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December 2010
Confidence in a sustainable global recovery is fragile. The sovereign-debt crisis continues in Europe, fears of inflation persist in China, and the U.S. economy remains weak. Unprecedented policy risks--both monetary and fiscal--abound as we move toward 2011. Deficit-reduction measures in the new Congress and pressure to scale back the second round of quantitative easing (QE2) could stunt U.S. economic growth and further dampen the global recovery.
Key points in this Outlook:
During 2010, the major issues facing the global economy have been and continue to be (1) the strength and sustainability of the U.S. economic recovery and, in particular, the ability of U.S. consumers to sustain consumption growth; (2) the ability of Europe to navigate its sovereign-debt problems; and (3) the ability of China to maintain growth while avoiding inflation.
In September and October, these concerns, each of which had intensified at various times during the first eight months of 2010, lessened to varying degrees. That said, problems remain in all three areas, with the largest uncertainties tied to the success or failure of QE2, the Federal Reserve's most recent round of quantitative easing, and--perhaps more important--to the outlook for U.S. fiscal policy under a new Congress with a Republican-controlled lower house pressing for smaller government and fiscal contraction.
The first few weeks of the fourth quarter may have marked a temporary high point in the ongoing and unsteady global recovery that has followed the financial crisis of 2008. The difficulty of getting economic growth back on track should come as no surprise. The lesson drawn from the history of financial crises, well documented in This Time Is Different: Eight Centuries of Financial Folly, Carmen M. Reinhart and Kenneth Rogoff's important historical study, is that the recoveries that follow such crises tend to be weak and nonlinear. Beyond that, the lesson from the Great Depression of the 1930s and Japan's burst property bubble of the 1990s, among other episodes, is that deflation is a persistent threat after financial crises. The fact that financial markets are now focused more on the fear of inflation and the inflationary potential of the Fed's QE2 program is underscored by the proposal of Robert Zoellick, president of the World Bank, that a gold standard be revisited. Should deflation persist, however--as is likely in the aftermath of financial crises--market expectations will have been off the mark and considerable volatility may well result.
Risks Rise in Europe and China
Europe's sovereign-debt crisis--essentially a reflection of the nonviability of a single currency area that ties the German economy, for example, to the troubled economies of southern European countries such as Greece, Portugal, and Spain, not to mention Ireland--initially flared up in spring 2010. The debt of southern European governments plunged in value despite substantial support from the European Central Bank. By June, European governments and the International Monetary Fund announced a commitment of nearly $1 trillion to finance, if needed, the entire debt issue and debt service for Greece, Portugal, and Spain for over two years. That calmed stage one of the sovereign-debt crisis in Europe. However, the crisis has reemerged in recent weeks as Ireland and Greece in particular discovered the doomed debtors' dilemma: efforts to reduce deficits can weaken an economy so much that they cause government revenues to plummet and actually end up raising deficits. The resultant rise in the interest rates demanded by lenders delivers the ultimate coup de grâce as the likelihood of necessary debt restructuring rises further. The German government's recently announced insistence that private lenders--rather than governments--eventually bear some of the losses tied to debt restructuring has caused more discomfort and given rise to new glimmerings of stage two of the sovereign-debt crisis.
Starting with Europe's reemergent sovereign-debt problems, the optimism that peaked early in November disintegrated rapidly. A loss of confidence in the postcrisis global recovery resurfaced as policymakers prepared for a G-20 summit where they thought heads of state would declare their satisfaction with the gathering momentum of worldwide recovery.
During the lead-up to the November 11-12 summit, each of this year's big three risks resurfaced. The sovereign-debt crisis continued to intensify in Europe, as Ireland's unsustainable fiscal position and the exposure of Irish banks to the government's fiscal risks brought its debt burdens to an acute level. In China, overheating appeared to spoil the "soft landing" scenario, as inflation in the three months ending in October surged to a 7.2 percent annual rate and the year-over-year official inflation index jumped to 4.4 percent from just 3.6 percent a month earlier. Chinese H-share stocks (Shanghai stocks traded in Hong Kong, a widely followed measure of the Chinese stock market) dropped 8 percent due to fears of additional monetary tightening in the face of Chinese overheating. Finally, while many headlines early in November centered on European and Chinese problems, perhaps more serious cracks in the global recovery scenario appeared in the United States. The brief period of euphoria tied to the Fed's launch of QE2 and the election of a strong Republican majority in the House of Representatives peaked on November 5 after reports of better manufacturing momentum and stronger employment data. Despite all the positive news, U.S. stocks fell by about 5 percent during the following ten days.
Policy Uncertainty in the United States
The Fed's QE2 effort to preempt deflation instead brought forth elevated--if unjustified--fears of more inflation. Uncertainty about the effort was reinforced by a reminder from Federal Reserve governor Kevin Warsh, published in the Wall Street Journal, that QE2 was a conditional commitment to expand liquidity that could or would be reversed if inflation appeared, whether or not the unemployment rate remained high--presumably close to its current level of 9.6 percent.[1]
Difficulties with the Fed's policy were also reinforced by an open letter to Chairman Ben Bernanke signed by a group of prominent economists and politicians calling for a cancelation of QE2.[2] While the Fed is unlikely to abandon its course, the letter highly politicized Fed activities at a time when newly elected members of Congress--some wishing to curtail Fed independence--will be taking on key committee posts.
The reality underlying the turbulence in finance and economic policy that has emerged in late 2010 is this: confidence in a sustainable global recovery is fragile. Reinhart and Rogoff remind us that this should not be a surprise in the aftermath of a large financial crisis such as the one that played out during 2007 and 2008. Postcrisis recoveries, as already noted, are unsteady, not linear as has been assumed by the optimists who drove up stock prices by 14 percent following Bernanke's Jackson Hole speech in August. Markets loved what they called "the Bernanke put." If the economy grew weaker, the Fed would fix it with more monetary easing; if the economy strengthened, the Fed would keep existing stimulus meas¬ures in place until the unemployment rate came down--maybe two or three years from now. What is particularly ironic is that once the Fed followed through on the promise of additional quantitative easing, clearly telegraphed during most of September and October, many in the marketplace decided that notwithstanding its aim of containing deflation, that approach would be ultimately inflationary.
Markets missed two things during that run-up in September and October, which was underscored by declarations of full containment of Europe's sovereign-debt crisis and China's soft landing. First, U.S. disinflation, and with it the rising danger of outright deflation, persisted. The core inflation component of the Consumer Price Index trended down to 0.6 percent by October--dangerously close to zero--for reasons Bernanke emphasized at Jackson Hole and in subsequent speeches. Inflation was (and is) well below the Fed's mandated goal of just under 2 percent. The Fed's QE2 announcement was aimed at avoiding deflation, although the Fed couched it in more traditional terms as an attempt to push down long-term interest rates.
A second thing the markets missed, at least initially, is that the inflation scare excited by QE2 implementation will actually be deflationary for two reasons. First, it forces the Fed to remind markets of its anti-inflation commitment and its willingness, as Warsh has stated, to tighten policy if inflation reappears, even if the unemployment rate is stuck over 9 percent. The Fed effectively has to wait until deflation is imminent to respond, given the initial negative reaction to QE2, which brought forth from some quarters hysterical cries of "Weimar Republic!" (the perpetrator of Germany's post-World War I hyperinflation).
A second problem tied to the protest over QE2 is the heightened uncertainty surrounding the future path of monetary policy. Once enacted, QE2 initially raised interest rates, then lowered equity prices. QE2 has gone from embodying a "Bernanke put" before it was enacted to a Catch-22 afterward. Now, even a pause in disinflation could force the Fed to tighten policy. If disinflation persists, the Fed is stuck "on hold" until deflation actually appears. But once deflation takes hold, it is much harder to reverse. Ask the Japanese.
Fiscal Policy: From Thrust to Drag
On a more fundamental level, a large part of the problem with QE2 is tied to the fact that monetary policy is being asked to do too much to sustain a tepid, postcrisis U.S. economic expansion. Since early 2009, the other policy tool, fiscal policy, has consisted largely of a stimulus package that cushioned household incomes with extended unemployment benefits worth about $60 billion per year, a payroll tax credit worth another $60 billion per year, and heavy transfers to state and local governments that have, until this quarter, enabled them to avoid substantial layoffs. Even if some of the Bush tax cuts are extended, these other measures will mostly expire at the end of the year.
Beyond the move from fiscal thrust to fiscal drag, the inventory-investment surge that resulted from the initial sharp recovery in 2009 is winding down quickly and, like fiscal thrust, will become a drag on output growth going forward unless demand growth accelerates more rapidly than expected.
To put the roles of fiscal thrust and inventory investment into sharper perspective, consider this: during the four quarters ending in the third quarter of 2010, headline annualized growth averaged 3.1 percent per quarter. Of that, 1.93 percentage points was due to inventory accumulation and 0.65 percentage points (based on Goldman Sachs's estimates) was due to fiscal stimulus. (Inventory volatility is a major factor in quarterly changes in GDP growth, but the average impact over time is zero.) Excluding these two items--fiscal stimulus and inventory accumulation, which are turning negative in Q4 (the biggest drag is 1.2 percentage points of fiscal drag in Q4)--annualized growth during the "recovery" (call it underlying growth) has averaged a mere 0.54 percent over the past year. If growth is to be sustained going forward, it will require some combination of stronger consumption, investment, and net exports.
It is probably true that in coming quarters the growth drag from weak net exports will rise by enough to offset, at least partially, the drop in inventory expansion as a contributor to U.S. growth. That said, the surge in net exports would have to be considerably greater than is typical to offset the coming drag from inventories. Over the past forty years, the average contribution to growth from the sum of net exports and inventories is virtually zero. The contribution from these two components of a mere 0.8 percentage points to growth over the coming year would be a standard deviation above the average for those four decades.
If net exports and inventory investment provide the normal zero percent contribution to growth over the coming year, then given fiscal drag of approximately 1.5 percentage points, positive growth would require a contribution of more than 1.5 percentage points from consumption and investment. For example, a 1 percent growth rate over the coming year would require (under these conditions) a positive growth contribution from consumption and investment alone of 2.5 percentage points. This is possible but unlikely in view of the weak growth of disposable personal income and a continued drag from residential investment.
The latest data on U.S. consumption and income growth are not encouraging. During the three months ending in September, consumption growth grew at a 2.6 percent annual rate, well above the negative 0.9 percent growth rate in real disposable income. While there was some pickup in consumer spending in October, growth of real disposable income has continued at a slow pace. The willingness of households to continue to run down savings to support consumption is limited, especially as fiscal stimulus is withdrawn and heightened uncertainty surrounds the future path of monetary policy.
As the lame-duck session of Congress gets underway, the outlook for near-term fiscal policy is highly uncertain. Even if the Bush tax cuts are fully extended, the United States faces a substantial additional fiscal drag as we move into 2011, much in the form of tax increases. Expiration of the payroll tax credit enacted in 2009, the emergency unemployment compensation program, and the earned income tax credit--all by the end of this year--will produce about $135 billion worth of fiscal drag or about 0.9 percent of GDP as we move into 2011. Estimates by Goldman Sachs and others suggest that the extension of the Bush tax cuts will increase fiscal drag going into 2011, with the subtraction of about 1.5 percentage points from growth during the first quarter and 2 percentage points from growth during the balance of the year. Add to that the possibility that the new Congress, with a mandate to reduce deficits and debt, could rescind the $200 billion of the Obama stimulus package as-yet unspent.
Unprecedented policy risks, both monetary and fiscal, abound as we move toward 2011. While U.S. fourth-quarter growth may hold at around 2 percent, helped by wealth gains from a higher equity market and the tail end of substantial government support for the disposable income of American households, fiscal drag will intensify sharply at the start of the year even if the much-discussed Bush tax cuts are extended. The 5 percent drop in the U.S. stock market following the November 5 rebound high--accompanied by lower stock markets the world over--is another ominous sign for growth, especially for growth driven by consumption and investment.
Weak U.S. Growth Outlook
U.S. growth during the first half of 2011 could be pushed back down to around 1 percent or lower if aggressive deficit-reduction measures are pushed forward by the new Congress. If the Fed's critics have their way and Bernanke is forced to scale back or rescind QE2 (not a likely development), then U.S. growth could turn negative by the middle of next year. In short, the United States could repeat Japan's mistake in spring 1997 of raising taxes at the first sign of an economic recovery. The result would be sharply lower U.S. growth and a further drift toward U.S. deflation.
Despite the signs of incipient deflation and the prospect of more fiscal drag, market measures of expected inflation rose immediately after the announcement of the Fed's QE2 initiative. The dissension among members of the Federal Open Market Committee, even some of those who voted for QE2, has reminded markets that the Fed's stance is one of symmetric conditionality. That means that the amount of government-bond purchases under QE2 could be raised or lowered depending on the path of economic data.
Perhaps QE2 was initiated too soon, before the possibility of U.S. deflation was widely accepted by markets. But rising fiscal drag and Fed tentativeness on its plan raised the likelihood of sharply weaker growth and disinflation or deflation in 2011. If that outcome materializes next year, markets, along with today's numerous Fed critics, will sit up and beg for a QE3 that is even bigger than QE2.
John H. Makin (jmakin@aei.org) is a resident scholar at AEI.
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Notes
1. Kevin Warsh, "The New Malaise and How to End It," Wall Street Journal, November 8, 2010.
2. Economic Policies for the 21st Century, "An Open Letter to Ben Bernanke," available at www.economics21.org/commentary/e21s-open-letter-ben-bernanke (accessed November 23, 2010)
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