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*** Stephen Roach 6-9-03 ***


Global: Macro Seduction

Stephen Roach (from London)
June 9, 2003

The stock market is up -- albeit still down from a year ago -- and there is growing hope the long nightmare is finally over. Convictions are rising that this rally is for real. Most believe that an imminent economic rebound is about to validate the increasingly optimistic earnings expectations now imbedded in share prices. So far, any such recovery is just a forecast. As I see it, the latest batch of backward-looking data reveals persistent sluggishness in the US economy and renewed weakening in Europe, Japan, and the developing world. The recovery bet is premised on the belief that the authorities finally get it -- that the massive global reflationary effort now under way will underwrite a sustained acceleration in the real economy. Policy makers and politicians are doing their very best to convince financial markets that they have both the wisdom and the tools to pull it off. Long frustrated investors want to believe these tantalizing promises. It’s the ultimate act of macro seduction.

On the surface, the policy bet isn’t hard to understand. The world’s major central banks are now taking dead aim at that once “nonexistent” risk -- deflation. The once lonely Bank of Japan has been joined in battle by the Federal Reserve and the European Central Bank. The anti-deflationary policy arsenal now has a stunning array of global weapons. Even the fiscal authorities have jumped in. America has led the way -- upping the ante on budgetary stimulus for the second time in three years. And the Europeans are looking the other way while budget deficits in the big countries exceed the arbitrary caps of the Growth and Stability Pact. American investors are taught, “Don’t fight the Fed.” Does anyone dare to confront the collective firepower of this international “coalition of the willing”?

Yet in the end, the policy bet may well be the weakest link in this daisy chain. History tells us that macro policy has had a truly terrible track record in dealing with deflation. That’s been the case since the 19th century but has been especially evident in so-called modern times. The worldwide deflation of the 1930s, to say nothing of the more recent Japanese experience, are grim reminders of stunning policy failures in dealing with this most corrosive of all macro diseases. Yet this time, we’re all being asked to believe it’s different -- that policy makers have learned the lessons of history and will never allow deflation to occur again. None other than Fed Governor Ben Bernanke -- the intellectual force behind America’s anti-deflation battle -- has said this in no uncertain terms. Recently, at Milton Friedman’s 90th birthday celebration, he honored the world’s most well-known monetarist by thanking him for showing us all the way. The “way” is Bernanke’s belief in the power of the printing press as the central bank’s antidote to deflation. It is at the core of the Fed’s purported last line of defense against deflation. It’s also as pure a monetarist prescription as you could ask for. Fed Chairman Alan Greenspan has echoed this confidence, boasting repeatedly of the Fed’s possession of the unlimited ammunition of monetary creation as the means by which the anti-deflationary battle ultimately will be won. It’s the ultimate compliment of a Friedmanesque view the world -- that fluctuations in the aggregate price level are first, and foremost, a monetary phenomenon.

There are few things that shock me these days -- with age comes an unfortunate cynicism. But I was truly shocked to read over this weekend that none other than the same Milton Freidman has just recanted the central premise of monetarism. In an astonishing interview published in the Financial Times, the now 91-year-old retired professor concedes that “The use of quantity of money as a target has not been a success. I’m not sure I would push it as hard as I once did” (see “The Long View,” an interview with Simon London contained in the Weekend Section of the Financial Times, June 7-8, 2003). This is an extraordinary mea culpa for a man who single-handedly turned the macro policy debate inside out over the past 30 years. The founding father of modern-day monetarism is now telling us that the quantity of money doesn’t matter after all. Ironically, the admission comes at just that same point in time when the Fed is telling us that it’s all that matters.

Friedman’s reversal takes me back some 25 years on my own journey. It was 1978 and I was on the research staff of the Federal Reserve Board in Washington, sitting in on one of the Fed’s great traditions -- a one-day seminar it conducted with a group of “academic consultants” who were brought in to debate the macro issues that bear on the conduct of monetary policy. The comments were off the record but with the “statute of limitations” having long since lapsed, it’s well worth revealing what transpired. G. William Miller had just taken over the reins of the Fed from the legendary but woefully incompetent Arthur Burns. Miller knew little of the intricacies of monetary policy nor did he express much interest in learning. But that didn’t stop the collected group of academic consultants from using the occasion to expose him and other Fed policy makers to a debate that I will never forget.

The best and the brightest from academia were in attendance at this particular meeting in 1978. Milton Friedman took the initiative. He was in his heyday back then, having just received the Nobel Prize in economics in 1976. He used the occasion to lecture the Fed on the sheer folly of its ways. Reaching deep into my memory bank, permit me to paraphrase the following exchange. Freidman’s opening salvo went something like this, “I am here only out of curiosity to meet a new Fed Chairman. I am not here to give advice to an institution that seems utterly incapable of taking it.” Paul Samuelson, America’s first Nobel laureate, was quick to respond that he was proud to have been invited to that meeting and was more than willing to offer his advice to Fed policymakers whenever they wanted it. James Tobin of Yale and a future Nobel Prize winner echoed Samuelson’s sentiments.

In the height of arrogance, Friedman suggested to Miller that his task was relatively simple -- that all the Fed needed to do was set the money supply on automatic pilot. This was consistent with one of the central tenets of monetarism -- that the discipline of a rules-based approach to money-growth targeting would cure all that ailed the macro-economy, especially inflation. The Keynesians in attendance begged to differ, arguing that policy makers needed far more discretion in balancing their complex objectives. It was a classic policy debate -- rules versus discretion -- that enthralled all of us who were in attendance that day. And now, some 25 years later, Friedman finally admits he was wrong. Unfortunately, most of this went over the head of the new Fed chairman. At the end of the heated exchange, Miller looked up and asked the assembled group, “Well, do we have a consensus?”

To its credit, the Fed has long seen through the follies of strict monetarism. It was a convenient foil for Paul Volcker to use when he led a courageous assault on double-digit inflation beginning in late 1979. At that point, the Fed introduced a rigorous targeting of money and credit into its policy calculus as a justification for the sky-high interest rates that finally crushed the real economy and the concomitant ravages of the Great Inflation. But the Fed discarded this tool quickly once the task had been accomplished. In its biannual monetary policy reports to the Congress, the Fed noted repeatedly it has “…little confidence that money growth within any particular range selected for the year (ahead) would be associated with the economic performance it expected or desired.” Finally, in mid-2000, the Fed formally abandoned monetary targeting, noting at the time that it was no longer legally required to do so and that such efforts “…for many years have not provided useful benchmarks for the conduct of monetary policy” (see the Federal Reserve’s midyear policy report to the Congress, June 2000).

But now the Fed is doing another about-face -- asking us to believe in monetarism as the ultimate cure for deflation. To rely on such a discredited framework, at precisely the time when its own intellectual founder has disavowed its central premise, smacks of the ultimate in macro hypocrisy. Unfortunately, the same can be said of the supply-side mantra that has once again infected the fiscal policy debate. Remember the infamous Laffer Curve that promised those trickle-down tax cuts would be self-financing? Think twice about that famous squiggle on a napkin when you look back at America in the 1980s as a nation of widening income disparities and massive budget deficits that averaged 5.1% of GDP over the four-year interval, 1983-86. Remember Rosy Scenario, that voluptuous temptress of the Reagan era who headed up the White House forecasting group that promised economic perfection for as far as the eye could see? Well the supply-siders are back with the same set of promises today. Never mind budget deficits or current-account gaps, they tell us. American can finance anything. Monetarism and supply-side economics made for strange bedfellows in the 1980s. It was such an alluring combination -- ever so seductive. Fast-forward 20 years and little has changed -- the infatuation endures.

All this fits too neatly with the understandable denial of the deflationary endgame -- it is simply too threatening for the economy and too scary for financial markets. Now that policy makers have ridden to the rescue, investors are eager to breathe a collective sigh of relief and even quicker to put aside the perils. And why not? The markets are up, and many an economic forecaster is joining the celebration. But a new note of caution is now in order: The same intellectual deception that was in vogue in the 1980s has returned with a vengeance. This is not the time to embrace the seductive promises of failed theories. Policy traction in a post-bubble and increasingly deflationary climate is not about the quick fix. That’s the lesson from history that keeps me awake at night. And yet that’s the very possibility that ever-bullish markets are now ignoring.

http://www.morganstanley.com/GEFdata/digests/20030609-mon.html

You're welcome! <gg>
Dan