Opinion

The Great Debate

Institutional failure week

November 2, 2010

-The opinions are the author’s own-

By the end of this week, the U.S. will face a government that is unable to act to aid the economy and a Federal Reserve that is unable to stop.

The stock market may well rise on this dysfunctional combination, only serving to prove that the economy and market are becoming fundamentally disconnected.

Tuesday’s election may well deliver a split Congress with the Republicans in control of the House of Representatives and the Democrats clinging to a narrow majority in the Senate. This means that there is no chance of further meaningful stimulus and that Democratic timidity will likely harden into an intransigence to match that of the Republicans.

Rather than building bridges, the next two years will be spent dickering over tax codes, and, as the 2012 election nears, fighting trade and currency wars.

Many will argue that this is right, that the election will freeze stimulative spending that is wasteful and unpopular.

Perhaps, but economic growth is extremely weak. The initial reading of third-quarter gross domestic product, released on Friday, showed the economy expanding at a faster 2.0 percent rate. Most of the growth, however, was from inventory rebuilding, a process that is very likely to slow. Actual growth in real final sales was an anemic 0.6 percent, making this the weakest such recovery on record, according to economist David Rosenberg of Gluskin, Sheff.

Rosenberg estimates that a 20 percent slowing in the rate of inventory building — and remember that inventories can grow faster than demand for only so long — in the current quarter would take the economy into contraction. Combine this with the fact that the reduced government spending in 2011 as the stimulus is burned through will remove 1.5 percentage points from the trend in GDP growth and you have the recipe for a double dip.

Here is where the Federal Reserve will, unfortunately, step in. Despite the risks to its independence this involves, the Fed seems likely to react to the interplay of a hobbled economy and recumbent government by starting another round of quantitative easing. The Fed will probably confine itself to buying Treasuries and perhaps may buy enough to in effect monetize all of the government’s borrowing needs with freshly created money.

A SHORTAGE OF FAILURE
The Fed will engineer lower interest rates in order to transfer risk to itself, to entice investment, to raise asset prices and to lower the value of the dollar, all forms of stimulus it hopes will help the economy to escape deflation and reenter vigorous, job-creating growth.

There are a lot of problems with this. The Fed, by weighing in when there is not consensus to stimulate through the fiscal process, opens itself up to further political interference, especially if it monetizes the debt. This is not to say that the political gridlock left to itself will bring on the best results, but that proper process and division of powers in a democracy matter.

Even putting that to one side, the resumption of quantitative easing is nothing more than the continuation of the policy the Fed has followed through the Greenspan years and into the reign of Bernanke. When faced with weakness, the Fed stimulates, when faced with bubbles, the Fed fails to act.

During the past decade globalization meant that something quite fundamental was changing in the U.S. economy, raising the natural rate of unemployment as jobs and industries moved overseas to cheaper places of production. Rather than allowing the U.S. to come to grips with this, to cut its cloth or its pie differently, or even to develop new strategies and industries, the Fed eased. This brought on a wasteful and false housing bubble. Labor and capital flooded into housing and homeowners spent as if the money were real.

That leaves the U.S. with a huge cohort of people in real estate and construction whose skills are no longer needed. What’s worse is the lost opportunity: a decade to grow export industries. Think of all the start-ups that never got funded or started because money was flowing to marble counter tops and construction.
On the flip side, think of all the companies that should have failed but didn’t, kept alive by low rates and easy money.

“More disturbingly for investment professionals, (asset price manipulation) changes the normal workings of capitalism and the market,” Jeremy Grantham of fund manager GMO wrote in a note to clients. “Weaker companies need more debt. Artificially low rates that are engineered by the Fed mean that leverage is less of a burden and survival is easier. Similarly, the Great Bailout allowed many companies that normally would have failed and been absorbed by the stronger or more prudent ones to survive.”

Rather than a great moderation, the past 15 years have been a great misallocation, and one which the Fed seems determined to extend and politicians unable to end.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. jamessaft@jamessaft.com)

Comments
9 comments so far | RSS Comments RSS

“Think of all the start-ups that never got funded or started because money was flowing to marble counter tops and construction.
On the flip side, think of all the companies that should have failed but didn’t, kept alive by low rates and easy money.”

Precisely.
No one could have said it better than you, James.

Over the years, the US economic system has been corrupted and perverted.
The Fed must be reformed, as well as the tax code.
No more free money, and no more subsidies.
The system is sick – This is not about a recovery, but about healing.

Posted by yr2009 | Report as abusive
 

So which is it? Are we to continue the unsustainable policies of an increasingly unpopular administration, or are we to allow the the will of the people have some say in what’s going on? I am unable to determine whether yours is a denouncement of the voters will, or whether it’s your view that the great unwashed masses are simply too stupid to conduct their own lives. It occurs to me that our nation was founded from a will to end the oppressions and usurpation’s of the elites and their pet bureaucrats. Doubtless there is truth in the fact that Democrats and Republicans alike place their own self interest before that of the citizens. However; when such self service defies the interests of the voting public, these politicians must be removed, either at election, or through proximate recall by the voters. No one said this was going to be easy, and it serves us all to recognize that it’s not all about business and corporate interests, but rather the unwillingness of both to accept the will of the people.

Posted by edweirdness | Report as abusive
 

Edward, it is going to be both whether we/they like it or not. Most legislation can be reversed if needed. But that isn’t always accurate in itself. So some times in a rush, we throw out the baby with the bath water. For instances, what exactly do opponents of healthcare have in mind? Where do opponents of bailouts draw the line? If incumbancy is the problem, how many terms should we be limited to and how often should we have to choose? “the will of the people” misleads us by believing apathy, ignorance, greed and self-centers take election day off. Many good Democrats will lose today. What hurts us most is the knee jerk reaction to reforms which were designed to emerge rather than explode as if ectasy. Obviously some adjustments should be expected but this constant teeter totter causes a lot of stampedes.

Posted by pHenry | Report as abusive
 

Gentlemen,

Everywhere we say that Fed / WBank and Policy Makers did this wrong or did that wrong .

But I havent come accros an article which says whats needs to be done to fix the problem of US and of Developed Economic situation in terms of Unemployment / Inflation , Currency and BOP Issue

Unless the Intellectuals , Free thinkers and Economists start to think and write about it policy makers will keep a deaf ear and will do according to their voting mandates.

Regards,

Ahmed

Posted by ma2416 | Report as abusive
 

Good Night America. Institutional failure ‘week’??? I hope this failure doesn’t last 20 years like ole Rip V.W’s slumber…. And when we finally awake, I hope our head has been cleared, and we’re not just suffering another hangover.

In the immortal words of Edward R. Murrow; Good Night, and Good Luck…

Posted by edgyinchina | Report as abusive
 

James Saft wrote: “the economy and market are becoming fundamentally disconnected.”

It is comments like this that make Saft my favorite Reuters columnist. He gets it. Wall Street and Main Street used to be joined at the hip, but outsourcing and Wall Street bailouts changed all that. Now the Dow can climb to the stratosphere, while unemployment remains high.

James Saft wrote: “the next two years will be spent dickering over tax codes”

Neither party is willing to curtail outsourcing. The Democrats are only marginally better at limiting Wall Street’s drunken orgy of greed. So gridlock might be a good thing, as few laws will be passed.

James Saft wrote: “Think of all the start-ups that never got funded or started because money was flowing to marble counter tops and construction”

And think of all the start-ups that never got funded because all of our money was being shoveled into Wall Street.

http://saucymugwump.blogspot.com/

Posted by saucymugwump | Report as abusive
 

I wish you wrong, but unfortunately you are precisely correct.
The problem is deeper:
US labor cannot compete with cheap labor from China, India etc. Our final labor cost includes cost of benefits (medical, retirement, vocations etc). They just don’t exist in China, India. Rather than covering the gap in cost by borrowing money US gov should assume medical cost it also shout impose ‘benefit tariff’ on import from countries with cheap labor.

Posted by S_K_V | Report as abusive
 

The US GDP grew by 40% in the past decade. The net job growth was zero. Even with GDP as a problematical indicator of social well being, this should give us pause in thinking about whether our assumptions related to economic growth are either complete or correct.

The USA would need about thirty million net new jobs by the end of this decade to bring us back to where we were in 2000 (so, jobs in addition to ones that will be eliminated by continuing productivity increases). This is probably not going to happen in the USA. Can anyone say where 30 million net new jobs are going to come from in the USA, especially given the growth of the productive sector in other countries? If so, that’s a great investment opportunity of a lifetime.

What will the USA be like after another decade of 40% GDP growth and 0% job growth, with a continual increase in population? Or worse in terms of unemployment, what if GDP stayed flat but productivity still rose by, say, 33% over that decade? With a new Congress unwilling to support new taxes and new social spending, we may see vast unemployment and vast social turmoil if productivity continues to rise and demand stays weak.

Sure, we may see some millions of new green energy jobs, but ultimately they will just replace a lot of old fossil fuel jobs, so I doubt there will be a “net” new job among those. Likewise, we’ll see some new green design jobs, but they will just replace lots of old inefficient manufacturing jobs with better designs that can be made more easily. We’ll probably see a net decrease in medical care jobs, even with an aging population, as all sorts of new (old) medical wisdom backed by scientific studies percolates through our society (like about curing vitamin D deficiency and about preventing disease by eating whole foods like vegetables, fruits, and beans) and as we start importing the robots Japan is developing to care for its aging population.

Our society is in a phase transition towards a new socioeconomic paradigm. I agree with James Saft that the housing debt bubble only obscured a fundamental shift that no one wants to think about which started a decade or more ago. But reality is sneaking up on the USA, and a high unemployment rate is one undeniable aspect of that new reality of limited demand for consumer goods (between environmentalism, voluntary simplicity, and business/credit cycles) alongside continually rising productivity (through robotics and other automation, better design, and voluntary social networks).

Possible ways forward include amplifying our current alternative approaches, like:
* moving from social security and medicare just for the old, and school payments just for the young to a true basic income for every citizen that they spend as they want (to provide predictable demand),
* moving from a haphazard volunteer sector and free software movement to a robust gift economy,
* moving from some local economic activity promotion (like with Ithaca HOURs) to stronger local subsistence communities everywhere in a more coherent way, and
* moving from a complex biased tax code to more transparent democratic resource-based planning to account mainly for market externalities using taxes, subsidies, investment, and regulation (so, perhaps less government, but government with a mission to address market failures).

I have more details on that here:
http://knol.google.com/k/paul-d-fernhout  /beyond-a-jobless-recovery#Four_long%28 2D%29term_heterodox_alternatives

Ultimately, the “institutional failure” is the failure to consider that a fundamental paradigm shift is occurring in the USA, one that has been predicted by many pundits for decades, even as it has been obscured by many other trends for a time.

Posted by pdfernhout | Report as abusive
 

Ron Paul is trying to downgrade power of FED and in yesterdays interview said: ‘If we succeed in Congress/Senate to challenge the power of FED significantly (what he suspect is not possible right now) ANY president would veto such decision’. Scary conclusion about real FED power. People and their representative including president cannot stop harmful actions of private cartel in any ways? Good morning America.

Posted by Pred | Report as abusive
 

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/
  •