Will rate cuts avert a recession?

I am somewhat surprised that the sensex as well as other stock markets the world over have taken off after the US Federal Reserve cut its short-term interest rate by 0.5%, to 5.5%. Other central banks are also expected to either cut interest rates or forbear from increases which had earlier been expected. Most central banks have opened their liquidity spigots after the subprime mortgages crisis.

The markets think the Fed will cut interest rates further, maybe to 4% by the end of 2008. This monetary easing, they think, will save the world economy from the recession threatened by the housing bust. Corporate profits may slow, but will pick up again. Based on this optimism, the bulls are dominating the markets again.

Yet some followers of the late Milton Friedman’s monetary economics may regard the reaction of markets as suspect, even crazy. Friedman would have said that the 0.5% cut was no more than a short-term ploy that would fool only the credulous. He held that the real economy could not be affected by monetary policy, save in the very short term.

Monetary policy could lift prices, but could not lift entire economies, and could not solve real-economy problems like the excess housing overhang that today threatens a global recession. So, those who are basking today in the rise of the sensex to record heights may be in a fool’s paradise.

The Fed’s interest cut has not fixed and cannot fix the real economy. This does not mean a recession is inevitable. But it does mean that, if a recession is averted, it will be for reasons other than the Fed’s monetary policy. What would Friedman have said about the current situation? He held that an injection of money into the economy would raise nominal GDP (which is real output plus inflation).

In the first few months, most of the increase might be in real output, but prices would soon catch up, and then the entire increase in nominal GDP would be on account of inflation. Real GDP would not be affected at all. Real GDP would be determined in the long run not by money but other factors such as innovation, productivity, entrepreneurship and investment.

Friedman’s most famous phrase summing up his philosophy was “inflation is always and everywhere a monetary phenomenon.” This did more than suggest what monetary policy could achieve. It also suggested what monetary policy could not achieve. It could be translated as, “real-economy booms and busts are never and nowhere a monetary phenomenon.”

Not all economists are fans of Friedman. I myself have grave doubts about the practical utility of some of his monetary economics. But most mainstream economists and central bankers are avid fans of Friedman. Ben Bernanke, head of the US Federal Reserve said in a 2003 conference in Dallas that “Friedman’s monetary framework has been so influential that in its broad outlines at least, it has nearly become identical with modern monetary theory.”

And yet it seems that central banks the world over believe that monetary policy can, in fact, steer the real economy. Indeed, most Americans believe that Fed chairman Alan Greenspan was responsible in large measure for the sterling performance of US economy after the mid-1980s.

Greenspan himself makes no such claims in his recent book. The Fed controls only short-term interest rates. Long-term rates are set by supply and demand in the market, and the Fed is helpless to fix them. Surely no monetary chief, Greenspan or otherwise, can control the fate of an economy by changing just one parameter, the short-term interest rate.

Yet Greenspan has widely, and incorrectly, been credited with steering the US economy to prosperity. Greenspan himself gives the credit to the rise in US productivity, globalisation, and deregulation of markets (much as Friedman would have).

In the last two years, short-term interest rates have risen above long-term ones in the US, inverting the yield curve. In earlier times, this would have indicated an imminent recession. But today Bernanke interprets it as a global savings glut (mainly in China, Japan and Opec countries) which has pushed down long-term interest rates everywhere.

If indeed the global savings glut is so powerful as to overpower short-term interest movements, should the markets get carried away by a cut of 0.5% in short-term rates by the Fed? Marketmen can justify their euphoria by saying that central bankers have done more than just cut interest rates. They have ended the financial panic after the subprime mess by pledging to inject enough liquidity to soothe roiled financial markets.

The Bank of England, which originally took a tough stand on imprudent borrowers, ended up by rescuing distressed mortgage lender Northern Rock. The British government said it would guarantee all deposits in all banks fully. In the US too, President Bush offered a rescue of distressed home borrowers who could not meet an increase in mortgage payments. This is not monetary policy. It is a fiscal guarantee backed by the full tax power of the government. It can certainly have real effects on the economy.

Whether this is enough to wipe out the negative wealth effect of the housing bust remains to be seen. Economic textbooks often imply that consumption is linked just to income. But in real life people spend more if they think their wealth has increased (because of a housing or stock market boom). Financial liberalisation in the US has enabled people to freely borrow against their increased wealth to finance a consumption spree, which far exceeds their income.

The housing bust now means that in the US, UK and other countries, the wealth effect may turn sharply negative, and induce people to spend much less. Whether that is an effect strong enough to cause a recession remains to be seen. Central banks have warded off a financial sector crisis. But monetary policy alone cannot ward off a recession. The business cycle, with its booms and busts, is alive and well.


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