Stiglitz: The Fed is in Deep Trouble

Joseph Stiglitz the Nobel prize winning Columbia University economist was on Bloomberg today talking about how the Banks Problems are Bigger Today Than Pre-Lehman. In his interview he made a couple of very interesting points which we paraphrase here:

Is the worst over for the global economy? If we were to define recovery as walking back from the precipice we faced a year ago, then yes the worst is over. If we define recession as two consecutive quarters of negative growth, then the recession may be over temporarily. However if we are to ask the question: will the economy return to a robust enough growth to negate the effects of unemployment? Then the answer is No. We are definitely not out of the woods.

Unemployment will continue to go up. American’s wealth which was largely tied up in their houses has been devastated. The deeply indebted American consumer will focus on saving to repair their household balance sheets. But this will be negative for the world economy since U.S. consumption was the engine for world economic growth.

So what will be the growth engine now? We are going into an extended period economic malaise. The U.S. economy will grow but not fast enough to offset the increase in unemployment, population and productivity. In order to just breakeven on the jobs front, the U.S. economy needs to grow at 3% or more. The labor market picture does not look good and if workers don’t have income, the economy cannot generate demand.

Many transitions will take place but not smoothly. Americans will save more and consume less while the Chinese will consume more and save less, however the two won’t move in tandem. Chinese consumption will not increase fast enough to offset decline in American consumption.

The Fed is in deep trouble as it has little room left to maneuver. The Fed is currently caught in a quandary between trying to provide enough stimulus/credit to generate a sustained economic recovery and preventing long term rates from rising.

On the fiscal side, there is chance of additional stimulus however it could stoke inflation fears and cause long term rates to rise, choking a weak recovery. On the monetary side, the Federal Reserve has already absorbed $1.7 trillion of U.S. debt issuance through quantitative easing. So far the Fed has stated that it will not engage in further quantitative easing, but then the question becomes: Who will absorb the trillions of dollars of U.S. debt issuances going forward? Many outsiders are already balking at purchasing U.S. debt due to the extremely low interest rates which do not adequately compensate them for future inflation risk.

So to prevent long term rates from rising will the Fed backtrack and restart quantitative easing next year? They could, but doing so would seriously damage the credibility of the Fed. It will only serve to showcase that the Fed has consistently misestimated where the economy is headed.

What are the chances that G-20 leaders will rein in the banks? Progress will be slow on this front especially in the U.S. because the administration is not seen as an honest broker. For example the Obama administration has proposed that the Fed be the new systemic regulator, when they were the ones who messed up in the first place. Similarly on bank bonuses the Obama administration has been dragging its feet due to strong lobbying by banks.