While the U. S. economy is no longer contracting—the real rates of growth of the economy have been positive since the third quarter of 2009—the economic recovery has been exceptionally slow despite record low rates of interest (see Charts 1 and 2). The unemployment rate has stayed stubbornly high, above 8 percent, and is unlikely to fall significantly in the near term (see Chart 2). The effectiveness of an easy monetary policy is in serious doubt. In fact, the real rate of interest, the difference between the nominal rate of interest and the rate of inflation (measured by the consumer price index (CPI)), has been negative since November 2009 (see Chart 2). The economy is in a classical “liquidity trap” situation. As is well known, one can pull on a string but not push on a string. Further lowering of the rate of interest and release of liquidity in the U.S. is unlikely to increase domestic investment, especially given all the uncertainties of this presidential election year.
Chart 1: Seasonally Adjusted Annualised Quarterly Rates of Growth of U.S. GDP
Chart 2: The Rates of Change of U.S. CPI, Interest, and Unemployment, and
Index of Euro/US$ Exchange Rate
The problem is that expectations can be self-fulfilling in the absence of any clear signal of change. If firms and households expect the economy to do terribly and act accordingly by reducing investment and consumption, the economy will indeed turn out to be terrible, fulfilling their expectations. This may lead them to expect a further worsening of the economy, and act accordingly, resulting in an even further decline of the economy, creating a self-perpetuating downward spiral in which negative expectations lead to declines and declines feed into even more negative expectations. This has been, unfortunately, the story of the Japanese economy since its property price bubble burst in 1990. In order for expectations to change, there must be some concrete action that can act as a signal to the firms and households that the economy will be improving soon.
The World economy has already experienced both “Quantitative Easing I (QE-I)” and “Quantitative Easing II (QE-II)” operations by the U.S. Federal Reserve Board. However, these operations did not seem to have done the U.S. real economy much good. Much of the excess liquidity generated went overseas, driving up exchange rates and asset prices elsewhere. If the U.S. had some form of capital control, so that the excess liquidity had to be kept and used within the U.S., it might perhaps have driven up some U.S. asset prices and led to some additional domestic investment. However, that has not been the case.
At this point, only an expansion of real aggregate demand can serve as an effective signal for a change in expectations. However, it does not appear likely that the U.S. Congress will authorise a fiscal expansion, even though that is exactly what is needed. There is ample excess capacity in the U.S. economy, especially in the construction sector and the building materials sector. What the U.S. Government should undertake is an expansion in capital expenditures focused on public infrastructure on the one hand and a reduction in recurrent expenditures on the other. It should be supporting growth and imposing austerity at the same time.
How can this be done, especially with a Congress that is unwilling to authorise any increase in expenditures, whether capital or recurrent?
2.Buying the Bonds of the Individual States
One possibility is for the Federal Reserve Board, in its next round of bond buying, to purchase new long-term bonds issued by the individual states and earmarked for public infrastructure in the respective states. For example, the Federal Reserve Board can offer to purchase a total of US$600 billion worth of new state bonds from the individual states, roughly in proportion to the population of each state, with the proviso that the proceeds must be used for infrastructural projects—either new construction or maintenance and upgrading of existing infrastructure—and cannot be used to pay for the recurrent expenditures of the state (e.g., salaries of the state government employees) per se. These infrastructural projects can include roads, highways, railroads, airports, seaports, bridges, dams, and even hospitals and schools, etc. This will increase aggregate demand, GDP, and employment in every state, and will be utilizing basically the excess capacity in the construction sector and the building materials sector and hence are unlikely to be inflationary. Moreover, such investments will turn out to be socially productive, given the current deteriorated state of U.S. public infrastructure, by enhancing the rates of return of past, present and future private investment. In addition, these expenditures on infrastructural projects will not increase the federal budget deficit; on the contrary, because of the GDP and employment that they will create in every state, they may actually help to reduce the federal as well as the state budget deficits.
Of course, the individual states will have to pay the interest on and eventually repay the principal of these bonds. However, the long-term rate of interest is at a record low and the state revenues will benefit directly from the increased GDP and employment in the states. In addition, the states can take a long period, say thirty years, to repay the bonds, during which time the state economies will have recovered sufficiently. I believe all fifty states will support such a bond purchase plan. (In fact, a similar plan can be used for Greece, so that while Greece needs to reduce its recurrent government expenditures, it can still undertake some capital projects so as to maintain some economic growth and prevent unemployment from becoming too high.)
3.Buying Mortgage Loans at a Discount
Another possibility is for the U.S. Federal Reserve Board to buy (exclusively or predominantly owner-occupied) U.S. mortgage loans or equivalently mortgage-backed securities at a discount. Owners of the mortgage loans or mortgage-backed securities can be asked to bid competitively the percentage discounts that they are willing to accept. The Federal Reserve Board will purchase those with the highest percentage discounts up to the maximum amount for that particular tranche of loan/bond purchases, say, US$100 billion. Since these mortgage loans are purchased at a discount, there will be room for the negotiation of work-outs with the actual borrowers, especially those who are owner-occupants, through a reduction of their loan principals. Moreover, the remainder of the loan, which may still be higher than the market value of the home, can be refinanced at the current lower rate of interest and perhaps even with an extended maturity, thus significantly lowering the monthly payments for the same home mortgage. In this way, it may become possible for many of such borrowers to avoid default and losing their homes. Once such mortgage loan default problems can be resolved satisfactorily, these households will have greater confidence as well as resources to start consuming normally again. The Federal Reserve Board can repeat the same exercise with successive tranches of such purchases of loans and bonds.
4.“Engineering” a Devaluation of the U.S. Dollar
The Federal Reserve Board has a great deal of latitude in deciding what types of bonds and/or loans to buy. Another possibility for increasing aggregate demand is of course to increase net exports. If the U.S. were any other country, its central bank could just undertake a significant one-off devaluation of its currency, leading to a significant increase in its net exports and resulting in an increase in both its GDP and employment. However, for various ideological and technical reasons, a direct intervention in the foreign exchange market is not an option for the U.S. or for the Federal Reserve Board. The Federal Reserve Board can offer to purchase new bonds to be issued by the Export-Import Bank of the U.S., thus enabling it to finance exports and export enterprises with super-low long-term interest rates. However, it is not clear that there is that much room there for Federal Reserve Board action.
Thus, the U.S. is left with two imperfect instruments--“persuasion” and “flooding the World with liquidity”--to try to devalue the U.S. Dollar relative to other currencies. Neither instrument can work perfectly. The rate of interest in the U.S. is already as low as it can become, so that it is not possible to induce much additional net capital outflow (and hence a devaluation) through a lower interest rate differential with other countries and regions per se. It is true that the Chinese Yuan and the Japanese Yen have actually appreciated significantly against the U.S. Dollar in the past couple of years and the respective bilateral trade balances seem to have narrowed. However, this strategy has not proved to be effective against the Euro (in part because of the European sovereign debt problem and the U.S.’s position as a safe haven for capital). In fact, the Euro/U.S. Dollar exchange rate has recently reached a 24-month new high (see Chart 2). Euro Zone countries, Germany and France in particular, are major competitors to the U.S. in the supply of capital and technology goods (e.g., airplanes, automobiles, machine tools, tractors, etc.), and their exporters remain extremely competitive with U.S. exporters in the Chinese, Japanese and other markets. It is possible that the U.S. Dollar may fall yet again relative to the Euro when the European sovereign debt crisis is finally resolved.
However, a significant effective devaluation of the U.S. Dollar against major currencies, even if it can be engineered, risks kindling inflation in the U.S. not only through a rise in the price of imports (the U.S. has been importing most of its consumer goods), but also through a rise in the prices of the major commodities, including oil, and possibly also through a rise in the U.S. asset prices due to increased foreign direct investment in the U.S. Unless U.S. net exports can be increased significantly as a result of such devaluation, there may actually be some risk of stagflation.
We have discussed two possible bond-buying programs that the U.S. Federal Reserve Board can launch that can result in an increase in aggregate demand directly and indirectly and hence improve the U.S. economy. There are also other possibilities. It does not have to be “Quantitative Easing III (QE-III)”, or in any case QE-III can take a very different form from QE-I and QE-II. The World economy desperately needs a healthy U.S. economy and the whole World wishes the Federal Reserve Board every success!
Lawrence J. Lau is the Ralph and Claire Landau Professor of Economics at The Chinese University of Hong Kong, and Kwoh-Ting Li Professor in Economic Development, Emeritus, Stanford University. He is most grateful to Mrs. Ayesha M. Lau for her helpful comments and suggestions. All opinions expressed herein are the author’s own and do not necessarily reflect the views of any of the organisations with which the author is affiliated.