Strategically Speaking: An Interview with Greg Ip

Although traders are famous for concentrating mostly on what is going on right now, most (if not all) also keep a very close eye on strategic trends in the overall economy because it is these developments that drive tactical moves in asset, credit and derivative markets. Economic issues dominating much of the financial headlines into the final weeks of 2010 — ranging from the ongoing budgetary problems in the U.S. and Europe, currency concerns, and a recovery in the U.S. — while there, seem tepid at best. Trader Daily caught up with Greg Ip, U.S. economic editor at The Economist and author of The Little Book of Economics: How the Economy Works in the Real World, for his views on these issues heading into 2011.

Trader Daily: The Federal Reserve’s stimulus plan known as QE2 has drawn vociferous criticism. What do you think are some of the unintended consequences that might come from it?

There are several. First, it could push the global “search for yield” into overdrive. Investors, disenchanted with ever-lower returns on Treasurys, plough into stocks, emerging market bonds, commodities, property, etc., driving them to bubble levels, precipitating a collapse. However, I don’t think these are likely to happen. Most of the world is still de-leveraging which makes it hard for speculators to borrow the money they need to buy these assets. Moreover, countries in which speculation is more likely, such as Asia, have remedies. They can raise domestic interest rates, allow their currencies to appreciate, and impose tougher regulatory conditions on speculative activity.

A second possible unintended consequence is that investors see the Fed printing money and conclude much higher inflation is on the way. Higher expected inflation can be self-fulfilling. Some argue that’s why gold is so high. But TIPS bonds provide a much cleaner read on inflation expectations than gold. And they are actually pointing to lower, not higher, inflation. Finally, when it comes time to reverse course, the Fed will have trouble “unprinting” all the money it printed, making it hard to raise interest rates. You never know until they try, but I’m pretty sure they can tighten monetary policy as much as they want, even with a couple trillion dollars of extra money sitting in the banking system.

Trader Daily: Observers such as PIMCO’s Bill Gross have said that stimulus may offer no way out of a classic liquidity trap. What else should the federal government be doing to dig our way out?

It’s true that monetary stimulus is not a guaranteed solution to a liquidity trap. You can print as much money as you want, but you can’t make anyone spend it. Arguably, that’s the problem we have now. The Fed has printed lots of money, but very little of it is being lent out; bank credit has been contracting. That said, a turning point is in sight. I expect a year from now, bank credit will be expanding, and we’ll conclude the Fed’s additional monetary stimulus was a success. But what if I’m wrong? If the private sector won’t spend, the public sector certainly can. The federal government could increase spending or cut taxes, and the Fed could continue to buy the bonds needed to finance either. This is Ben Bernanke’s notorious helicopter drop of money, and it’s how we paid for mobilization during World War II. But politically, this is dangerous territory. It would look like the Fed is monetizing the debt, and a Republican tilt to Congress makes it much less likely.

Trader Daily: Should the Fed’s QE plan also extend to Fannie Mae and Freddie Mac debt?

It would be pointless. Fannie Mae and Freddie Mac are now regarded as the same credit as Treasury debt, and they have no problem raising money. You could make a case for the Fed to buy Fannie and Freddie-backed mortgage-backed securities. But even there, the spread between MBS and Treasurys, adjusted for the fact that mortgages can be prepaid, has virtually disappeared. There’s little incremental benefit to buying MBS versus Treasurys, and arguably, the Fed would so dominate buying [that] liquidity in the entire MBS market could shrivel up. There may be a case for the Fed to experiment with ways of buying small business debt; there’s some evidence small business is having a lot of trouble getting credit, even with interest rates so low.

Trader Daily: How does Alan Greenspan’s handling of interest rates and inflation look with the benefit of retrospect? Did the bubbles simply move to new asset classes?

The recovery from [the] 2001 recession was unusually weak and presented the Fed with a choice: err on the side of tighter policy and risk higher unemployment and possibly deflation, or err on the side of easier monetary policy and risk inflation and/or an asset bubble. The Fed thought it was better equipped to deal with the latter type of risk than the former. Given what they knew at the time, they made the right choice. What almost no one, including the Fed, understood was just how far the leverage and speculation spread during the ensuing period, and how fragile that made our country’s largest financial institutions. This speaks badly of the Fed’s regulatory record under Mr. Greenspan. That said, many regulators failed in that period, not just at the Fed and not just in the United States. In the broader sweep, I think historians will judge Greenspan on his entire 18-year tenure, which is more flattering than his last few years.

Trader Daily: How much was the Fed to blame for the real estate bubble, as opposed to fraudulent underwriting and unrealistic homebuyers?

I don’t know how you disentangle these things. In my book, I discuss how both business cycles and crises are unavoidable features of a market economy and of human nature. We shouldn’t want an economy without bubbles and crises, because that would mean no risk taking, no entrepreneurship, and ultimately no growth. It’s become popular to blame the Fed for the real estate bubble, both because of its regulatory failings and its low interest rate policy.  But you could equally argue that the Fed’s greatest contribution to the crisis was, perversely, its prior success at bringing down inflation and unemployment and moderating the business cycle – the so-called “Great Moderation.” The Fed seemed to have made the world a less risky place, and thus people were willing to take on more debt and hold less liquidity. It’s like forest rangers being so successful at preventing fires that excess kindling accumulates on the forest floor and ensures that when a fire finally does occur, it will be truly massive.

Trader Daily: We’ve seen the recommendations of the congressional deficit commission. How has our view of budget deficits changed over the last decade? How important is its management to recovering from the current recession?

You have to distinguish between cyclical (i.e. temporary) and structural (i.e. long-lasting) budget deficits. The first type is a perfectly acceptable by-product of the business cycle. The second is a dangerous drain on the savings needed for productive investment. Governments are always tempted to expand the deficit because it’s politically popular, and they think the economy needs the boost. This is dangerous thinking: The Fed can almost always provide faster, more effective stimulus than Congress, and withdraw it without politics clouding its judgment. The exception is when the Fed is out of conventional ammunition, i.e. has lowered its interest rate target to zero. We’re in that situation now. It doesn’t happen very often — the last time was in the 1930s. So this is one of those rare times when a larger deficit might be a good thing.

Trader Daily: Inflation has been the bogeyman of the global economy for years, but now economists tell us the rate of inflation may be too low. Can one distinguish between “good inflation” and “bad inflation?”

We used to think there was no such thing as good inflation. We now think a little bit of inflation is a good thing. First, the way we measure inflation has a bit of upward bias because we’re slow to incorporate new, cheaper products and stores, so 1% measured inflation might in reality be zero. Second, wages are sticky. If an employer has to cut prices to cope with poor sales and needs a way to cut labor costs, it is more likely to lay off workers than to cut their wages. A bit of inflation means that instead of laying off workers the employer can freeze their wages, in effect imposing a real (that is, inflation-adjusted) pay cut. Third, when the economy is really a mess, like now, the Fed likes to engineer negative real interest rates, i.e. push interest rates below the inflation rate. It can’t do that if inflation is at or near zero. Fourth, people and companies take on debts with a view to how much their wages and prices will rise. If inflation turns out much lower than they expect, or actually becomes deflation, they’ll have much more trouble paying back their debts, which could lead to a cycle of rising real debt, default, and weaker economic growth. Underlying inflation is now around 1%; it would be better to get it back to around 2%.

Trader Daily: China’s currency policies are taking on central importance to the global economic regime. Is there a way for the U.S. and China to cooperate and establish some sort of rapprochement over relative currency valuations? Do trade considerations trump the consequences of competitive devaluations?

Yes. For a country like China, trade considerations have so far trumped the benefits of a flexible exchange rate and open capital markets. However, China needs to recognize that keeping its currency artificially low is creating a lot of tension with its trading partners and making it harder for the entire world to rebalance away from over-spending Americans and towards over-saving Chinese. The good news is that Treasury has so far used the right amount of carrot and stick to nudge China along, and the yuan is now rising. I’d be worried if more protectionist interests took charge of U.S.-China relations in either country, but that hasn’t happened yet.

Trader Daily: Jobs are the biggest issue from the public’s perspective, but from an economist’s point of view, are they the largest problem we’re facing?

Yes. On this issue, the public and most economists are on the same page. The unemployment rate at 9.6% is some four or five percentage points above its “natural” level. This translates into six to eight million more unemployed people than a healthy economy would otherwise have. This represents a terrible human cost and a waste of productive resources. It is also the single most important reason why our budget deficit is so large: The unemployed are not paying taxes.  If only we agreed as much on the prescription as the diagnosis. More fiscal stimulus would help bring unemployment down, but only if we have a coherent plan for eliminating the budget deficit once the recovery is entrenched, and we don’t have that yet. And while I think a Greek-style fiscal meltdown is unlikely – we control the world’s reserve currency and have a history of paying our debts – we’ve seen how badly things can spiral out of control when investor confidence evaporates. There’s also some concern that when the government spends money, the public spends less to prepare for higher taxes later on. Personally, I don’t think that’s going on; but the risk cannot be dismissed out of hand.

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