Naked Economics (29 page)

Let me offer two caveats, however. First, if a government runs a deficit, then it must make up the difference by borrowing money. In the case of the United States, we issue treasury bonds. The national debt is the accumulation of deficits. Beginning around 2001, the United States has been consistently spending more than we take in. It adds up. The U.S. national debt has climbed from a recent low of 33 percent of GDP in 2001 to a projected 68 percent of GDP by 2019. If the debt becomes large enough, investors may begin to balk at the prospect of lending the government more money.

Second, there is a finite amount of capital in the world; the more the government borrows, the less that leaves for the rest of us. Large budget deficits can “crowd out” private investment by raising real interest rates. As America’s large budget deficits began to disappear (temporarily) during the 1990s, one profoundly beneficial effect was a fall in long-term real interest rates, making it cheaper for all of us to borrow.

Current account surplus/deficit.
The U.S. current account deficit in 2008 was around $700 billion. Is it time to rush to the supermarket to stock up on canned goods and bottled water? Maybe. The current account balance, which can be in surplus or deficit, reflects the difference between the income that we earn from the rest of the world and the income that they earn from us. The bulk of that income comes from trade in goods and services. Thus, our balance of trade, which again can be in surplus or deficit, is the largest component of the current account. If we are running a trade deficit with the rest of the world, then we will almost always be running a current account deficit, too. (For the purists, the U.S. current account would also include dividends paid to Americans who own foreign stocks, remittances sent home by Americans working overseas, and other sources of income earned abroad.)

When the current account is in deficit, as ours is now, it is usually because a country is not exporting enough to “pay” for all of its imports. In other words, if we export $50 billion of goods and import $100 billion, our trading partners are going to want something in exchange for that other $50 billion worth of stuff. We can pay them out of our savings, we can borrow from them to finance the gap, or we can sell them some of our assets, such as stocks and bonds. As a nation, we are consuming more than we are producing, and we have to pay for the difference somehow.

Oddly, this can be a good thing, a bad thing—or somewhere in between. For the first century of America’s existence, we ran large current account deficits. We borrowed heavily from abroad so that we could import goods and services to build up our industrial capacity. That was a good thing. Indeed, a current account deficit can be a sign of strength as money pours into countries that show a promising potential for future growth. If, on the other hand, a country is simply importing more than it exports without making investments that will raise future output, then there is a problem, just as you might have a problem if you squandered $100,000 in student loans without getting a degree. You now have to pay back what you borrowed, plus interest, but you have done nothing to raise your future income. The only way to pay back your debt will be to cut back on your future consumption, which is a painful process. Countries that run large current account deficits are not necessarily in financial trouble; on the other hand, countries that have gotten themselves into financial trouble are usually running large current account deficits.

National savings.
We all tuck money away for our individual needs: college, retirement, etc. Businesses save money, too, by retaining profits rather than paying them out to the owners of the firm. Those private savings decisions, along with the government’s decision to run a deficit or surplus, have a profound impact on our economy. The simple reason is that savings are necessary to finance investment, and investment is what makes us more productive as a society. If you put 10 percent of your income in the bank, then somewhere else in the country that money will end up building a plant or financing a college education. If Americans do not collectively put savings in the bank, then we must either forgo important investments or borrow from abroad. Again, this assumes that foreign investors are willing to lend at a reasonable rate, which may not be the case for an economy in a precarious state. Over time, countries’ investment rates show a striking correlation with their domestic savings rates.

The U.S. national savings rate tells a cautionary tale. Personal saving fell steadily from over 9 percent in the 1960s and 1970s to 6 percent in the 1980s to below 5 percent in the mid-1990s to roughly zero by the end of the 1990s.
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When the recession hit in 2007, the personal savings rate started to climb again. Governments (Washington, D.C., and the states) have been running deficits, or “dissaving.” (U.S. businesses were the only ones setting any money aside until households were shocked into saving by the recession.) We can and have borrowed from abroad to finance our national investment—at a cost. Nobody lends money for nothing; borrowing from abroad means that we must pay some of our investment returns to our foreign lenders. Any country with significant exposure to foreign lenders must always worry that when times get tough, the herd of international investors will get spooked and flee with their capital.

Demographics.
Americans are getting older, literally. As economist Paul Krugman has noted, the age distribution in America will eventually begin to look as it does in Florida. That is good for the companies that manufacture shuffleboard equipment. It is not so good for government finances. The bulk of government benefits, notably Social Security and Medicare, are bestowed on Americans who are retired. These programs are financed with payroll taxes imposed on younger Americans who are still working. If the ratio of young Americans to older Americans begins to change, then the financial health of programs like Social Security and Medicare begins to change, too.

Indeed, we can explain the importance of demographics
and
fix Social Security all in the next two paragraphs. Social Security is a “pay-as-you-go” program. When American workers pay into Social Security (that large FICA deduction on your paycheck), the money does not get invested somewhere so that you can draw on it twenty or thirty years later, as it would in a private pension fund. Rather, that money is used to pay current retirees. Straight from young Peter to old Paul. The program is one big pyramid scheme, and, like any good pyramid scheme, it works fine as long as there are enough workers on the bottom to continue paying the retirees at the top.

Therein lies the problem. Americans are having fewer children and living longer. This shift means that there are fewer workers to pay for every retiree—a lot fewer. In 1960, there were five workers for every retiree. Now there are three workers for every retiree. By 2032, there will be only two. Imagine Social Security (or Medicare) as a seesaw in which payments made by workers are on one side and benefits collected by retirees are on the other. The program is solvent as long as the seesaw balances. As the number of workers on one side shrinks while the number of retirees on the other side grows, the seesaw begins to tip. In theory, fixing the problem is easy. We can take more from current workers, either by increasing the payroll tax or by making them more productive and raising their incomes (so that the same tax generates more revenues). Or we can give less to retirees, either by cutting their benefits or by raising the retirement age. That is the very simple economic crux of the problem. Of course, if you think any of these solutions would be politically palatable, please go back and read Chapter 8 again.

Total national happiness.
You decide. We don’t have a number for that one yet.

An autoworker in Detroit who has spent his career getting laid off for months at a time and then called back to work is going to ask a simple question: Are we getting any better at all of this? Yes, we are. The United States has gone through eleven recessions since World War II.
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None, including the recession that began in 2007, is even of the same order of magnitude as the Great Depression. From 1929 to 1933, real GDP fell by 30 percent while unemployment climbed from 3 percent to 25 percent. Prior to the Great Depression, the United States regularly experienced deep recessions, including financial panics, far worse than what we’re going through now.
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We haven’t made the economic bumps go away, but they are smaller bumps.

One can also argue that what we’ve learned from past economic downturns, and the Great Depression in particular, has helped with policies this time around. Fed chairman (and former Princeton professor) Ben Bernanke is a scholar of the Great Depression. So is Obama’s chair of the Council of Economic Advisers (and former UC Berkeley professor) Christina Romer. I can promise you that economists will still be arguing fifty years from now about what should or shouldn’t have been done in response to the recession and subsequent financial crisis. However, even the toughest critics should concede that officials at the end of the Bush administration and the beginning of the Obama administration avoided the worst mistakes of the 1930s, when the Federal Reserve raised interest rates in the face of the Great Depression and Congress raised taxes—thrusting both monetary and fiscal policy in the wrong direction.

There is something to be said for not doing exactly the wrong thing. I suspect history will judge that policymakers did even better than that.

S
ometimes simple statements speak loudly. On September 11, 2001, hours after the terrorist attacks on the United States, the Federal Reserve issued the following statement: “The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.”

Those terse and technical two sentences had a calming effect on global markets. The following Monday, as America’s markets opened for their first trading sessions after the attack, the Federal Reserve cut interest rates by 0.5 percent, another act that moderated the financial and economic impact of the terrorist assaults.

How exactly does an inelegant two-sentence statement have such a profound effect on the world’s largest economy—indeed, on the whole global economy?

The Federal Reserve has tools with more direct impact on the global economy than any other institution in the world, public or private. During the economic crisis that began to unfold in 2007, the Federal Reserve used everything in that toolkit—and then acquired some new gadgets—to wrestle the financial system back from the brink of panic. Since then, some have criticized the Fed and its chairman, Ben Bernanke, for doing too much; some have criticized the Fed for doing too little. Everyone agrees that what the Fed does matters enormously.

From where does the Federal Reserve, an institution that is not directly accountable to the voting public, derive such power? And how does that power affect the lives of everyday Americans? The answer to all those questions is the same: The Federal Reserve controls the money supply and therefore the credit tap for the economy. When that tap is open wide, interest rates fall and we spend more freely on things that require borrowed money—everything from new cars to new manufacturing plants. Thus, the Fed can use monetary policy to counteract economic downturns (or prevent them in the first place). And it can inject money into the financial system after sudden shocks, such as the 1987 stock market crash or the terrorist attacks of September 11 or the bursting of the American real estate bubble, when consumers and firms might otherwise freeze in place and stop spending. Or the Fed can tighten the tap by raising interest rates. When the cost of borrowed funds goes up, our spending slows. It is an awesome power. Paul Krugman once wrote, “If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.” The same is now true of Ben Bernanke.

God does not have to manage by committee; Ben Bernanke does. The Federal Reserve System is made up of twelve Reserve Banks spread across the country and a seven-person board of governors based in Washington. Ben Bernanke is chairman of the board of governors—he’s the “Fed chairman.” The Federal Reserve regulates commercial banks, supports the banking infrastructure, and generally makes the plumbing of the financial system work. Those jobs require competence, not genius or great foresight. Monetary policy, the Federal Reserve’s other responsibility, is different. It might reasonably be described as the economic equivalent of brain surgery. Economists do not agree on how the Federal Reserve ought to manage our money supply. Nor do they even agree on exactly how or why changes in the money supply have the effects that they do. Yet economists do agree that effective monetary policy matters; the Fed must feed just the right amount of credit to the economy to keep it growing steadily. Getting it wrong can have disastrous consequences. Robert Mundell, winner of the 1999 Nobel Prize in Economics, has argued that bungled monetary policy in the 1920s and 1930s caused chronic deflation that destabilized the world. He has argued, “Had the price of gold been raised in the late 1920s, or, alternatively, had the major central banks pursued policies of price stability instead of adhering to the gold standard, there would have been no Great Depression, no Nazi revolution, and no World War II.”
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The job would not appear to be that complicated. If the Fed can make the economy grow faster by lowering interest rates, then presumably lower interest rates are always better. Indeed, why should there be any limit to the rate at which the economy can grow? If we begin to spend more freely when rates are cut from 7 percent to 5 percent, why stop there? If there are still people without jobs and others without new cars, then let’s press on to 3 percent, or even 1 percent. New money for everyone! Sadly, there
are
limits to how fast any economy can grow. If low interest rates, or “easy money,” causes consumers to demand 5 percent more new PT Cruisers than they purchased last year, then Chrysler must expand production by 5 percent. That means hiring more workers and buying more steel, glass, electrical components, etc. At some point, it becomes difficult or impossible for Chrysler to find these new inputs, particularly qualified workers. At that point, the company simply cannot make enough PT Cruisers to satisfy consumer demand; instead, the company begins to raise prices. Meanwhile, autoworkers recognize that Chrysler is desperate for labor, and the union demands higher wages.

The story does not stop there. The same thing would be happening throughout the economy, not just at Chrysler. If interest rates are exceptionally low, firms will borrow to invest in new computer systems and software; consumers will break out their VISA cards for big-screen televisions and Caribbean cruises—all up to a point. When the cruise ships are full and Dell is selling every computer it can produce, then those firms will raise their prices, too. (When demand exceeds supply, firms can charge more and still fill every boat or sell every computer.) In short, an “easy money” policy at the Fed can cause consumers to demand more than the economy can produce. The only way to ration that excess demand is with higher prices. The result is inflation.

The sticker price on the PT Cruiser goes up, and no one is better off for it. True, Chrysler is taking in more money, but it is also paying more to its suppliers and workers. Those workers are seeing higher wages, but they are also paying higher prices for their basic needs. Numbers are changing everywhere, but the productive capacity of our economy and the measure of our well-being, real GDP, has hit the wall. Once started, the inflationary cycle is hard to break. Firms and workers everywhere begin to expect continually rising prices (which, in turn, causes continually rising prices). Welcome to the 1970s.

The pace at which the economy can grow without causing inflation might reasonably be considered a “speed limit.” After all, there are only a handful of ways to increase the amount that we as a nation can produce. We can work longer hours. We can add new workers, through falling unemployment or immigration (recognizing that the workers available may not have the skills in demand). We can add machines and other kinds of capital that help us to produce things. Or we can become more productive—produce more with what we already have, perhaps because of an innovation or a technological change. Each of these sources of growth has natural constraints. Workers are scarce; capital is scarce; technological change proceeds at a finite and unpredictable pace. In the late 1990s, American autoworkers threatened to go on strike because they were being forced to work too much overtime. (Don’t we wish we had that problem now…) Meanwhile, fast-food restaurants were offering signing bonuses to new employees. We were at the wall. Economists reckon that the speed limit of the American economy is somewhere in the range of 3 percent growth per year.

The phrase “somewhere in the range” gives you the first inkling of how hard the Fed’s job is. The Federal Reserve must strike a delicate balance. If the economy grows more slowly than it is capable of, then we are wasting economic potential. Plants that make PT Cruisers sit idle; the workers who might have jobs there are unemployed instead. An economy that has the capacity to grow at 3 percent instead limps along at 1.5 percent, or even slips into recession. Thus, the Fed must feed enough credit to the economy to create jobs and prosperity but not so much that the economy begins to overheat. William McChesney Martin, Jr., Federal Reserve chairman during the 1950s and 1960s, once noted that the Fed’s job is to take away the punch bowl just as the party gets going.

Or sometimes the Fed must rein in the party long after it has gone out of control. The Federal Reserve has deliberately engineered a number of recessions in order to squeeze inflation out of the system. Most notably, Fed chairman Paul Volcker was the ogre who ended the inflationary party of the 1970s. At that point, naked people were dancing wildly on the tables. Inflation had climbed from 3 percent in 1972 to 13.5 percent in 1980. Mr. Volcker hit the monetary brakes, meaning that he cranked up interest rates to slow the economy down. Short-term interest rates peaked at over 16 percent in 1981. The result was a painful unwinding of the inflationary cycle. With interest rates in double digits, there were plenty of unsold Chrysler K cars sitting on the lot. Dealers were forced to cut prices (or stop raising them). The auto companies idled plants and laid off workers. The autoworkers who still had jobs decided that it would be a bad time to ask for more money.

The same thing, of course, was going on in every other sector of the economy. Slowly, and at great human cost, the expectation that prices would steadily rise was purged from the system. The result was the recession of 1981–1982, during which GDP shrank by 3 percent and unemployment climbed to nearly 10 percent. In the end, Mr. Volcker did clear the dancers off the tables. By 1983, inflation had fallen to 3 percent. Obviously it would have been easier and less painful if the party had never gone out of control in the first place.

Where does the Fed derive this extraordinary power over interest rates? After all, commercial banks are private entities. The Federal Reserve cannot force Citibank to raise or lower the rates it charges consumers for auto loans and home mortgages. Rather, the process is indirect. Recall from Chapter 7 that the interest rate is really just a rental rate for capital, or the “price of money.” The Fed controls America’s money supply. We’ll get to the mechanics of that process in a moment. For now, recognize that capital is no different from apartments: The greater the supply, the cheaper the rent. The Fed moves interest rates by making changes in the quantity of funds available to commercial banks. If banks are awash with money, then interest rates must be relatively low to attract borrowers for all the available funds. When capital is scarce, the opposite will be true: Banks can charge higher interest rates and still attract enough borrowers for all available funds. It’s supply and demand, with the Fed controlling the supply.

These monetary decisions—the determination whether interest rates need to go up, down, or stay the same—are made by a committee within the Fed called the Federal Open Market Committee (FOMC), which consists of the board of governors, the president of the Federal Reserve Bank of New York, and the presidents of four other Federal Reserve Banks on a rotating basis. The Fed chairman is also the chairman of the FOMC. Ben Bernanke derives his power from the fact that he is sitting at the head of the table when the FOMC makes interest rate decisions.

If the FOMC wants to stimulate the economy by lowering the cost of borrowing, the committee has two primary tools at its disposal. The first is the discount rate, which is the interest rate at which commercial banks can borrow funds directly from the Federal Reserve. The relationship between the discount rate and the cost of borrowing at Citibank is straightforward; when the discount rate falls, banks can borrow more cheaply from the Fed and therefore lend more cheaply to their customers. There is one complication. Borrowing directly from the Fed carries a certain stigma; it implies that a bank was not able to raise funds privately. Thus, turning to the Fed for a loan is similar to borrowing from your parents after about age twenty-five: You’ll get the money, but it’s better to look somewhere else first.

Instead, banks generally borrow from other banks. The second important tool in the Fed’s money supply kit is the federal funds rate, the rate that banks charge other banks for short-term loans. The Fed cannot stipulate the rate at which Wells Fargo lends money to Citigroup. Rather, the FOMC sets a target for the federal funds rate, say 4.5 percent, and then manipulates the money supply to accomplish its objective. If the supply of funds goes up, then banks will have to drop their prices—lower interest rates—to find borrowers for the new funds. One can think of the money supply as a furnace with the federal funds rate as its thermostat. If the FOMC cuts the target fed funds rate from 4.5 percent to 4.25 percent, then the Federal Reserve will pump money into the banking system until the rate Wells Fargo charges Citigroup for an overnight loan falls to something very close to 4.25 percent.

All of which brings us to our final conundrum: How does the Federal Reserve inject money into a private banking system? Does Ben Bernanke print $100 million of new money, load it into a heavily armored truck, and drive it to a Citibank branch? Not exactly—though that image is not a bad way to understand what does happen.

Ben Bernanke and the FOMC do create new money. In the United States, they alone have that power. (The Treasury merely mints new currency and coins to replace money that already exists.) The Federal Reserve does deliver new money to banks like Citibank. But the Fed does not give funds to the bank; it trades the new money for government bonds that the banks currently own. In our metaphorical example, the Citibank branch manager meets Ben Bernanke’s armored truck outside the bank, loads $100 million of new money into the bank’s vault, and then hands the Fed chairman $100 million in government bonds from the bank’s portfolio in return. Note that Citibank has not been made richer by the transaction. The bank has merely swapped $100 million of one kind of asset (bonds) for $100 million of a different kind of asset (cash, or, more accurately, its electronic equivalent).