SERIOUS MONEY:Barack Obama is back in the White House for a second term. The news was greeted with enthusiasm by revellers on Pennsylvania Avenue and elsewhere, but not on Wall Street. Investors switched their focus to the looming "fiscal cliff", which threatens to push the economy back into recession in the not-too-distant future.
The US economy will be hit by a fiscal contraction of roughly $600 billion (€472 billion) – or 4 per cent of GDP in 2013 – unless Obama and congressional leaders reach agreement by the end of this year. The contractionary impulse will result in a pronounced downturn in activity, which could prompt a self-reinforcing downward spiral, and raise the spectre of deflationary depression just four years after such a negative outcome was successfully averted.
The need for long-term fiscal discipline is beyond dispute, particularly so with age-related expenditures set to spiral in the years ahead. But the fragile economic recovery highlights the need to postpone “responsible” government policy for now. The US should embrace temporary fiscal expansion to bolster an economy, which like so much of the developed world is caught in a liquidity trap that has rendered conventional monetary policy ineffective.
The implosion of the credit-fuelled housing bubble four years ago prompted a pronounced deleveraging of household and corporate sector balance sheets that resulted in a more than 11 percentage point swing in the private sector’s financial balance relative to GDP. The unusually sharp increase in private-sector savings relative to investment drove the economy into the deepest recession since the 1930s.
Unprecedented monetary stimulus, in concert with a gargantuan fiscal spending programme, prevented a depression, but more than three years into recovery the economic outlook is far from encouraging. A debt-constrained consumer and the shortfall in demand it delivers has created a reluctance on the part of the corporate sector to invest in either human capital or productive assets. That threatens to lower the economy’s potential growth rate. Subdued household demand has contributed to a relatively jobless recovery and the elevated unemployment rate has eroded labour’s bargaining power. As a result, nominal wage gains have consistently failed to match the rate of inflation. Stagnation in real household incomes has had a material impact on expectations.
The Thompson Reuters/University of Michigan Survey of Consumer Sentiment shows that households expect their dollar incomes to grow at less than 2 per cent a year today, compared with an average of more than 5 per cent a year during the “Great Moderation” – from the early 1980s until the financial crisis. Household expectations do not point to a robust expansion in consumer demand soon.
Furthermore, the latest earnings season confirms that corporate profitability has peaked, which means that hiring and business investment are certain to remain subdued. High rates of unemployment are sure to persist as a result, while investment rates are likely to continue below trend. The erosion of human capital, alongside the degradation of the productive capital stock, will certainly result in a loss of productivity, and lower the economy’s potential growth rate.
Faced with a liquidity trap, monetary policymakers can do little but slow the deleveraging process via lower debt-servicing costs and higher asset prices. The inability to ignite a private-sector credit cycle and a consequent robust economic expansion means that, if possible, governments should run large fiscal deficits to fill the demand gap. US politicians should not only reach agreement on the “fiscal cliff” as a matter of urgency, but should also embrace expansionary policies in the short term, simply because they can.
An extremely important paper* co-authored by J Bradford DeLong and Lawrence Summers, shows that in unusual times, such as now, fiscal expansion is likely to pay for itself . “In a depressed economy . . . temporary fiscal expansion does not materially affect the overall long-run budget picture.”
The “fiscal cliff” threatens to drive the US into recession, but policymakers should go further and embrace temporary fiscal expansion. The ball is in the politicians’ court, but the verdict is out as to whether they grasp the economy’s predicament. Will public servants put an end to austerity madness or allow the economy to be dragged into a deflationary depression? Time will tell.
* Fiscal Policy in a Depressed Economy, Brookings Papers on Economic Activity, Spring 2012
