Following on the heels of the Greenspan Conundrum, we may get a Bernanke Paradox. Rapid cuts of US interest rates may not revive the debt-ridden and asset-dependent US economy, but instead drive it closer to what Mr. Bernanke fears most: the hole of a liquidity trap. Given the nature of the developing recession (deflationary asset and credit contraction), the odds of this happening are increasing.
Central to this line of thought is the observation that the current slowdown is not the common variety, caused by excess inventory accumulation. Rather, it is most similar to the popping of the Japanese bubble: a stubborn contraction preceded and caused by excessive credit expansion and unsustainable asset appreciation.
The term "excessive credit expansion" is best explained by the following chart, showing the annual growth in household debt (red line) and hourly earnings (blue line). Borrowing rose much faster than earned income for too long (1998-2006) and is now imploding because households cannot properly service their existing debt out of current income. It follows that Americans won't jump into more debt and won't rush out to buy new assets until their balance sheets are lighter and debt service can be more comfortably met by earned income - a process that will take many years (The Slow Recession).
The characteristics of this potential liquidity trap is different from the classical definition (lenders unwilling to lend). This trap may be aggravated by borrowers unwilling or unable to borrow, even if benchmark interest rates near 0%. Thus, the Bernanke Paradox.
I am aware that American consumers (72% of GDP) have historically pulled the economy out of previous slumps and that betting against their propensity to "shop till they drop" has been a losing proposition. But, in my opinion, right now they are "dropped, so they can't shop". It's not for lack of want, but lack of means that the mighty US consumer is pulling back.
Under such a scenario, cutting interest rates in a panicky mode can only exacerbate matters. It officially signals that the Fed and the government expect worse to come for the economy and causes consumers to respond by shutting down spending even faster. Let's not forget that the "wealth effect" caused by the prior real estate run-up is now rapidly becoming a "poverty effect", further depressing their propensity to consume.
In the last few days several economists are finally saying that monetary policy alone won't do the job, a position that I have long held and expressed in this blog. They want fiscal policy to help out but I fear they are looking in the wrong direction, since they focus exclusively on tax cuts. It is quite obvious that Bush's favorites (permanent tax cuts for the rich) won't do a thing, but even cuts and one-time rebates targeted to the poor and middle classes won't achieve more than a temporary boost. And this, assuming most of the money isn't saved instead, a possibility that can't be ignored.
To be effective, economic policy must rapidly raise real earned incomes for the "bottom" 95% of Americans that have not substantially benefited from the 2003-07 expansion and who are feeling unsure of their future. In other words, what we need is a targeted jobs program. This is a difficult proposition that does not lend itself to quick fixes, announced as TV sound-bites by politicians ("$1,000 for every family"). Instead, serious problems demand serious fixes, not one-liners.
My proposal may smack of "state planning" - and you know what? That's exactly what it is. The US needs official policies that will create high value-added jobs in energy and environmental mitigation, to name my two favorite fields that are also the most pressing problems facing our world. Hoping that the invisible hand of the free market will cause solutions to miraculously materialize is tantamount to believing in the tooth fairy.
We need government-sponsored action on a scale several times bigger than the Manhattan or Apollo projects. Expecting private enterprise to undertake them is unrealistic: such projects are simply not profitable enough in the short time horizon that business operates in. Every infrastructure development that radically altered the American economy was undertaken and financed by the government: going as far back as the Erie Canal (1817-1825), the Panama Canal, TVA, the great dams, the interstate highways, ports and airports.. even the Internet was originally a government scheme.
This is the kind and scale of economic - fiscal policy we urgently need. If anyone has a better idea, please let me know because I, for one, do not believe in tooth fairies.