The majority of Americans can be forgiven for believing -- as they do -- that the U.S. economy is still in a recession when it’s not. The economy is certainly growing, which is the definition of not being in a recession. But growth has been painfully slow this year, running at just about a two percent annual rate. No one would call that good performance. It is, in fact, little better than half the growth rate that many forecasters expected when the year began. Reflecting this weakness, forecasts for both 2011 and 2012 are being revised downward.
Think of the U.S. economy as an airplane flying on three engines. The main growth engine is always the private sector, with monetary and fiscal policy, the two smaller engines, giving the aircraft a boost now and then. In normal times -- which these are not -- the private sector provides more than enough forward thrust. So the two supporting engines, monetary and fiscal policy, are not needed. Indeed, there are times when the private sector generates so much power that the other two engines must be fired in reverse to hold the airplane back. (My metaphor is breaking down here. Licensed pilots, please forgive me.)
But the present is one of those times when the main engine is faltering a bit. It hasn’t gone dead. The economy is still flying well above the clouds, not nose-diving the way it did in the winter of 2008–9. But the normally powerful private sector is not generating much forward momentum right now. It could use a little help from the supporting monetary and fiscal engines, but it doesn’t look likely to get any. In fact, they are more likely to do harm. That is what is so worrying.
Why has growth slowed down so much? There is not one crisp answer; rather, it seems to be a combination of factors. Higher oil prices have taken a toll, although they seem to be receding of late. The earthquake in Japan also nicked growth a bit, especially in the automobile sector, although that also seems to be ending. The housing market stubbornly refuses to show a pulse and, indeed, appears to be taking another dip. (What a shame that the foreclosure problem was never tackled.) Government spending is being scaled back, too, as the 2009 stimulus bill peters out and state and local governments continue to retrench. Meanwhile, the U.S. consumer, once the growth engine of the world, is stuck firmly in neutral, neither propelling growth nor retarding it. All in all, it is a less than inspiring near-term outlook.
And yet a fiscal contraction -- some combination of tax increases (such as the expiration of the 2011 payroll tax cut) and spending cuts to reduce the budget deficit -- looks to be coming soon. Given the horrendous long-run deficit projections, that sounds like the prudent thing to do. But it is not what an economy needs when it is suffering from a paucity of demand. For now, the U.S. government should be like Saint Augustine: seeking chastity, but not just yet. Because, contrary to much misleading political rhetoric, cutting government spending does not create jobs; it destroys them. (This should be obvious: How could a government kill jobs when it buys things from private companies?)
How large a fiscal contraction is in store is hard to say. It depends on how the budget negotiations turn out, and that, in turn, depends on the mysteries of partisan politics. The most likely outcome is that the near-term cutbacks will be modest; political gridlock has its virtues. But this prediction could easily prove wrong. Perhaps the two parties will surprise everyone by agreeing on a large budget deal that embodies huge spending cuts right away. But the bigger risk is that they strike no deal at all, and the government crashes headlong into the national debt ceiling. That could force immediate federal spending cutbacks of 40 percent or more.
While the fiscal engine seems likely to fire in the wrong direction, the only question being how strongly, the monetary engine has fallen silent. The Federal Reserve, which aggressively fought the recession and supported the recovery in its early days, now looks like a spent force. Its controversial second round of quantitative easing, which just ended, earned the Fed a huge amount of criticism and may not have done the economy much good anyway. Fed Chair Ben Bernanke is fighting (and so far winning) an internal battle to hold back the Fed’s so-called hawks, who, if they had their way, would tighten monetary policy rather than ease it. Nor is it even clear what more Bernanke would do if he were given a free hand.
All this paints a not-very-pretty picture for the near term. The main growth engine (private spending) is sputtering, and taken together, the two supporting engines (monetary and fiscal policy) look likely to reduce demand slightly. And that is without even mentioning the two crash-landing scenarios.
In one, the inability to reach a budget agreement collides with the Republican Party’s unwillingness to raise the national debt limit without massive spending cuts. The resulting impasse precipitates both a financial crisis, as investors conclude the U.S. government has lost its marbles, and massive reductions in federal spending to comply with the debt limit. A double-dip recession would not be out of the question.
The second adverse scenario comes from abroad. Suppose the Europeans mishandle the delicate Greek debt crisis, setting off either a messy sovereign debt default or a withdrawal of Greece from the euro system, possibly both. Either event would have strong, rapid, adverse repercussions on Ireland, Portugal, probably Spain and beyond, and certainly on the world financial system.
Neither of these dark scenarios is likely, but each is possible. With bad luck, both could come true. In the meantime, the economy is limping along with unemployment hovering near nine percent and job creation inadequate. What to do?
There is a way out, but the government is not likely to take it. Republicans and Democrats could agree on a two-part fiscal package consisting of a moderate stimulus program for a year or two that is sharply targeted on job creation, coupled with a multitrillion-dollar deficit-reduction program that would be enacted now but only start cutting spending and raising taxes in, say, a year or two. A big, credible deficit-reduction program should allay any market or political fears that the budget deficit is spiraling out of control, thereby creating room for some short-term stimulus.
The Fed, for its part, could blast some of the inert excess reserves out of the banking system, and into productive uses, by lowering the interest rate it pays on excess reserves (which is now 0.25 percent) at least to zero and preferably to some negative number -- which would mean charging a small fee for holding idle deposits at the Fed. Neither of these policies is a panacea that would magically transform the economy overnight. But each would do some good. Unfortunately, they both look like pipe dreams today, given the deep partisan divisions in Congress and the Fed’s felt need for a pause.
More realistically, one can hope that the coming fiscal contraction is too small to do serious damage to demand. And one can hope that the Fed just maintains its current hyper-expansionary policy stance for quite a while, without doing more. Indeed, both seem likely -- the latter, especially so. Doing those two things would at least minimize the net drag emanating from fiscal and monetary policies. It is a sad state of affairs when the best advice that policymakers might actually take is, First, do only a little harm. But that seems to be the case today.
About 80 years ago, Andrew Mellon, the secretary of the U.S. Treasury, assured President Herbert Hoover that the best way to get the economy growing again was for the government to get out of the way and let the Great Depression run its natural course. “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate,” he famously advised. “It will purge the rottenness out of the system. People will work harder, live a more moral life . . . and enterprising people will pick up the wrecks from less competent people.” The breathtaking belief in both laissez faire and social Darwinism is, depending on one’s point of view, either quaint or chilling.
But it is apparently not dead. Mellon’s ideas live on, starting with his admonition to “liquidate real estate,” which the country has followed to a tee by refusing to adopt serious measures that might have limited the wave of foreclosures. Stop artificially stimulating the economy by monetary or fiscal policy, policymakers are told. Stop regulating it; indeed, roll back previously enacted financial and health-care regulations. Stop “debasing the currency” with inflationary monetary policy. All this was terrible advice when Mellon gave it to Hoover. It remains terrible advice today.
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