Dennis J Snower, President of the Kiel Insitute for World Economics, is surprised that we keep getting surprised by bad news. Snower suggests that investors are bad at adapting to broader shifts in the macroeconomic and investment landscape and generally never expect large paradigm shifts. Since the early and mid nineties, investors in the U.S. have grown used to robust growth accompanied by low inflation, and its difficult to think about things outside the context of this theme. But just because we’re used to a certain pattern, doesn’t mean it won’t change:
Why does the public repeatedly underestimate the repercussions of the present financial crisis? The answer is simple: most of us are short-sighted; we can’t imagine a future that is radically different from the present. In particular, most of us don’t understand that economic events often unfold gradually due to the operation of important lagged adjustment processes embedded in the economy. The public, the media and politicians would do well to give them close attention. Lagged adjustment processes. After the Titanic’s hull was punctured, it took hours for its hull to fill with water; thus the passengers couldn’t imagine that it would sink.
Snower thinks that four emmerging trends in the macro environment may signal a fundamental paradigm shift for the US economy, a shift that will be defined by low growth and higher inflation:
1) The continued liquidity crisis precipitated by the credit crunch:
The subprime mortgage crisis gave rise to a liquidity crisis in the international banking system, due to uncertainty about who holds the losses. This is leading to reduced lending to firms and households. But that is not the end of the story, because the reduced lending will lead to reduced consumption and investment. With a lag, reduced sales of goods and services will reduce stock market valuations. And, with another lag, the lower stock market prices will – in the absence of any favourable fortuitous events – intensify the banks’ liquidity crisis.
2) The continued collapse of housing markets:
As more and more U.S. households find themselves unable to repay their mortgages, foreclosures are on the rise, more houses are put on the market, the price of houses falls further – with further lags – this leads to more foreclosures and declines in housing wealth. This dynamic process plays itself out only gradually, as households face progressively more stringent credit conditions and house sales gradually lead to lower house prices.
3) The inevitable collapse in consumer spending, profits, investment, and employment that will result from household budgets being pressured by falling housing prices:
As U.S. households’ wealth – in the housing market and the stock market – falls, their consumption is beginning to fall and will continue to do so, again with a lag. This decline in consumption is leading to a decline in profits, of which more is on the way, which in turn will lead to a decline in investment. The combined decline in consumption and investment spending will eventually lead to a decline in employment, as firms begin to recognise that their labour is insufficiently utilised. The decline in employment, in turn, means a drop in labour income, which, with a lag, leads to a further drop in consumption.
4) The falling dollar:
As the Fed reduces interest rates to combat the crisis, the dollar is falling. This is leading to higher import prices and oil prices in the United States, putting upward pressure on inflation. The greater this inflationary pressure – which is currently in excess of 4 per cent – the more difficult it will be for the Fed to reduce interest rates in the future, without running a serious risk of inflaming inflationary expectations and starting a wage-price spiral. U.S. firms and households will gradually recognise this dilemma and the bleak prospect of little future interest rate relief will further dampen consumption and investment spending.
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