America may be heading toward a Japanese-style lost decade of slow growth and painful economic choices. Until recently, the conventional wisdom among economists was no way. After all, the Fed’s aggressive rate cutting and asset purchases, aka quantitative easing, dwarfed Japan’s too-little-too-late efforts to revive growth. As a student of the Great Depression, Chairman Ben Bernanke’s shock-and-awe response, combined with massive federal spending, meant the U.S. economy would bounce back stronger and faster — right?
Well, not exactly. While fiscal and monetary stimulus may have prevented a depression, the V-shaped recovery many had hoped for is nowhere in sight. At best, we seem to be facing a period of limping growth, and the J-word is creeping back into the conversation. “I used to think the Japanese lost decade scenario was bullshit,” says Greg Valliere, veteran Fed watcher and chief political strategist of the Potomac Research Group. “But now I think it’s a real threat. We could be entering a period of Japanese-style stagnant growth and disinflation or deflation where individuals and companies think: Why buy anything now when it will be cheaper four months later?”
For more than a year, dire warnings of the Japanese deflation story have been coming from Richard Koo, chief economist of Nomura Research Institute, the research arm of Nomura Securities in Tokyo. 15 years ago, he watched as an implosion in Japanese real estate prices set off a massive wave of deleveraging by companies and individuals and a prolonged deflationary recession. Now it’s groundhog day all over again as he watches the same movie unfolding in the U.S. and Europe. There, as in Japan, interest rate cuts are having very little effect. “For lowering of rates to work, borrowers have to be out there borrowing,” says Koo. “But demand for loans is falling” as companies and individuals pay down debt.
Austerity is in vogue now.”-Greg Valliere
In the face of this kind of “balance sheet” recession, he says, rate cuts and other monetary stimulus won’t work because people aren’t interested in borrowing; they are rebuilding their balance sheets. The only way out of this predicament, Koo maintains, is for the government to boost growth by government spending and tax cuts.
If he’s right, we’ve in a hellava pickle. For the first time I can remember, there seems to be an emerging political consensus in America -- thanks in part to Tea Partiers — that, even in the short term, we shouldn’t be increasing spending. “It’s politically toxic now,” says Valliere. “Most Americans think fiscal stimulus is immoral and ineffectual. They are flat out wrong — TARP worked spectacularly well and prevented a depression. But spending is out. The wave is lifting Chris Christy in New Jersey. The public is convinced new spending is futile. Austerity is in vogue now.”
With high-stakes congressional elections looming, the odds of passing new tax cuts are paper thin. There is talk of a payroll tax holiday and targeted jobs tax credits to help spur small business hiring, but that could be politically difficult, given Congress newfound fiscal concerns. “Tax cuts are radioactive,” says Valliere. More likely is an extension of the Bush tax cuts, at least for the middle class. But extending tax cuts we already enjoy isn’t likely to feel very stimulating. On the fiscal front, says Valliere, “we’re just about out of ammunition.”
Call it the QE2.
That may explain why there’s increasing talk of a second round of quantitative easing by the Fed. Call it the QE2. With the fed funds target rate already at zero to 0.25 percent, it can’t go much lower. But the central bank could lower interest rates on excess reserves held at the central bank. That could encourage banks to lend.
Or, the Fed could begin buying government securities again. But what kind? Allen Sinai, president of Decision Economics, suggests the Fed might buy six-month and one- or two-year Treasuries, on which many bank loans are priced. “The lower rates go the better,” he says. Additionally, he argues that the Fed should create a special lending facility for small and regional banks, whose balance sheets are stronger than those of the big banks but don’t now have access to the Fed’s borrowing window.
Needed: Post-Partisan Heroics
But is Ben Bernanke willing to go the distance? Even if he does, can a further loosening of credit help stimulate growth if, as Koo argues, businesses and individuals really don’t want to borrow? If Koo’s right, Democrats and Republicans face an even more daunting task: working together to right-size spending and reform the tax code in a way that can spur growth. In other words, compromising and putting economic growth — and jobs — first.
That will take some post-partisan heroics. Mr. President, are you listening?
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