By John Richardson
THE US Federal Reserve thought it understood how the world worked, thanks to its FRB/US (Ferbus) computer model.
“Assuming that the FRB/US model does a good job of capturing the macroeconomic implications of declining house prices, such an event does not pose a particularly difficult challenge for monetary policy,” John Williams, then a Fed analyst and now president of the San Francisco Fed, said during a debate on the housing boom in 2005.
Oh dear. Wind forward to today and here is a real mouthful for you: The Fed is now trying to predict and then direct the behaviour of the US economy via another model built by the New York branch of the Fed – the dynamic stochastic general equilibrium model.
There is a parallel here with oil markets. Back in late 2014, when oil prices collapsed, some of the existing cost-of-production models failed to recognise that shale-oil production costs would continue to fall. The consensus view was thus that supply and demand would swiftly come back into balance and we’d soon be back at $100/bbl.
What was missing from yesterday’s oil-market models and today’s Fed model is this: A recognition that people participate in markets, and so human behaviour shapes markets.
Now let’s focus on the chart above and what it tells us about the failure specifically of the Fed’s “sit-behind closed doors and don’t talk to enough people” modelling of the US economy:
- It was the Babyboomers that gave a tremendous one-off boost the US economy – and the global economy as well. US births rose by 52% in 1946-1964 compared with the previous 18 years.
- Another important one-time demographic boost to demand was the arrival of women in far-greater numbers in the workforce. Growth in dual-income households and immigration were responsible for between 15% and 20% of growth in aggregate US output over the past half century.
- This led to too much demand chasing too little supply – hence, the jump in US inflation and an explosion of innovation. Companies invested heavily in research and development, and then in the commercialisation of all these fantastic ideas, because the demand justified the effort. So we also saw many years of high productivity growth.
- But since 1970 US birth rates – and those across the West in general – have been below 2.1 per mother. This is below the population replacement.
- In 2001, the oldest Boomers began to join the New Old 55+ generation. As you first approach retirement you spend less money, as of course you are saving for your retirement. When you actually retire your spending declines even further as a.) You have already bought most of the things that you need and b.) You are living on your pension income.
- We have thus seen a collapse in inflation as too much supply chases too little demand. Companies have also stopped innovating, as today’s demand levels are not worth the effort. This helps to explain the fall in productivity growth.
The real human tragedy of the failed Fed computer modelling is that this suppression of demand as people retire is going to be much worse than should have been the case. Their model said, “Cut interest rates, and, if that doesn’t work, cut them again and again”, which has left pension funds unable to meet their liabilities because of the fall bond yields. As the Financial Times wrote in a recent article:
In the US, pensions run by companies in the S&P 1500 index were underfunded by $562bn by the end of last month, according to Mercer — nearly $160bn wider just seven months earlier thanks to further drops in bond yields.
For US public plans — which are allowed to assume far higher interest rates than are available in the bond market, making their liabilities look unrealistically cheap — the problem is far worse. Joshua Rauh, a professor of finance at Stanford University, estimates that their total deficits, if liabilities were priced in the same way as corporate plans, would be about $3.4tn.
What happens next? A collapse in confidence that the Fed can turn things around. A big mystery is why this collapse has yet to occur, given that US Fed has projected faster growth than the US economy delivered in 13 out of the last 15 years.
If this loss of confidence occurs at the same time as world wakes up to the acceleration of the economic reforms in China, we will be in big trouble – perhaps as soon as Q4 this year.
These might not be the triggers for the new global economic crisis. But because of the imbalances created by the Fed, and by other central banks, the only question is when rather than if there is another crisis.
How do we travel to the other end of this dark tunnel? It will be by first of all recognising that people shape markets.
We then need economic policies that serve the needs of all the people in the West who are moving into retirement, but who can expect to live another 20 years, thanks to improvements in life expectancy.