Our Undeniable Future
The future is fiction — not a time and place
where events await us, but an infinite set of possibilities that ripple out in
concentric circles from every action we take.
The mere act of predicting a trend can alter it. The simple fact that many fear
a disaster can help prevent it. Nothing is truly inevitable.
however, that we could somehow travel forward in time, witness historic
decisions, and look back on what's happening today with the benefit of 20-20
hindsight. What would we see?
For an answer, we go to Camp David, Maryland ...
The time is 11 am on a Sunday morning; the
occasion, an emergency gathering among the president, the Secretary of the
Treasury, an economist from Council of Economic Advisors (CEA) and the Chairman
of the Federal Reserve. The atmosphere is casual, and the discussion, very
frank. The men sit comfortably on plush sofas, as the fireplace crackles. The
Treasury Secretary is the first to speak.
Treasury Secretary: I came here today prepared to tell you
about a dangerous fork in the road for our economy, and about a landmark
decision we must make this week: Do we persist in our multi-year effort to
stimulate the economy ... or do we turn our attention to putting out the new
fires that are bursting onto the scene? Do we plow ahead with more tax cuts and
more money pumping ... or do we start slamming on the brakes? Should we fight
recession or do battle with inflation?
[The secretary pauses, tilting his head slightly in the direction of the
President: I'm a bit perplexed by your choice of words, but go
Treasury: That's what I was prepared to talk about. But late
last night, I realized there's something wrong with that classic metaphor,
something that doesn't fit with the numbers we're seeing right now.
President: For example?
CEA economist: Let's start with autos. Sales in the automobile
sector have been plunging since June.
CEA: No one can pinpoint exactly why, but here's what we do
know: Even before interest rates started going up, the auto industry had pushed
cut-rate financing deals well beyond the normal limits of diminishing returns.
First they offered zero interest. Then they offered zero interest plus zero
money down. Next they added zero payments for an extended period. Meanwhile, the
average term of auto loans was extended out far beyond the average life the car.
And when all of these gimmicks stopped working, they even let people take cars
home for a free trial.
The market for sedans, sports cars, SUVs, and light trucks was saturated, but
Detroit didn't get it. So they inadvertently created their own kind of bubble.
Now, with interest rates rising, that bubble is bursting.
Housing was the next to crack. At first, rising interest rates actually spurred
a rush to buy. But it was a one-time spurt.
President: Please explain.
What happened was that, during the mortgage and refinancing boom, there were a
lot of people who had been thinking about doing it but never did. They just kept
putting it off. But as soon as they saw the Fed finally raising rates — that's
when they rushed to lock in their rates, refinance their homes or take out a new
mortgage to buy a home. This generated a final buying climax. But once the
climax was over, the market practically died, just like autos.
Now, here's the crux of our problem: In any other cycle, whenever you see the
economy turning soft, you can cross inflation off your list of nagging problems
to deal with. Not this time. Despite the obvious weakness in two of the
economy's largest sectors — autos and housing — inflation is still accelerating.
President: Does anyone have a rational explanation for this?
Treasury: The new numbers are forcing our team at Treasury to
recognize that, maybe, what we actually have here is not an economy that's
approaching a classic fork in the road.
President: What is it then?
Treasury: A sick patient that's falling by the wayside.
Remember: For the past two to three years, we've done everything humanly
possible to resuscitate the economy, to get it back on its feet. We brought on
the cheap dollar to help boost exports. We packed in the biggest back-to-back
tax cuts in decades. We injected enough money to bring interest rates down to
the lowest level in 46 years. Never before have we fired so many big guns in
such quick succession!
President: But it worked, right?
Treasury: Of course it worked. We saw factories begin to crank
up. We finally saw jobs kick in. We saw the economy rise to its feet and start
marching forward. But now it's stumbled again, and most people I talk to don't
seem to know why.
President: Don't you?
Treasury: As I see it, there are two things happening right
First, the effect of the stimulants — lower interest rates and tax cuts — is
waning sooner than we expected.
Second, the money we've injected into the economy in recent times is flowing
through the pipeline and pumping up inflation. That's driving bonds down and
interest rates up.
In other words, the side effects — inflation and rising interest rates — are now
overwhelming the desired effects. Some economists are even arguing that those
side effects could be worse than the original disease.
President: Who can tell me what's really happening with
Fed Chairman: Mr. President, I'm not quite ready yet to admit
this in a public forum, but I can confess to you right here and now that most of
the Federal Reserve governors greatly underestimated the inflationary embers and
fires throughout the economy. First, we thought that we could ignore rising
producer prices. Then we thought we could ignore the surge in energy and food
costs, relying strictly on the core inflation numbers, which still seemed
subdued. Finally, we thought we could ignore the anecdotal evidence that rising
energy and food prices were beginning to stir up inflationary trends in the core
By the time we recognized all the smoke for what it was, the conflagration was
out of control. Consumer price inflation, which was running at an annual rate of
over 5%, surged to 6%, then 7%. The inflation that was earlier confined to the
core areas spread to a wider range of consumer prices. And worst of all,
inflationary expectations among consumers and businesses rose to a
President: Earlier, it was said that this is somehow different
from previous cycles, that the classic metaphor of a fork in the road does not
CEA: In previous cycles, first you got the economic boom, then
you got the inflation. Now the boom is barely beginning — even faltering — and
the inflation is already hitting.
President: What do you call that?
CEA: Years ago, we called it "stagflation." But I don't think
that word adequately describes the current situation.
President: Why not?
CEA: Because stagflation implies stagnation — certainly
undesirable, but still relatively stable; and because this situation is anything
but stable. You have major financial/industrial bubbles. You have massive
overhangs of consumer debt. You have overspeculation with formerly cheap credit.
And now, you have two great triggers that can puncture the bubbles — falling
revenues in key industrial sectors and rising inflation.
THE LAST OPTIONS
President: I appreciate your candor, but I don't like what I'm
hearing. We're in a critical phase in the recovery right now. We cannot let it
fail. We must persist and persevere. What are our options?
[The others look at each other, waiting for a cue to speak that never comes,
while the president answer his own question.]
President: When the economy was sailing along nicely, we
started raising interest rates gradually. Now, if it's running into doldrums, we
will lower them again.
Fed: Not feasible. Remember: The Fed funds is still far too
low, still very close to emergency levels. These low rates were justifiable only
as an extreme measure to combat deflation and bankruptcies. Now with inflation
raging, there's just no way we can justify holding them down any more.
Even if the economy is not as strong as we had hoped, we must stay on course to
raise interest rates over the next several months. We're committed to that
course. If we back down from that course right now, we'll be the laughing stock
President: What's worse — damage to our pride or an abortion of
Fed: What's worse — no recovery or no market for our Treasury
securities? We can survive a recession. We cannot survive a shut-out in the
market for Treasuries. Yet if you ignore inflation — just let it run amuck —
that's what you'll get. Investors will shun our Treasury security auctions.
Worse, they'll dump the Treasuries they currently hold in their portfolios.
Ultimately, if we can't sell our bonds, we cannot raise the money we need to run
the government. We can't meet payroll.
President: What about more tax cuts?
Treasury: Also not feasible — and for exactly the same reason
as the Chairman just cited. It would send the signal that we are going to let
the federal budget, already out of control, go to hell in a hand basket. Bond
investors in the U.S. and overseas would sell in panic. We'd be unable to float
new bonds to raise the money we need to run this country.
CEA: Mr. President. It's high time we recognize that the
disease in the economy is deeper than previously recognized. It should have been
abundantly evident in the first years of the decade, but we didn't want to
believe it back then. We didn't want to face the fact that we had more than just
a traditional recession. We also had a bust in technology, a fiasco in
accounting, an unraveling of Wall Street scams. Plus, we had — and still have —
an accumulation of debts and deficits that is unprecedented in our nation's
President: I cannot understand. Everything you're saying sounds
bad. If that's the case, it's time to do MORE — not less. Is this a dire
emergency or not?
Fed: I am convinced that this is not yet a dire emergency. We
have falling auto and housing sales, but that is nothing new. We have falling
stocks and bonds. That has also happened many times before. I have not talked to
the board members or the members of the FOMC in a few days. However, I do have a
fairly good idea of what they would be saying if they were here today.
President: What would that be?
Fed: There would probably be some disagreement with respect to
your question — is this an emergency or not? However, there would be no
disagreement on the best mechanism for responding to any emergency: They would
sternly urge a steady, measured approach and staying on course with rising
interest rates. We must never forget the other, hidden risks in our economy
President: What risks?
Fed: First is the budget. If the budget were robust
fundamentally, maybe we could get away with lowering interest rates or lowering
taxes again. Unfortunately, that is absolutely not the case. In addition to our
official deficit estimates of over $500 billion, there's an off-balance-sheet
deficit of a few hundred billion more.
THE RISK OF A DOLLAR DECLINE
President: Is that correct?
Secretary: I'm afraid it is.
Fed: The second risk is the dollar. The dollar went up for
years, so it was often assumed the dollar was strong, that it was not a risk.
Not so. Foreign investors hold close to $5 trillion in U.S. stocks and bonds.
They are the single largest owner of most of our asset categories — larger than
our domestic banks, insurers, or any other single domestic sector. If you do
anything to shatter their confidence, if you frighten them in any way, look out
President: Can't we afford to let it fall for a while? Won't
that help America become more competitive? Won't it help stop American jobs from
being lost to cheap-wage countries like China and India?
CEA: Perhaps. But that's assuming you can control the dollar
decline. Suppose it starts falling beyond your control. Then what are you going
Fed: Plus, as you've seen in recent months, there's a third
risk — real estate. In recent years, a lot of people have been saying money was
leaving the stock market and going into real estate. That was only partially
true. The primary source of money for real estate has always been mortgage debt,
and we now have outstanding mortgage debt approaching $7 trillion. But it is not
growing any more. Now, that sector is weakening, and if it continues, you can
kiss the recovery goodbye.
Plus, there is also a fourth hidden risk — derivatives. We can't tell you much
about them, and therein lies the heart of the problem. It's largely an unknown
risk. All we know is that in terms of their total face value, which admittedly
exaggerates the problem, there are over $70 trillion in the U.S. and perhaps
another $50 trillion overseas — more than all interest-bearing debt in the
world. Plus, we also know that certain large U.S. banks — Morgan Chase, Bank of
America, and Citibank, for example — are at the center of the derivatives
markets. The key concern is that each of these banks is risking 100 percent or
more of its capital on derivatives, according to the OCC.
President: Gentlemen, you've knocked down every single
suggestion I have made today. I have no problem with that. But you gentlemen are
the brains, the experts here. If my suggestions are no good, give me an
alternative. And don't give me a wimpy, pea-gun solution that may have some
trickle-down effect someday. The economic recovery is failing now. All
these frightening risks we've heard about are in existence now. So I
want a cannonball solution that has big-bang impact potential — also now.
Fed: We all understand the urgency. But here's the dilemma in a
nutshell: You have two fundamental choices — you can try to save the economy or
you can try to save the government bond market. You can't do both.
Assume choice number one — you try to save economy. Result: You shatter
worldwide confidence in the U.S. government and you torpedo the entire
government bond market.
Assume choice number two — you try to save the bond market by fighting
inflation. Result: You torpedo the entire economy.
Those are your choices: Kill the bond market or kill the economy.
President: I've had enough of this "damned if we do, damned if
we don't" talk. What do you suggest we do?
President: You mean you don't know?
CEA: No, sir, I know exactly what we should do in this
situation: Nothing. Stand pat. Go back in history and look at the experience of
the past. Every aggressive action produced an unexpected market reaction. And
every action-reaction cycle has come with shorter and shorter intervals. Nixon's
wage-and-price freeze bombed and led to runaway inflation and the Arab oil
embargo. President Ford's budget deficits and easy money were a prelude to the
first dollar collapse. Carter's bond market rescue package of 1980 resulted in a
sudden recession. The 1984-86 money — pumping binge produced still another
dollar collapse and the worst stock market crash in history. Clinton
deregulated, and it helped open the spigots for the greatest tech stock
speculation in the history of mankind.
Now, all these crises are coming to a head. We have an automobile industry
crisis, a housing industry crisis, an accounting crisis, a budget crisis, a
recession crisis, a stock market crisis, a bond crisis, a dollar crisis — all at
the same time. Regardless of the consequences, you have only one choice, and
that is to keep your hands off — not because of some invisible hand that will
magically cure everything, but because, at this particular juncture, the
no-action choice is the wisest decision a true leader can make.
President: Do you want a do-nothing president?
CEA: No. But right now, we need a market-neutral government.
Let the market make the decisions. We have no other choice.
BACK TO TODAY
The meeting ends, and we return to today's reality of complacency and relative
quiet. But don't let it deceive you.
Also, don't let election-year politics distract you from what you have to do to
Remember: This is not about Democrats vs. Republicans. Nor can we blame the
current administration for present and future economic predicaments. The
situation we face today represents the accumulated consequences of multiple
administrations, and many congressional sessions.
My advice: Prepare for both a weaker economy AND higher inflation at the same