At a ‘Fed Listens’ event held where the US central bank’s policy-setting board meets, Federal Reserve Chair Jerome Powell in October described how the room with “26-foot (eight-metre) ceilings, a monumental marble fireplace and a 1,000-pound (450-kilogram) brass and glass chandelier” had “seen a lot of history since Franklin Roosevelt dedicated this building in 1937”.
That’s probably the most innocuous economic event linking 1937 and the 32nd president. The pairing is more renowned for the ‘depression within a depression’ Roosevelt triggered in his second term when he tightened monetary and fiscal policies after US production surpassed pre-Depression levels.
Under Roosevelt’s direction, the Fed boosted bank reserve requirements by 50% and the Treasury withheld gold inflows from the monetary base, to guard against inflation. Government spending was cut in a quest to eliminate the federal deficit within two years. The result was the third-worst recession of the 20th century. Real GDP dived 10% and industrial production plunged 32% while the jobless rate jumped to 20% as four million people lost their jobs.
Roosevelt’s premature tightening still haunts US policymakers. Avoiding 1937-style missteps was pertinent in 2016 when the economy was healthy enough for the Fed to tighten monetary policy and for the administration of Barack Obama to reduce budget deficits towards 2% of output from a post-crisis peak of 10% of GDP in 2009.
That the US expansion that began in 2009 has entered a record 11th year shows officials have avoided a 1937 rehash. To help ensure no repeat, the Fed this year resumed loosening monetary policy, while Washington’s budget deficit is widening. President Donald Trump’s tax cuts of 2017 have stretched the shortfall beyond 4% of output.
Prolonging an upturn with stimulus is an achievement but it comes with risks. Three leap out. One is that stimulus can delay adjustments an economy might need to thrive over the long term. Today’s US recovery is sluggish and it is at risk if imbalances metastasise. These distortions include record asset prices and government, household and business debt at worrying levels.
A second is the Fed is unable to respond in a meaningful, conventional way to threats. The central bank has cut the cash rate to between 1.5% and 1.75% and its balance sheet is still distended from three bursts of asset buying (or quantitative easing).
The third, flowing from a stranded Fed, is that policymakers might need to double down on fiscal solutions to extend the expansion. The risk with loosening fiscal policy is it might feed doubts about US government finances. Washington’s projected deficits, on top of almost continual shortfalls since 1970, are forecast to boost its debt to 95% of GDP by 2029, the highest ratio since just after World War II. At some point, the public and investors could lose confidence in Washington’s budgeting abilities.
Given the gloomier outlook, US policymakers will be under pressure to prolong an expansion that already contains imbalances. The question they might ask themselves as they view these distortions is whether extending the expansion might lead to an uglier downturn than what they might have evaded so far.
To be sure, any slump comes with social costs best avoided; policymakers had little choice politically but to stimulate the economy when they could. The US’s imbalances aren’t as large as those of the eurozone and Japan, where radical stimulus has largely failed to stir robust growth. It should be noted too, that rather than stimulus, micro-economic reforms that boost productivity would be a better way to raise long-term living standards. But policymakers almost always must do something and stimulus is handy like that.
Now conventional monetary policy is nearing its limits, authorities could be tested on how much fiscal stimulus they can inject without stoking distortions or triggering repercussions that trouble the economy. The longer the recovery, the greater the risk that a coming year might gain infamy for when policymakers realised that endless stimulus leads to a bigger downturn.
Stimulant side effects
Herbert Hoover was president when the Great Depression struck in 1929. In his memoirs, Roosevelt’s predecessor told of the advice of his treasury secretary, Andrew Mellon. “Liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate. It will purge the rottenness out of the system.”
The quote summed up the tightening of fiscal and monetary policies that officials followed in the 1930s, the same type of voluntary deflation known as austerity that Europe pursued during the eurozone debt crisis. Repeated spectacles where austerity misfired by hurting the economy gave credence to the remedies of John Maynard Keynes. The UK economist argued that easing monetary and fiscal policies in tough times and doing the reverse in good times prolongs growth and softens recessions. Such policy activism explains why five of the six longest US expansions of the 34 upturns recorded from the 1850s have occurred since the 1960s.
While advocating macro management, Keynes was aware of its limits, especially with monetary policy. In The general theory of employment, interest and money of 1936, Keynes warned of the ‘liquidity trap’, a concept that describes situations when uncertainty is so great, low interest rates would fail to generate enough demand to ensure full employment.
‘The reversal interest rate’ is modern term that warns low interest rates can even backfire. A US paper of 2018 with that title cautioned that accommodative monetary policy could reduce lending by tightening capital constraints. While there is no consensus on whether the US is near the ‘reversal rate’ or even that the concept holds, policymakers are questioning if loose macro settings might come with complications that are storing trouble.
One question they are asking themselves is whether emergency steps could be ineffective or even prompt perverse behaviour. On the fiscal side, policymakers are assessing whether prolonged activism might only lead to torpor and damaged public finances. Italy’s budget deficit, for instance, averaged 3.4% of output from 1995 to 2018, which boosted government net debt from 101% to 120% of output. Yet the economy struggled most years. With monetary policy, central bankers are watching for signs that rate cuts towards zero are worrying people so much they save rather than spend.
Another question central bankers are asking themselves is, given that conventional monetary stimulus is finite and nearly exhausted, how will they fight future downturns. Policymakers could come under pressure to adopt radical steps that might boomerang. Many, for instance, are calling for fiscal authorities to resort to the inflation-prone practice of ‘money printing’, when money is whisked up and handed to the public.
Central bankers are also questioning whether loose monetary policy could reduce the pressure on politicians to take the steps economies need to thrive over the long term. They are aware that the European Central Bank calmed the eurozone debt by 2014 and saved the euro. Yet that allowed politicians to duck devising the fiscal, political and banking unions the currency union needs to endure.
Another side effect policymakers are wary of is that stimulus can inflate asset prices and foster risk-taking. The ‘Greenspan put’ described how Fed chief Alan Greenspan repeatedly cut interest rates to insulate the economy from falling stock prices. These cuts rewarded excessive risk-taking, which is often cited as causing the global financial crisis. The pertinent question they ask themselves is: Could this happen again?
Policymakers are asking too if policy activism might make people too dependent on stimulus. Household budgets, for instance, appear unprepared for any meaningful rise in interest rates, however unlikely that might appear.
A sixth question that policymakers are asking is whether prolonged stimulus could feed imbalances that recessions usually correct. The ‘Austrian School’ of economics opposes stimulus because slumps rid economies of ‘malinvestment’. While that’s considered extreme, low rates have led to record household, corporate and government debt in many countries. Policymakers are aware that imbalances typically get corrected one day.
The complications of stimulus don’t argue against heeding the lessons of 1937. They just mean that when policymakers gather in their splendid rooms to ponder options they must ask themselves if they risk creating a world of rarer but perhaps harsher downturns.
By Michael Collins, Investment Specialist