John Rapley
SOMETHING STRANGE seems to be happening in U.S. financial markets, and nobody can account for it. But it is troubling the world's central bankers, who are starting to worry that another financial meltdown could be on its way.
After the 2000 stock-market crash induced a recession, the U.S. Federal Reserve Board lowered short-term interest rates to historic lows. Its aim was to induce Americans to borrow cheap money, and thereby support the economy.
The strategy worked. Americans returned to the shopping malls. Moreover, while they did not crowd back into the stock market - many had burned their fingers there, and not a few their whole life-savings - they began buying houses, driving real estate values sharply higher. The result is that the U.S. economy was quickly put back onto a growth path.
So, as America emerged from its recession, the Fed started returning interest rates gradually to their previous levels. The idea was to slowly 'mop up liquidity', gently encouraging Americans to cut back their spending and increase their saving.
LOOMING MARKET CRASH
But while short-term interest rates have tripled in the last year, something strange has happened. Long-term interest rates continued declining. This, plainly, is not supposed to happen. Puzzled by this development, Fed chairman Alan Greenspan recently confessed he found it a conundrum. Many explanations have been put forth for this anomaly, from Chinese pur-chasing of U.S. bonds to the changing investment patterns of older Americans. Mr. Greenspan has looked at all of them, and found them wanting.
Conundrum or not, Mr. Greenspan has a problem. Due to retire next year, he does not want to bequeath America another market crash. But not a few observers worry that such an eventuality is now looming as a possibility.
Soaring house prices worry many economists. Mr. Greenspan himself has warned that housing bubbles have developed in several American cities. His critics argue that after helping to inflate the stock-market bubble in the 1990s with a loose monetary policy, Mr. Greenspan subsequently shifted the bubble to the real-estate sector. But if it is a bubble, it is sure to burst eventually. And there are signs that this could occur sooner rather than later.
INFLATION RATES RISING
Housing prices do appear stretched. But rather than sit on their gains, Americans have been using them to obtain secured loans to do more spending. They are also, apparently, using their increased paper-wealth to boost their real-estate investments. This looks to many analysts like the sort of speculation that precedes a fall. Nevertheless, U.S. banks are providing ultra-generous terms - such as interest-only loans - to keep their clients borrowing. It all looks a bit reckless.
Meanwhile, inflation in real estate has apparently started to feed into the rest of the economy. Despite falling interest rates, inflation in the U.S. is rising. There are reasons to expect this trend to continue indefinitely.
Meanwhile, the U.S. saving rate remains impossibly low. As a result, the cash balances in the country's financial institutions are dwindling. This will inhibit future lending and investing. Sooner or later, this is bound to either drive up interest rates - which could well provoke a downturn in housing and share prices - or provoke a recession. Either way, the broader economy will suffer.
Of course, there is the possibility that the reason economists cannot explain the conundrum of declining long-term interest rates is that it is a wholly novel phenomenon. Perhaps we have entered a new age in which the old laws of economics no longer apply. In that case, the sky will not fall. Rather than fear a crash, we should embrace the conundrum.
Perhaps. However, if history is any guide, it is that talk of a new economic era always precedes a thudding return to normality. In the late 1990s, everyone - even then-President Bill Clinton - jumped on the new-economy bandwagon and declared that the stock market would continue surging to heights never before seen. Uh-huh.
It's hard to say how this will play out, precisely because so much of what is going on defies explanation. But it would probably be best to err on the side of caution, and assume that the U.S. may be moving into an 'adjustment' phase in its economic growth. That would have implications for all of us.
John Rapley is a Senior Lecturer in the Department of Government, UWI, Mona.
