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Endless Stimulus: Partying Like It's 2003

Marc Joffe
December 8, 2011, 5:49pm

The recession ended more than a year earlier. The economy registered several quarters of steady, if unspectacular growth. That wasn't good enough for policymakers, so fiscal and monetary stimulus continued.  It sounds like now, but it was also the situation in 2003.

So, how did that turn out? Today, many blame the Fed's low interest rate policy of 2003 for the housing bubble and collapse that followed.  Policy rates of around 1 percent supported cheap mortgages, enabling more borrowers to buy more house than they could otherwise afford. Builders responded by constructing more houses, and larger houses than ever before. Meanwhile, tax cuts unbalanced by spending reductions together with unfunded wars permanently ended the era of surpluses that had started in 1998. The precipitous rise in the US's debt-to-GDP ratio was underway.

Today, policy rates of near zero ensure the availability of cheap money for other purposes yet to be known. Thus far, most of the extra cash has been stashed in Treasuries, fostering the illusion that the Federal government can run massive deficits forever without consequence.

Low Treasury rates will cease to satisfy once investors realize that they are losing value in inflation adjusted terms.  Given the amount of stimulus now being provided, it is hard to imagine how price inflation can remain below the 2.1 percent currently paid on 10-year Treasuries.

That rate matches the most recent 12 month change in "core" CPI reported by the Bureau of Labor Statistics. Throw in food and energy - which seem pretty "core" to me - and we are looking at a 12-month rate of 3.5 percent. For those less willing to believe government figures, John William's Shadow Government Statistics estimates the inflation rate at about 7 percent using the Bureau of Labor Statistics methodology that prevailed prior to 1980.

Since Treasuries do not provide a real return, investors will have to find some other asset class to preserve and grow capital. Unfortunately, theories about herd instinct and recent history suggest that investors will all pile into a single asset class at once. If this happens, we can expect to encounter a new bubble and another crisis in the not-too-distant-future.

When I learned Keynesian economics - too long ago - the idea was to provide fiscal stimulus by running deficits during recessions and then mopping up the stimulus with surpluses during times of expansion. Now the goal posts have shifted:  today, even slight reductions in the enormous deficit are dismissed as contractionary.

I also learned that unemployment was a lagging indicator, and thus not a good basis for policy decisions. Today, the focus is almost exclusively on this flawed metric.

Whether the focus is on GDP growth or unemployment, past results may not be indicative of future "full employment" levels. In the 80s, 90s and aughts, economic growth was fueled by the proliferation of PCs, the rise of the internet and globalization. These secular trends have peaked and today's hot areas - social networking and mobile technology - are unlikely to fuel similar rates of GDP growth. Also, the earlier demographic dividend provided by the baby boom generation is now turning into an economic drag as this cohort retires. Going forward, labor force participation and durable goods spending will face headwinds as boomers continue to age.

Thus the intellectual case for continued fiscal and monetary stimulus is shaky at best. Policy discussion needs to move beyond the false promise of government fostered job creation and should instead address the question of how to properly balance revenues and expenditures in an environment of market determined - rather than Fed-manipulated - interest rates.

Whether the party started in 1999 or 2003, too much celebration is often followed by a nasty hangover. Instead of finding further excuses to belly up to the stimulus bar, it is time for policymakers to sober up and get both fiscal and monetary policies under control.

Marc Joffe is Research Associate

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