Monetary Stimulus Will Work

Op-ed in Welt am Sonntag

February 6, 2008

The Federal Reserve keeps cutting interest rates, yet the stock market keeps declining, and the latest US economic data appears to be grim. Some commentators claim this is because the channels for looser money to reach the real economy are blocked and make comparisons to Japan's deep recession of a decade ago. Others add that monetary policy cannot do much to work off accumulated bad debt, and so it is pointless for the Fed to keep cutting. There is a more general panicked sense that both the Fed's and Congress's efforts will be too little, too late.

Like most panic-driven assessments, however, this one is false, akin to those of the child in the dark who thinks that every creak of the house is a sign of monsters lurking. While the prospect of monetary stimulus being ineffective due to a broken credit system is a terrifying one, as economic nightmare scenarios go-and the very small risk of that emerging is part of what has pushed the Fed into aggressive action-it is far from worth losing sleep over. The Federal Reserve's interest rate cuts plus the likely US government stimulus package will prove effective in stabilizing US growth, albeit with a lag, and if anything prove to be too much once the immediate financial disruption lifts, rather than too little.

To some degree, the monetary loosening has already had an effect. Combined with the multinational central bank effort to directly inject liquidity into the core banking system, the spreads on interest rates between more and less reliable borrowers (a measure of financial stress) have shrunk. Some, though not all, types of securities have returned to normal trading. The US money center banks do remain reluctant to lend to each other, which is a source of concern, but they have taken significant capital write-downs and provisions for losses which is the primary step to moving beyond past mistakes. Much of the gloomy economic data being seen today is the result of past events, rather than a forecast of failure for today's policy measures.

More importantly, investment and capital spending by nonfinancial businesses in the United States is not solely dependent upon bank credit. This is one of the positive aspects of the extensive development of securitization in the United States. Even some smaller companies are able to issue bonds and gain trade credits independently of bank loans, while larger ones can tap international credit markets and issue commercial paper or stock. Many American companies have been financing their investment with retained earnings. For all these channels of credit, reductions in the cost of borrowing due to the Fed's loosening are still stimulative-irrespective of the banking system.

Yes, the rate of investment will slow in the first half of this year, but that will be a temporary demand decline, reversible by the monetary actions underway, not a supply-driven credit crunch. Similarly, increases in lending standards, constricting mortgage availability, and credit card debt, will be a drag on the economy, but those borrowers also will respond over time to the lowering of interest rates. Housing construction will remain stalled due to the surplus of homes built, but nonresidential construction has been largely stable and growth in net exports has more than compensated for declining residential investment. And lower interest rates have contributed to the dollar's decline, which will continue to fuel US exports for the rest of this year (even if the dollar stabilizes at current exchange rates).

When forecasting the US economy, what happens to the business sector and investment is far more salient than what happens to consumption. While private consumption makes up 70 percent of the economy, it fluctuates over a far smaller range than investment or net exports (which makes sense, since what households purchase does not vary all that much with the business cycle). A decline in consumption commensurate with the decline in housing prices, and thus households' perceived wealth, would be on the order of 1.25 percent of GDP, based on how they increased spending as house prices went up. That estimate is essentially what the forecast slowdown in the US economy over the next couple of quarters amounts to-it is not in itself enough to cause a persistent recession. And since at least 1945, the United States has never had a consumer-driven recession, precisely because consumers behave this way.

Despite the impression left by the timing of the Fed's between meeting rate cut last month, stabilizing the stock market is not an objective of monetary policy in the United States or elsewhere-and despite the fact that many traders in the markets want ever more rate cuts from the Fed, monetary ease is having the desired stimulative effect on the real economy as well as on the core banking system. Thus, whatever may happen to the Dow or the Dax in the coming months, people should expect the economic slowdown in the United States to be short and shallow. Activist monetary policy has already prevented the worst outcome in all likelihood; the banking system is not the only channel through which such policy affects the economy; and the full impact of this aggressive easing will become apparent in the months to come.