Over the past three years, central bankers have flooded the U.S. financial system with money. Interest rates are at historical lows. But the economic recovery has stalled anyway.
Unemployment remains troublingly high. Home prices and stocks are still down a third from their pre-recession peaks.
The traditional approaches to stimulating the economy -- ultralow interest rates and government spending -- just aren't working.
What we need is a healthy dose of inflation.
Yes, I know that might sound crazy, but I'm not talking the Weimar-style hyperinflation that Germany suffered through during the 1920s or even the spike we saw at the end of the 1970s. A return to an annual inflation rate on the order of 3% to 4% is what's needed.
- Companies are hoarding cash instead of putting it to work, because, with capital so cheap, even the tiny return from saving it is a boon.
- Investors are tucking money into safe, low-return investments instead of feeding growth by buying company stocks.
- Consumers are saving instead of spending despite low interest rates, partly because prices may fall lower.
- Banks, scared to lend, are piling up excess reserves that are earning virtually nothing.
An increase in prices would force changes in these behaviors. (I made a similar argument in April.)
Without it, we risk a slide into a Japanese-style deflationary spiral in which the economy falters and the cost of our debt burden swells. And as I recently warned, reliving Japan's experience of the past 20 years wouldn't be pretty. The Dow Jones Industrial Average ($INDU) could drop below 4,000, and home prices could fall an additional 46% by 2030.
You might wonder why low interest rates, combined with budget-busting fiscal stimulus from the federal government, haven't been enough to get the job done this time around.
It's not like rates aren't low enough. By some measures, they are in negative territory. The yield on three-month Treasury bills has been below 0.2% since early 2009, a prolonged stay at levels that haven't been seen since the early 1940s. And it's not like there isn't plenty of money in the system. Since November 2007, the Federal Reserve has expanded the monetary base from $857 billion to more than $2 trillion.
The problem is extreme risk aversion. And it's being enabled by low inflation.
The hordes are hoarding
Instead of using cheap financing to invest and hire workers or even raise dividends or repurchase shares, corporations are hoarding cash. The ratio of liquid assets to total assets has jumped from 2.9% in 1980 to nearly 7%, a level not seen since 1960. As a result, the manufacturing capacity of the country is beginning to rust away as managers forgo even basic maintenance expenditures to stash money in the bank, a subject explored at length in a recent column.The banks aren't doing much either. Although we've seen some positive signs, with lending standards finally beginning to ease, there are now fewer loans outstanding than there were in September 2008. Instead of extending credit to businesses and consumers, the financial sector is dumping its cash into U.S. Treasurys and parking money in the Federal Reserve's vaults. The latter strategy earns a paltry 0.25%, yet the amount of money sitting idle at the Fed has jumped from just $810 million in the months before the recession to more than $1 trillion now.
These are reservoirs of cash waiting to be tapped.
Similarly, U.S. consumers aren't using cheap credit to buy discounted luxury homes or go on spending sprees. That's despite mortgage rates that have plunged to just 4.3% while home affordability has returned to levels not seen since before the bubble. Credit card debts are being paid down. Indeed, the personal savings rate has jumped from a low of 0.8% in 2005 to 5.9% now.
Obviously, part of the problem is that many consumers, banks and businesses are still paying for past sins. Debts are being repaid and balance sheets rebuilt. And millions of people are still without work.
But the process is nearing its end. Banks are about 85% of the way through recognizing their housing-bubble losses, according to estimates by Credit Suisse and the International Monetary Fund. And Fed data show that household debt-service burdens have improved to levels not seen in 10 years. Overall, the picture is of an economy rebuilding its ability to create and consume credit.
