore, after interest rates for companies reached their lowest levels in decades (for the largest companies, it was negative compared with its real value, meaning savers are in fact paying companies so that those companies can borrow their money); so the cost of capital may not be the reason behind the unwillingness of companies to increase their investments in the United States. There is no doubt that huge subsidies could prompt companies to reconsider the matter, though shouldn’t we be wondering if there are more effective ways of dealing with the problems that lead companies to refrain from investing?

There is another point of view that says families are frightened, making them keen to save more. These savings must be primed towards consumption by reducing the returns on savings. Despite that, it’s difficult to imagine that American households are over-saving, given that the savings rate reaches 5 percent, and that they are encumbered by the burden of debt. While it would be nice to encourage these households to increase their spending slightly now, and to save more later, it is not an easy direction to push them in. It’s well known that the housing bubble grew in part because of American households’ trust in the hope that they would carry on spending and get the US out of the recession which followed the collapse of the internet bubble.

There is a third approach through which easy money could achieve the desired goal of pushing up the value of assets such as stocks, bonds and housing to make people feel they’ve become richer, and thus increase their tendency to spend. But in order for this approach to be sustainable, the gains of wealth must be permanent. At the end of the day, what rises must fall, and this makes American households more fearful of the markets.

Clearly, someone has to suffer the consequences of extremely low interest rates, and it is of course, the patient non-complaining saver. It is noteworthy that low interest rates could damage total spending if the traditional spenders such as corporations and young families are unwilling or unable to exploit the benefits of low interest rates, since savers such as pensioners receive less income and so limit their spending.

These concerns are not new. As is the case with taxes and subsidies, the net effect depends on whether tax payers cut down on their spending to less than those who benefit from subsidies. Economists used to claim that China was raising the interest rates it pays on bank deposits so that Chinese households can increase their earnings, and thereby increase their consumption. Some Japanese are now questioning whether it’s possible to consider the policy of extremely low interest rates as a cause of deflation.

Equally disturbing are the distortions created by easy money, as evidence revealed during the latest crisis indicates that extremely low interest rates was a cause of a wide range of adjustments in investment portfolios, which led central banks in Asia and the Middle East to keep hold of safer low interest stock, whilst the financial sectors in US and Europe indulged in excessive risk-taking. History never repeats itself in the exact same fashion, and those who light fires know the risks of playing with matches. We must understand that abnormally low interest rates will lead to consequences other than inflation.

Finally, what about inflation itself? Despite wage inflation being contained within the United States, perhaps global financial policy was too lenient, and this was one of the reasons which left oil prices soaring sky high. In fact, the Federal Reserve Bank (quite rightly) blames foreign central banks which keep interest rates extremely low in order to prevent their currencies from rising against the dollar. But the Federal Reserve cannot make policy on the assumption that everyone else might respond with an ideal equation. High oil prices that are now curtailing growth in the US are partly an unintended consequence of current policy.

There are many things the United States must undertake in order to create sustainable growth, including improving the quality of its workforce and infrastructure. Easy money is not, however, one of these things.