The Fed and America’s Distorted Expansion

The U.S. economy has been in expansion mode since November 2001. Though of reasonable duration, the expansion has been persistently fragile and unbalanced. That is now coming home to roost in the form of the sub-prime mortgage crisis and the bursting house price bubble.

As part of the fallout, the Federal Reserve is being criticized for keeping interest rates too low for too long, thereby promoting credit and housing market excess. However, the reality is low rates were needed to sustain the expansion. Instead, the root problem is a distorted expansion caused by record trade deficits and manufacturing’s failure to fully participate in the expansion.

If the Fed deserves criticism it is for endorsing the policy paradigm that has made for this pattern. That paradigm rests on disregard of manufacturing and neglect of the adverse real consequences of trade deficits.

By almost every measure the current expansion has been fragile and shallow compared to previous business cycles. Beginning with an extended period of jobless recovery, private sector job growth has been below par through most of the expansion. Though the headline unemployment rate has fallen significantly, the percentage of the working age population that is employed remains far below its previous peak. Meanwhile, inflation-adjusted wages have barely changed despite rising productivity.

This gloomy picture justified the Fed keeping interest rates low. However, it begs the question of why the economic weakness despite historically low interest rates, massive tax cuts in 2001 and huge increases in military and security spending triggered by 9/11 and the Iraq war?

The answer is the over-valued dollar and the trade deficit, which more than doubled between 2001 and 2006 to $838 billion, equaling 6.5 percent of GDP. Increased imports have shifted spending away from domestic manufacturers, which explains manufacturing’s weak participation in the expansion. Some firms have closed permanently, while others have grown less than they would have otherwise. Additionally, many have reduced investment owing to weak demand or have moved their investment to China and elsewhere. These effects have then multiplied through the economy, with lost manufacturing jobs and reduced investment causing lost incomes that have further weakened job creation.

The evidence is clear. Manufacturing has lost 1.8 million jobs during the expansion, which is unprecedented. Before 1980 manufacturing employment hit new peaks every expansion. Since 1980 it has trended down, but it at least recovered somewhat during expansions. This business cycle it has fallen during the expansion. The business investment numbers tell a similar dismal story, with spending being much weaker than in previous cycles.

These conditions compelled the Fed to keep interest rates low to maintain the expansion. That policy worked, but by stimulating loose credit and a house price bubble that triggered a construction boom. Thus, residential investment never fell during the recession and has been stronger than normal during the expansion. Construction, which accounted for 5 percent of total employment, has provided over twelve percent of job growth. Meanwhile, higher house prices have fuelled a borrowing boom that has enabled consumption spending to grow despite stagnant wages. This explains both increased imports and job growth in the service sector.

The overall picture is one of a distorted expansion in which manufacturing continued shriveling while imports and services expanded. This pattern was carried by an unsustainable house price bubble and rising consumer debt burdens, and that contradiction has surfaced with the implosion of the sub-prime mortgage market and deflation of the house price bubble.

The Fed is now trying to assuage markets to keep credit flowing, and it will likely soon lower interest rates. On one level that is the right response and it may even work again – though it does increasingly seem like sticking fingers in the dyke to prevent the flood. However, the deeper problem is the policy paradigm behind the distorted expansion, which is where the Fed is at fault and where it deserves criticism.

The ideological and partisan Alan Greenspan wholeheartedly endorsed corporate globalization and promoted the White House and Treasury’s unbalanced expansion policies. The Fed’s professional economics staff also seems to have dismissed domestic manufacturing’s significance and endorsed corporate globalization in the name of free trade. Consequently, the Fed has tacitly supported the underlying policy paradigm that has given rise to America’s distorted expansion. Despite talk about reducing global financial imbalances, the Bernanke Fed still seems locked in to this paradigm and that is where constructive criticism should now be directed.

Copyright Thomas I. Palley

4 Responses to “The Fed and America’s Distorted Expansion”

  1. Stephen Schlaikjer Says:

    Tom: Enjoyed your latest description of the way the world works. How do you react to latest couple of months’ data showing that US manufactured exports are rising, apparantly in response to strong growth overseas and a weakening dollar? (And thus even adding some fractional percentage to US GDP growth. ) Does this strengthen your conviction that the Fed–along with the rest of the US Government–has the policy paradigm all wrong? And/or does it suggest a built-in adjustment mechanism whereby the dollar has to weaken due to the imbalances that US macro policies have helped create, and the US manufacturing sector–in those areas where we have competitive advantage–will naturally recover?

  2. Bernardo Aito Says:

    Hi to all,

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  3. marc pilkington Says:

    Thomas: I agree that the Fed has tacitly endorsed the so-called corporate globalisation paradigm. Any paradigm shift (which you do not make quite explicit, I’m afraid) is no longer a US macro policy choice though. The emergence of transnational corporations calls for a reflection on optimal currency areas, exchange rate management and, of course, global governance. When we refer to corporate globalisation, there’s no turning back at this stage, only specific global institutional adaptations…

  4. TOM PALLEY Says:

    Hi Steve, Thanks. The economy clearly has some self-adjusting mechanisms and exports are part of that. However, (1) the export boom is relatively small in total and coming late in the day. It’s doubtful it can offset the negative effects of the sub-prime market bust and house price deflation. (2) Trade deficit adjustment is being undermined by China’s refusal to adjust its exchange rates. Consequently, while adjustment is taking place against the rest-of-the-world-x-China we’re still bleeding versus China. Best, Tom