No quick fix to America's mess
SERIOUS MONEY:Obama’s stimulus package will not be enough to restore full employment – but the market will not bear a bigger injection, writes CHARLIE FELL
THE US economy is deep in the throes of the most severe downturn in decades with no end in sight. Private sector balance sheets are under considerable strain and the necessary deleveraging is under way but the massive destruction of wealth means that little improvement has been made, while the surge in unemployment and income losses has increased the probability of destructive debt deflation.
The Federal Reserve has responded to the threat through a reduction in interest rates to the zero-bound and the introduction of various innovative measures that provide liquidity to the ailing economy. Growth in the stock of money has exploded to the upside but a collapse in velocity is thwarting the Fed’s efforts and nominal GDP is on course for its first yearly decline since 1933.
The most feeble economic expansion in modern history that came to an end 15 months ago was built on low savings and ever higher levels of debt that seemed reasonable to some, given rising asset prices. The result was a surge in non-financial private sector debt from less than 140 per cent of GDP at the start of the new millennium to 190 per cent today, a level that is 25 percentage points higher than the comparable figure on the eve of the Great Depression.
Monetary policy can only cushion the blow at best in the face of the massive private sector deleveraging that must happen if the economy is to secure a self-sustaining recovery down the road.
Indeed, a renewed borrowing and lending cycle engendered by accommodative monetary policy would not be desirable as it would lead to even higher levels of debt and an even more dangerous unwinding in the future. Fortunately, this won’t happen as interest rates even at the zero-bound are six percentage points above that prescribed by the respected Taylor rule.
The need for Keynesian stabilisation policy to offset private sector contraction is obvious and Barack Obama, in an attempt to re-invigorate the American Dream, has signed into law a near $800 billion fiscal stimulus package. The budget deficit expected for 2009 before consideration of the Obama plan is already the largest in modern history at more than 8 per cent of GDP and jumps to 13.5 per cent upon its inclusion, a level only exceeded by the war years from 1942 to 1945. The size of the package is truly extraordinary – but will it be sufficient to return the economy to full employment and close the output gap that in the absence of the plan should easily amount to 7 per cent of GDP both this year and next?
The $800 billion is to be spread over several years, reaching a peak of more than $350 billion in 2010. Estimates of the Keynesian multiplier range from 0.8 to two and the resulting boost to the economy next year amounts to $280 billion in the pessimistic scenario and $700 billion in the most optimistic case. These figures come to roughly 2 and 5 per cent of GDP respectively and even using the implausible high multiplier fall well short of that necessary to return the economy to full employment. Indeed, even the analysis provided by Christina Romer and Jared Bernstein from Team Obama does not foresee a drop in the unemployment rate below 6 per cent until 2012 and consequently, the cumulative output shortfall could easily reach $4 trillion.
The fiscal stimulus plan simply does not fit the bill but it is clear from the sell-off in Treasury bonds since the start of the year that the financial markets would be unable to stomach deficit spending of the size that would prove sufficient to offset private sector contraction. Deleveraging should see the private sector record surpluses of roughly 6 per cent of GDP in the years ahead, which, combined with a structural current account deficit of some 4 per cent of GDP, means that the government needs to run double-digit fiscal deficits indefinitely. This is simply not feasible as it would likely alarm foreign investors and result in falling bond prices and rising interest rates; hardly a recipe for recovery.
Deflation remains a clear and present danger for the US economy and aggressive monetary policy and fiscal spending will only cushion the blow. The wealth destruction caused by the precipitous decline in asset prices combined with surging unemployment means that debt-burdened households are unlikely to resume their role as the world’s consumer of last resort any time soon. Balance sheet deleveraging is set to continue and the secular bear market rolls on.