America's Economic Challenges

May 17, 2008

The foremost short-run economic uncertainty is whether enough policy stimulus is in the pipeline to avoid a U.S. recession or at least to make it brief and shallow. A $400 billion fiscal stimulus via tax rebates is slightly less than 1% of GDP, but it lands into household hands over a compressed period of time and amounts to roughly 3% of quarterly GDP. That’s a significant sum. A lot of discussion has been devoted to how the rebates will be used: spend immediately, saved, used to pay down debt, or consumed in covering ever-higher energy costs. From the standpoint of net stimulus, it matters less than generally realized how the rebate money is allocated. All the uses leave households better off than if no fiscal support were coming. Covering money at the gas pump or reducing debt leaves more purchasing power for discretionary spending. Building up rainy-day money will help stabilize consumer confidence. It is true that the fiscal stimulus will not lend on-going support, but the medicine’s maximum impact in the second half of 2Q08 and through the summer is well timed to arrive when the economy truly needs help.

On the monetary policy side, it generally takes at least six months for an interest rate cut to lend support. The quarterly averages of the federal funds rate were 5.25% in 2Q07, 5.19% in 3Q, 4.53% in 4Q, 3.24% in 1Q08 and 2.08% in the present quarter. Juxtaposing the first differences in those means against two quarters into the future yields an interest drop of 66 bps in 2Q08, 129 bps in 3Q08, and 116 bps in the final quarter of this year. Monetary conditions have been additionally relaxed as a result of dollar depreciation wherein a 10% drop in the trade-weighted exchange rate produces roughly the same effect as a one percentage point decline in short-term interest rates. The dollar-adjusted interest rate decline, lagged two quarters, was a relatively insignificant 36 basis points last quarter, when U.S. real GDP expanded just 0.6% saar. The dose of adjusted interest rate support then will rise to 115 bps in the present quarter, 145 bps in 3Q08 and remains high at 110 bps in 4Q08. So even as fiscal support fades late this year, incremental monetary policy support will continue to be substantial.

Policy support will be mitigated by continuing deflationary headwinds. Until real estate values fall enough to find an equilibrium, new foreclosures will keep coming on stream. The labor market lags the business cycle but also reinforces it. It is fortunate that new jobless claims have thus far stayed below 400K, a threshold that has been exceeded in earlier recessions. But if layoffs accelerate, private consumption will respond accordingly, and a vicious cycle of declining demand and income will become more entrenched. The accelerating climb of energy prices poses further danger. The quarterly average of oil prices rose by 11.8% in 2Q07, 15.0% in 3Q07, 20.8% in 4Q07, 7.9% in 1Q08, and 18.8% to a mean of $116.03 in the first half of 2Q08. Already, the price is some $10 per barrel higher than $116, and forecasts of $150-200 are sprouting. Unless the oil price express can be reined in, the fiscal and monetary policy support, while substantial, may still not be sufficient to prevent a full-blown recession.

America’s long-term economic challenge is one that has taken down numerous imperial powers throughout history: Greece, Rome, France, Britain, and the Soviet Union. I refer to the diversion of scarce resources to supporting military activities abroad. The U.S. spends more each year policing Iraq than will be dished out in tax rebates. Considerably more taxpayer money supplemented by borrowed funds that will have to be serviced in the future are consumed by the entire war on terrorism, including ventures in other parts of the Middle East and the homeland security budget. Nobody said the price of freedom is cheap, but a major and unappreciated component of that cost involves the hollowing out of the economy. One lesson of history, as Bush in Israel argued, is that appeasement of tyrants doesn’t work. An equally important separate lesson is that political leaders must learn to distinguish between instances where national freedom is really imperilled from foreign ventures that are not essential and whose pursuit will leave a country so weakened as to have little of value to defend.



Comments are closed.