The Perils of Loose Living

For decades, Americans have looked to monetary policy as an engine of economic growth -- and suffered the dire consequences.

Documentaries like Inside Job and books like Michael Lewis's The Big Short have spun a narrative of America's economic crisis that stars Wall Street bankers and credit-rating agencies as the ultimate villains. But despite popular belief, subprime mortgages with exotic features had little to do with the housing bubble and the current debt overload weighing down U.S. households. They accounted for a mere 5 percent of mortgages at the time. The story line is just wrong.

The real culprit was the Federal Reserve. With its ultraloose monetary policy in the early 2000s, the Fed single-handedly created the refinancing boom and ushered in the housing bubble. The record-low interest rates not only fed the boom that had to go bust, but also favored that sector of the U.S. economy that is predominantly financed with debt, i.e., the financial sector, at the expense of sectors that are more reliant on risk capital, such as manufacturing. That might explain why, by the mid-2000s, bank profits accounted for 30 percent of all profits reported by S&P 500 companies. In other words, Americans stopped making stuff and relied on paper earnings instead.

Yet the only prescription being applied to the depressed U.S. economy today is basically what it was a decade ago: cutting interest rates in an attempt to inflate prices for assets like houses and stocks and boost consumption. Because the federal funds rate is already close to zero, the Fed has been buying up bonds with a longer maturity to drive down long-term interest rates. Although the latest bond-buying program -- nicknamed QE2 -- ended in June, its effect on interest rates will continue as long as the Fed holds onto the bonds. A third round of what economists call "quantitative easing" is imminent. But if consumption, the very hallmark of American culture, did not save the day in the 2000s, why would it do so today? It was China, not the United States, that prospered from Americans' spending binge as hundreds of millions of Chinese were lifted out of poverty.

In this year's State of the Union address, President Barack Obama invoked the idea of a "Sputnik moment" for this generation, implying that the United States was besieged by China as it had been half a century before by the Soviet Union. According to Obama, the country needed historic new levels of research and development akin to the massive investment that fueled the space race with the Soviets in the 1960s. But instead of backing up his vision with money, as President John F. Kennedy had, Obama announced a spending freeze, boasting that it would bring discretionary spending down to levels not seen since President Dwight Eisenhower. It's hard to miss the irony here.

And lower interest rates won't do the trick, as they won't bring down the cost of risk capital. For much of the 1980s and 1990s, any decrease in interest rates was mirrored by a similar drop in the cost of risk capital, spurring innovation. Since 2000, however, the cost of risk capital has gone up in spite of dramatically falling interest rates. The expected yield on risk capital is now more than three times the yield on 10-year Treasurys. The mechanism behind this is quite simple. U.S. consumption spurs economic growth and savings in China. But China's savings are mainly invested in risk-free assets, perhaps because the Chinese are culturally risk-averse, but also because the financial markets in China are still underdeveloped and not fully liberalized.

Whatever the reason, it's now clear that monetary policy is not an effective way to promote innovation. China and Germany both have a tradition of promoting new investment and innovation through state subsidies. The German government's subsidies for research, development, and innovation are four times as high as Britain's, and the Chinese government is luring investors with free land and other subsidies up to 40 percent of capital cost.

It should not come as a surprise that the economies of China and Germany have been thriving. Economic growth in China this year has been close to 10 percent, and it might have been even higher were it not for the People's Bank of China's successful attempts to cool down the economy. And even though economic growth in Germany somewhat disappointed in this year's second quarter, the unemployment rate hit a historic low. No jobless recovery there.

Thirty years ago, Chinese leaders realized that for China to become relevant, it had to look more like the United States. Now it's time for Americans to realize that to stay relevant, the United States will have to look more like China.


Cashing Out

America's status as the world's banker has shielded it from harsh economic realities for more than half a century. Not anymore.

The honor of printing the world's reserve currency did not come accidentally, or easily, to the United States; the dollar's post-World War II ascent to global primacy would not have happened had America not demonstrated the unrivaled economic, military, and technological power to back it up. But being the world's banker comes with benefits as well as obligations -- and first among them is that the whole world wants to make sure you don't default on your debt. If you are in a position to repay your obligations by just printing more money, you might never default.

What is a blessing in the short run, however, could turn out to be a curse in the long run. A country that controls the international currency runs less financial risk when it borrows, but is thus likely to be less alert to the risk of financial bubbles. Costs can be underestimated, and problems undiscovered, for a long time. The United States is now learning this lesson in a very big way.

For many countries, such as Argentina and Vietnam, a budget deficit of more than 3 percent of GDP or a 5 percent current account deficit has been enough to plunge them into a financial crisis. The United States, by contrast, maintained about the same figures on its balance sheet for a decade while enjoying a period of economic expansion. The result was overconfidence and a flawed vision of limitless potential growth, as if Americans could keep spending without saving to no one's detriment. Some economists even claimed this was a result of the "super-efficiency" of the U.S. economy.

You can see the logical consequences of this illusion in today's overleveraged, debt-plagued U.S. economy, the major cause of both the 2008 global financial crisis and the current concerns over U.S. government debt. The lesson is clear: The United States may enjoy a greater line of credit than everyone else in exchange for providing the dollar, but even the most forgiving balance sheet in the world has its limits. America's long experiment with ballooning debt and an ever-expanding financial sector has left the country with other problems, too. Wall Street's disproportionate size in comparison with "real" sectors of the U.S. economy such as manufacturing has resulted in deteriorating industrial competitiveness, growing trade deficits, and unemployment.

We cannot and should not attribute all of America's current problems to the dollar's special status and the illusions that come with it. But without it, we cannot explain why the United States did not make the hard economic choices that less-privileged countries would have had to make, and long ago. Today, even the world's banker can't put off the reckoning any longer.

Javier Jaen