Most of the news coming out of the US economy is bad and may get worse. Inflationary pressures continue, albeit at a slackening pace. But employment growth seems to be declining at a rapid pace while thousands of jobs are being shed. Unsurprisingly, confidence among American consumers has declined for five consecutive months up to February to levels not seen since 1996.
As conditions turn relentlessly bearish, it appears that Alan Greenspan has been spooked into lowering interest rates in the vain attempt to protect stock markets. However, it is naive to believe that stock market corrections lead economies into recessions. Once again, those who support interest rate cuts are whistling in the wind. This is because their arguments once again confuse the direction of cause and effect.
When it comes to the US stock markets, it is amazing how much banality has passed for good judgment. Much pain has been inflicted by the bad analysis that contributed to the dotcom bubble and the snake-oil panderers of the New Economy.
Unsurprisingly, the aftereffects of so many years of such lousy analysis linger. Remedies for the slowdown/recession afflicting the US economy can come only after there is a good answer to the source of these problems.
And what is the cause? Credit expansions generate structural distortions. And when the credit expansion is large and long, these distortions tend to be more extreme.
Credit expansions pump up an economy and obscure the true nature of the market demand for loans and distort the perceptions of future demands for products. The main problem is that artificially-low interest rates create unrealistic expectations of the real value of future earnings both by companies and households.
Faulty signals
Under these conditions, entrepreneurs receive faulty signals and tend to make unwise investments. In a sense, a sort of Gresham's Law is put into motion where bad entrepreneurs will crowd out good entrepreneurs. More prudent entrepreneurs are likely to perceive the uptick in the economy to be temporary and illusory while less competent ones will begin to buy out the others. Consequently, capital is placed in the hands of entrepreneurs who are less suited to use it and that capital is put to uses that will show lower profits in the future.
And what is the remedy? It is unlikely that the ongoing rounds of interest rate cuts can sufficiently inflate manufacturing prices to eliminate the profit squeeze that is occurring. Even though excess and idle capacity is at the highest level since 1992, producer costs are rising by nearly 5 percent a year and are the highest since 1990-91. And even if lower interest rates were to lessen profit pressures in the short-run, the essential problem of excess capacity can only be resolved through liquidation of capital that has been unwisely invested.
And so it is that the resolution of any artificial boom requires that a liquidation phase must occur. This process involves the painful shedding of excess capacity, including bankruptcies and layoffs.
However, this economic pain sets the stage for recovery by liberating inputs that are being held captive in non-productive activities so they can be used in wealth-producing activities. But there is a way to reduce the adjustment period: tax reform that reduces the overall burden and lowers marginal rates.Whereas lowering interest rates is what got us into the economic slowdown that is so threatening, such a step should not be seen as part of a coherent solution. In all events, there should be no illusion about whether governments or central banks can control levers that can magically set things right. There has been a preternatural belief in Alan Greenspan as the guardian of the unprecedented prosperity enjoyed by America and imported by parts of the rest of the world.
Expansionary policy
Artificially-low interest rates as part of an expansionary monetary policy make the most significant contribution to imbalances that lead to unsustainable economic booms. However, once they have done their dirty work on the economy, their effectiveness as a corrective tool is quite limited. Although six increases in base interest rates by the Federal Reserve lifted the cost of credit, it did not curb borrowing for household consumption or business investments over the past few years.
There is no reason to believe that attempts to manipulate interest rates will be more effective under current conditions than they were in the past. However, democratic politics invokes incentive to defer necessary adjustments that might cause rising unemployment to the future when another elected official might be held accountable.
And so it is that cutting interest rates involves an illusory, short-run remedy that will lead to long-run costs. The responsibility of modern central banks does not include stimulating the economy. Their brief is to keep the value of money stable so that entrepreneurs can make sensible and informed decisions to provide the basis of long-term growth.
Unfortunately, America's central bankers are setting a bad example for other countries. Interest rate cuts will not solve the problems with most of the world's economies. This is true whether speaking about Japan, the US or the emerging market economies. It is misguided to try to apply stimulus policies like interest rate cuts or greater government spending to resolve structural problems.
It appears that a simple lesson has not been learned despite years of evidence.
It is that economic remedies designed to cope with short-term cyclical problems should not be applied to long-run structural problems.
Christopher Lingle is Global Strategist for eConoLytics.com and author of The Rise and Decline of the Asian Century.
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