July 31, 2011

Taking Their Eye Off the Ball

Friday's GDP (advance estimate) release for the second quarter shows that the economy is stalling, and benchmark revisions show that the 'Great Recession' was deeper than originally thought.  This comes amid continued impasse, both within Congress and with the Obama Administration, regarding the Federal Government's debt ceiling and long-term deficits.

With regard to the debt ceiling/deficit-reduction negotiations, two things are certain:
  1. Failure to raise the debt ceiling before the deadline (estimated to be August 2nd) forces the federal government to choose which of its current obligations it will and will not meet.  A default can, and would likely, be avoided by paying foreign creditors ahead of any domestic spending.
  2. A credible longer-term deficit reduction plan is needed to prevent a downgrade of the U.S. AAA credit rating.  It is this AAA rating that allows the federal government to finance expenditures, that revenues don't cover, so cheaply.
The Congress, along with the President, must make tough decisions in order to address the deficit, which will require addressing rising health care spending and falling tax revenues.  The financial crisis of 2008 and the ensuing recession led to massive bailouts and stimulus spending, as well as a decline in tax receipts - exacerbating the deficit problem.  (For the record - it is my belief that these were necessary.)  The lack of a credible plan and a potential downgrade are creating greater uncertainty among already cash-hoarding companies and cautious consumers.

This begs the question: should the government, instead, be focused on bolstering the economy?

In the second quarter, the economy grew 1.3% - a rate that barely keeps up with inflation yet is not robust enough to make a dent into the 9.2% unemployment rate.  Consumer spending, which makes up about two-thirds of the economy, grew a paltry 0.1%.  While controlling deficits is important, policy maker's priority should be to spur economic growth and get people working again.  They must also be careful not to create a further drag on the economy in their attempt to address the deficit.  Any cuts in federal spending, in the short-term, would end payments to private contractors hired by the government and wages to government employees who would then have to cutback themselves.  Likewise, any immediate tax increase would take from both corporations and individuals, further constraining business investment and consumer spending.

In 1935, two years after the Great Depression had ended, the economy was roaring with double-digit growth and moderate inflation of 3% when the government decided to introduce the payroll tax and tighten monetary policy.  By 1937 the country had fallen back into recession.  We are currently two years removed from the end of the 'Great Recession', growth remains below potential, unemployment has barely budged and inflation is within the Federal Reserve's comfort zone of 2%.  An introduction of austerity measures would surely push the U.S. into recession.  The government's focus should be on spurring economic growth that creates jobs.

The trouble is, there isn't much appetite in Washington for further stimulus, and the Fed has already lowered interest rates to near-zero and pumped trillions of dollars into the money supply.  Another option is inflation.  The difficulty is then to rein in that inflation before it becomes rampant.  Meanwhile consumer are saving and corporations are sitting on record profits.  So what can be done to spur consumer demand and business investment?

There is pent-up demand, the goal is to get people spending now.  To do that, we need to dis-incentivize savings.  The Fed could begin to charge interest on excess bank reserves to encourage lending.  The Fed could also communicate to the market that interest rates will go up once specific "economic performance checkpoints" have been reached.   This would encourage consumers to make the home purchase that they have been on the fence about before rates rise.  It would also push companies to purchase plant and equipment sooner, make acquisitions and take on additional payrolls.  Whatever the action taken, it needs to lead to spending now, rather than later.

The challenge is great.  Perhaps that is why Congress has turned its attention toward the deficit - apparently no easy task either.

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