By John H. Makin, AEI Economic Outlook, September 2011. He is a Resident Scholar at American Enterprise Institute. This article is available at http://www.aei.org/outlook/101075
Key points in this Outlook:
- The United States is close to another recession: the first-half growth rate is 0.7 percent and employment growth is weak.
- Current conditions point to a threat of systemic risk: the sudden shock of the US financial crisis, interconnections between the US economy and the European financial system, and the absence of viable policy solutions.
- We need good economics over politics, now more than ever. That means sensible tax reform, a Fed focus on maintaining liquidity, and rationalization of the European monetary system.
By June of 2011, with first-quarter growth reported at a 1.9 percent annual rate, employment growth sharply weaker, and second-quarter growth estimates being revised downward, it was becoming clear that the second round of monetary and fiscal policy stimulus had not significantly re-energized the US economy. Sharply higher energy prices and supply-side disruptions from Japan’s March tsunami were partially to blame, but even as energy prices fell and Japanese production began to recover, US and European growth continued to slow.
In Europe, the sovereign-debt crisis intensified and spread to larger countries, including Spain and Italy, while the exposure of European banks to claims on weakening sovereign bonds increased uncertainty and weakened growth as banks eschewed additional lending. The exposure of American banks and money market funds to an increasingly unstable European financial system compounded US financial uncertainty.
Fraying nerves further, by mid-July, the US Congress was deeply embroiled in a contentious debate over deficit reduction and raising the debt ceiling, which included threats of default on US government debt and, should Congress fail to agree on a plan to lift the debt ceiling, 40 percent cuts in all federal spending except interest payments to avoid default. During this disquieting debate, the initial report on US gross domestic product (GDP) for the second quarter estimated the growth rate at a modest 1.3 percent and included a revised figure for first-quarter growth of just a 0.4 percent annual rate (down from a previously reported 1.9 percent rate). Moreover, other recently released data, including a larger-than-expected US trade deficit and a second-quarter growth rate that was revised down to 1.0 percent, leave first-half growth at a 0.7 percent rate, perilously close to zero.
Worse Than a Midyear Growth Scare
The sudden onset of a midyear “growth scare” and the rapid drop in global equity markets, coupled with the simultaneous rush to buy US Treasury securities, at first reminded investors and policymakers of last year’s midyear sell-off of risky assets. The problems in Europe unnerved markets as US economic data weakened. But last year, US disinflation intensified enough to give Fed chairman Ben Bernanke an opening to hint at further easing during his August 2010 Jackson Hole speech.
This year, the Fed and global policymakers face a much more complicated situation that is rapidly turning into a systemic crisis. First, after a year of indecision, the European sovereign-debt problem remains unresolved and has in fact become more serious, with a rush away from currencies and into gold. While finally attempting to deal with the financing needs of Greece, Ireland, and Portugal, European authorities neglected to address the intensifying problems in Spain and Italy. The exposure of the European banking system to these two large countries is substantial. Second, as Europe’s debt crisis has intensified, so too has that of the United States, with threats of outright default averted at the last minute by a weak agreement to reduce future deficits. Meanwhile, Standard and Poor’s has seen fit to downgrade US government debt from AAA to AA+.
Bernanke has no deflation risks to lean on now. Headline and core inflation have risen to year-over-year rates of 3.6 percent and 1.8 percent as of July, so it would be difficult to use deflation risks as the rationale for further Fed easing, especially with gold prices soaring. In his July 13-14 testimony to Congress, Bernanke tied his hands by linking more easing to “deflation risks.” The only rationale for further Fed easing in terms of its traditional mandate is stubbornly high unemployment and a slowing economy, but even there, the Fed faces serious obstacles. After QE2 (signaled last August at Jackson Hole), the stock market recovered smartly, but employment and growth did not, even with a push from an extra fiscal stimulus package enacted by the last Congress in December 2010. And now, with weakening economies in the United States
and Europe and sharply elevated risks in their financial sectors, stock markets are back to or below their levels of last August.
At its meeting early in August 2011, the Fed sharply downgraded its growth forecast and took the unprecedented step of stating its intention to hold short-term policy rates at zero for another two years. While three regional bank presidents dissented from the two-year commitment to lower rates, it was clear in the 7-3 vote in favor of the lower rate commitment that a majority on the Federal Open Market Committee (FOMC) perceived a distinct need for further stimulus.
Analysts have revised down European and US growth forecasts for the balance of 2011 and for 2012. On the first weekend in August, the Financial Times suggested a crisis reminiscent in intensity to the Lehman Brothers crisis in September 2008. The threat of systemic risk–a breakdown of the financial system–has reemerged.
Criteria for Systemic Risk
The emergence of systemic risk is tied to three conditions. The first is the suddenness of the onset of shocks hitting the global economy or the global financial system. The second is the pervasiveness and interconnectedness of the effects of the shocks, and the third is the absence of obvious solutions to the problems resulting from the shocks. All three conditions exist now. In terms of suddenness of onset, a financial shock like the collapse of Lehman Brothers constitutes
a serious risk. If a financial disruption weakens the real economy enough to weaken the financial sector, an adverse feedback loop can develop whereby the global financial system and economy are put at extreme risk.
This year’s double-dip recession scare is different from the Lehman crisis in one basic sense: it has originated in the real economy in the United States and the financial sector in Europe, as opposed to the US financial sector. A sudden slowdown in the US economy–revealed by data revisions, by elevated uncertainty attached to US deficit debates and regulatory burdens, and by a sharp slowdown in Europe tied to elevated sovereign financial risks–has weakened stock prices and inspired a rush into cash and gold. Some investors have been willing to forgo the liquidity of cash in exchange for the inflation protection offered by gold purchases. The short interval between Bernanke’s guarded but reasonably confident testimony to the US Congress in mid-July and the cover ofthe Economist magazine early in August warning of a double-dip recession represents an unusually rapid onset of a real economic slowdown that negatively affected financial assets. Now, as this is written in late August, the negative feedback loop is making another round. The sell-off in financial assets is further exacerbating weakness in the real economy, and the potential for systemic risk is rising.
The pervasiveness and interconnectedness of this summer’s rapid real economic slowdown are also troublesome. Europe’s sovereign-debt crisis is doubly problematic because of the reported heavy exposure of US banks and money market funds to European banks, with significant exposure in turn to southern European sovereign debt. Withdrawals from US money market funds have risen abruptly since mid-July. It started with a run into Treasury bills that drove yields on shorter-term bills of three months and under virtually to zero. Some uneasiness about Treasuries arose late in July with threats of default emanating from the congressional debate about raising the debt, but ultimately the default risk evaporated once the debt limit was increased. There has also been a run into transaction deposits that pay zero interest because these are the only deposits fully insured by the Federal Deposit Insurance Corporation. The intensity of those flows was underscored early in August when at least one institution levied charges on transactions, which was tantamount to offering negative interest rates. Similarly, at times, some shorter Treasury securities have continued to yield zero to negative interest rates. And a run into longer-term Treasury securities has sharply depressed yields, as dire talk of default risk and a possible collapse of the bond market have been temporarily forgotten while investors flee a collapsing stock market.
A liquidity trap may be emerging in the United States with investors rushing into cash and Treasury securities in search of a safe haven in the midst of substantial uncertainty in the global economy and financial markets. Governments could offer unlimited insurance on depository accounts, as opposed to transactions accounts, as was done during the 2008 crisis. But this would simply reinforce flows into cash and thereby further weaken the economy. That said, investors desperately searching for a safe home for their cash assets are not likely to be heavy spenders.
There is, of course, a fundamental tension inherent in the simultaneous moves into cash and gold. If the fear of inflation rises, more funds will flow from cash into gold, but the converse is also true–if inflation worries abate, gold will lose some of its luster. The ultimate outcome will depend on whether the wealth-erasing sell-off of equities depresses aggregate demand and prices of goods and services enough to cause disinflation or even deflation. The desire of central banks to preempt deflation risks by creating more liquidity pushes investors into gold. As noted above, markets bet more heavily on gold after the European Central Bank joined the quantitative easing club with purchases of Italian and Spanish bonds outright on August 7. Simultaneously, prices of commodities and most raw materials have dropped alongside the rise in gold prices, indicating the unique status of gold as a wealth haven in times of extreme financial stress. As also noted, the rising doubts about the efficacy of policy measures to boost demand by enough to preempt slower growth and deflation, coupled with collapsing equity prices, have made US bonds much more attractive. This is true despite the turmoil of the debt-ceiling debate just passed and the contradictory message about much higher future inflation contained in the rise in the price of gold. It will be important to watch the relative performance of gold and government bond prices to see if expectations of higher inflation or deflation dominate the outlook going forward.
Adding to the difficulties of the global economy this year is the absence of China as a substantial source of global economic stimulus such as it provided late in 2008. China is fighting an inflation problem and some excesses that resulted from its part in that massive stimulus.
Whatever its response to the current double-dip scare and financial market turbulence, China is not likely to repeat the large stimulus–equal to nearly 14 percent of GDP–that it enacted in 2008.
Absence of Policy Solutions
The final problem facing the global economy in 2011 is an absence of obvious policy solutions to the rapid slowdown of the real economies in the United States and Europe,as well as to the consequences flowing from these slowdowns to financial markets and from financial markets back to real economies through an adverse feedback loop. As in 2008, the European Central Bank raised rates early this summer, sending the wrong signal at a time when the global economic slowdown threatened. The resources provided in the recent agreements to support Greece and other small, distressed southern European economies entail substantial fiscal austerity as a condition for transfers from the International Monetary Fund and a shrinking group of other European economies able to provide loans. Recall that, in an abrupt reversal of its feint toward tightening, the European Central Bank became an outright buyer of Spanish and Italian bonds in August.
In the United States, after a highly criticized QE2 by the Fed and an ignored or discredited second round of temporary fiscal stimulus enacted in December 2010, the US economy is close to stall speed and may have already reentered recession. As fiscal stimulus packages unwind in early 2012, fiscal drag may rise in the United States to a level equivalent to about 1.5 percentage points of GDP.
We are left with the Fed, whose last effort at stimulus was tied to deflation risk, highly criticized, and in fact arguably not very successful. It may be that the FOMC will be convinced that the emerging signs of a liquidity trap and a rush into cash constitute an incipient deflationary threat that would, in turn, justify further measures to ¬stimulate the economy beyond the conditional pledge to hold short-term interest rates at zero for two years. Most of its stimulus options, however, like paying interest on the reserves that banks hold or lengthening the maturity of Treasury securities purchased, are not particularly promising, especially in the presence of fears that the real economy is slowing rapidly.
The toxic combination of a sudden economic slowdown, potential interconnectedness between the slowdown and the financial risk, and an absence of obvious solutions to these problems constitutes an alarming signal of systemic risk. There is no grand solution to the long list of self-reinforcing problems in the financial sector and the real economy that have intensified very rapidly during August, especially in Europe and the United States.
Solutions
A prerequisite for getting through this very difficult period is to stop ignoring the extreme seriousness of the problems. In the United States, we need–as we have needed all along–fundamental tax reform with lower marginal tax rates financed by closure of arbitrary tax loopholes. We need lower growth in spending on entitlements once the current financial crisis is over. And, perhaps most fundamentally, we need leadership in both political parties that rises above mere partisanship and provides policy measures best suited to curtailing our current crisis of confidence. Ultimately, given that most macro policy measures are stretched to the limit, measures that reduce regulatory burdens, reduce uncertainty, and encourage private efforts to improve resource allocation are especially important.
The Fed’s major role should be to maintain adequate liquidity, especially if the large wealth losses in equity markets depress spending and cause deflation risks to reemerge. Claims such as those heard from one Republican presidential contender that any additional Fed easing would amount to “treason” are highly irresponsible and will only add to the toxic uncertainty that is erasing wealth in financial markets and threatening further downward pressure on growth.
Europe needs to abandon the illusion adhered to for too long of a single currency area that included such disparate economies as Germany and Greece. That impossible dream has now left Germany virtually isolated as the only economy that can survive Europe’s single-currency illusion. The result has been to impose overly stringent policies on the rest of Europe that have come to threaten the solvency of the European banking system while slowing even German growth. And the global interconnections of the world financial system mean that Europe’s problems have increased threats to growth and solvency worldwide, especially in the United States. As these problems intensify, those threats to growth and solvency will spread worldwide. China, the world’s leading growth engine, will not be spared.
Economic reality needs to be placed ahead of political discord and expediency if the global economy is to move past its second systemic crisis in less than three years. US fiscal mayhem and Federal Reserve escape goating, along with absurdly complex and counterproductive legislation like last year’s health care bill and the Dodd-Frank Act, have all taken a serious toll on confidence, hiring, and growth. Europe needs to end the use of public funds to attempt to shore up the finances of countries forced to contract sharply in order to receive the funds. Insolvent nations need to resolve, reschedule, and write down their debts. Perhaps Americans and Europeans might even wish to collaborate with each other and with other large, developed, and emerging economies to work toward one stable global framework that can help contain these problems. But supposedly they do that every year at the meetings of the G-7 and the G-20, where politics actually always trumps sound economics. Let’s hope that the voters in the upcoming elections in the United States, France, Germany, and elsewhere will keep in mind the huge gap between the platitudes emanating from politicians and the reality of the systemic crisis that has returned in 2011.
