The dramatic economic slowdown this summer has provoked an increasingly contentious debate among analysts, including an unusually public split among members of the Federal Reserve Board, over the U.S. economy’s long-term outlook and the possibility of a Japan-like “lost decade.”
The Fed’s gloomy assessment this week, combined with a spate of poor U.S. economic numbers, is raising the stakes in the escalating argument between top economic thinkers fearful that the nation is headed for a decade of decline and stagnation versus those who think it’s a temporary funk driven by businesses and consumers grappling with uncertainty from a deluge of regulatory and tax changes.
Both views are being bandied about not only in Congress’ heated fights over stimulus legislation but in the cloistered halls of the Federal Reserve, where officials met earlier this week and made clear that they fear a further slowdown. In their statement, the Fed members declared that the recovery’s pace “has slowed in recent months” and is “likely to be more modest in the near term than had been anticipated.”
On Wednesday, all three major indexes reacted to the bad Fed assessment and recent statistics, losing more than 2 percent of their value. The Dow Jones industrial average was down 265.42 points to close at 10,378.83, the Standard & Poor’s 500 index fell 31.59 points and finished at 1,089.47, and the Nasdaq composite index lost 68.54 points and ended the day at 2,208.63.
The unusually acrimonious debate within the Fed about the chance of a lengthy deflationary spiral broke into the open at the end of last month when James Bullard, president and chief executive officer at the Federal Reserve Bank of St. Louis, touted a white paper ominously titled “Seven Faces of the Peril.”
It posited that the weakening economy is closer than it has ever been to a Japanese-style period of stagnation and deflation, often dubbed the “lost decade” of growth, although in Japan it has spanned closer to two decades.
According to Mr. Bullard’s analysis, official measures of inflation in the United States have fallen to about 1 percent and are expected to decline further - entering what economists consider a deflation danger zone where consumers and businesses could trigger a destructive downward spiral in the economy by putting off purchases as they await lower prices. This last happened in the United States during the Great Depression.
Mr. Bullard said a repeat of that economic nightmare is unlikely but that the Fed’s low-interest rates policies - it has held short-term rates close to zero for nearly two years - could be contributing to deflationary psychology. The Fed must be ready to counteract another economic plunge through unconventional measures such as purchasing government bonds, he said.
Indeed, that’s what the Fed did, saying Tuesday that it would start buying government debt in a bid to lower interest rates, boost borrowing and stimulate the economy. On Wednesday, it announced an $18 billion purchase to run from Aug. 17 to Sept. 13.
As for the prospect of an extended Japanese-style stagnation period, Richard W. Fisher, president and CEO of the Federal Reserve Bank of Dallas, dismissed Mr. Bullard’s broad argument. He said there’s nothing wrong with the economy that couldn’t be overcome by clearer and more rational fiscal and regulatory policies from Washington.
Businesses and consumers are not spending and making plans as usual because of large tax increases looming at the end of the year while Washington is moving to increase the cost of nearly everything else from health care to energy and credit, he said.
In internal Fed meetings, “I have ascribed the economys slow-growth pathology to what I call ‘random refereeing’ - the current predilection of government to rewrite the rules in the middle of the game of recovery,” he said in a July 30 speech to the San Antonio Chamber of Commerce. The recently enacted financial reform bill is a prime example of that, he said.
Mr. Fisher cataloged an array of outstanding questions whose resolutions could affect nearly every citizen, including what to do with President George W. Bush’s expiring tax cuts at the end of the year and whether baby boomers and future generations can expect scheduled Social Security and Medicare benefits or lose some of them as Congress moves to tame out-of-control deficits.
“In a tumultuous economic climate accompanied by extraordinary economic and political divisions, it is perhaps unsurprising that there is no consensus on even what the general thrust of fiscal policy should be, let alone which specific provisions should be adopted,” Mr. Fisher said. But businesses and consumers need to know before they can make major decisions.
Meanwhile, major industries - including energy, banking and health care - are being confronted with radical new regulatory and tax regimes that make it unclear how they will do business in the future - or even whether they can stay in business, he said.
The problem is not deflation, he said, but the changing rules of the game have created what Fed Chairman Ben S. Bernanke described as “unusual uncertainty,” which is thwarting the usual business and consumer enthusiasm for the future that propels growth.
“Uncertainty reigns,” Mr. Fisher said. “In whatever realm or whatever form, excessive uncertainty is the enemy of growth.”
The paralysis is evident, he said, as businesses - even though they’ve largely recovered from the “deflationary shocks” that led to the recession - are now sitting on a mountain of $1.8 trillion of accumulated earnings that normally would be deployed to create jobs and make investments.
Banks are sitting on another giant heap of about $1 trillion of reserves that also would normally be used to make loans to consumers and businesses, he said.
But “until business operators are provided with the clarity they need, they will continue to hoard their cash,” he said.
Mr. Bernanke, while agreeing with the idea that uncertainty is holding back the economy, has said that much of the uncertainty revolves around whether economic growth will pick up or remain lackluster, both here and abroad. He predicts the economy will continue to slowly recover and eventually shake off the doldrums that have stymied growth. Most private economists agree.
But part of Mr. Bernanke’s job is to try to move the disparate views within the Fed toward a consensus that enables the central bank to act in relative unison to thwart any potential threat of deflation.
The more extreme views aired by some Fed officials may be difficult to reconcile, though nearly every economist has some concerns about deflation and regulatory uncertainty.
The debate also rages on Wall Street and Main Street, where a growing number of major players are warning about the threats of deflation and misguided action in Congress.
Bill Gross, co-chief investment officer at Pimco, the largest bond fund, sees the U.S. economy evolving much like Japan’s, with anemic growth, heavy debts, deflation and population decline all in the offing.
“Japan is the modern-day example of what deleveraging in the face of a slowing and now negatively growing population can do,” he said.
Mark Vitner, senior economist at Wells Fargo Securities, said Mr. Bullard’s warning about the perils of deflation cannot be dismissed easily, above all because the St. Louis banker in the past has gained respect as an “inflation hawk” more worried about a reawakening of inflation, so the concerns about deflation are uncharacteristic and noteworthy.
“The threat of deflation is evident from all the major price indexes,” which have declined precipitously for three straight months, Mr. Vitner said. So-called “core inflation,” which excludes energy and food prices and is the Fed’s preferred inflation measure, has moved below 1 percent, and is expected to decline further in the weak economy.
Still, he said, the deflation threat “should not be exaggerated.” Falling prices would have to persist for much longer before they became a big problem for the economy.
Other economists side with Mr. Fisher in worrying more about the whiplash of budget and regulatory policies holding back the economy.
Richard S. Berner, chief U.S. economist at Morgan Stanley, said “rising uncertainty” about tax policy is particularly roiling the financial markets, where many investors have assumed that the Bush tax cuts for the middle class would be extended, while those on investments and for wealthier people would expire, as advocated by President Obama. The testy debate in Congress so far has not borne out those assumptions.
“Partisan divisions, a limited congressional calendar, and a difficult legislative process all add up to either gridlock or kicking the can down the road,” Mr. Berner said, adding further to uncertainty.
Allowing all of the tax cuts to expire, he estimated, would cut next year’s economic growth rate by as much as one percentage point. But even a temporary extension of all the tax cuts will not help the economy much, he said.
“While that would temporarily preserve stimulus, it would also leave tax and fiscal policy unusually uncertain for an extended period,” he said. “Such policy uncertainty could blunt the intended impact of maintaining the stimulus.”
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