Thoughts on the Current Economic Environment

Posted by Jeffrey Brown on Aug 16, 2011

Filed Under (Finance, U.S. Fiscal Policy)

Larry DeBrock and I were interviewed by News Bureau Business & Law Editor Phil Ciciora, on the chances of another recession, and what the government needs to do to avert another economic crisis.  Below are our responses.

Jeff Brown: The recent volatility in financial markets is one of several indications that we are operating in an environment marked by high levels of economic uncertainty. While I continue to believe that the most likely scenario going forward is that we will continue to experience a very slow recovery marked by a prolonged period of high unemployment, I also believe there is something on the order of a one-in-four chance that we will fall into a second recession.

It appears that markets are responding to three primary concerns. First, we have had a mixed set of economic indicators released in recent weeks suggesting that the recovery in the U.S. is still quite fragile. Second, the sovereign debt problems in Europe – Greece, Spain and Portugal, among others – are weighing heavily on the minds of many investors, as Europe is a major trading partner. Third, there is tremendous political and policy uncertainty about the willingness and ability of the U.S. to get its fiscal house in order.

The down-to-the-wire debt ceiling debate has clearly signaled to the world that our economic policy-making process is dysfunctional, thus casting some doubt on whether we have the political backbone to address the serious fiscal problems that lie before us. Also, the fact that Congress kicked the can down the road by leaving the hard choices in the hands of a Congressional “super-committee” creates tremendous policy uncertainty, leaving individuals and companies unsure what tax rates they will face in the future.

The current economic environment is extremely difficult to navigate. Many believe we need short-term stimulus, such as reducing payroll taxes or increasing government spending, in order to boost economic activity. From a longer-term perspective, the problem is that these are the wrong policies for reducing deficits. And many of the proposals for stimulus really do very little good over the long run because of their explicitly temporary nature.

The most important thing to understand is that the private sector, and not the government, is the real engine of job growth over the long run. So the best thing the government can do is to create a policy environment that is pro-growth.

How do we do this? First, quickly come up with a credible plan for reducing our long-term deficits, one that is more heavily focused on spending cuts than on revenue increases. Second, reform our tax system so that we promote, rather than penalize, business investment, entrepreneurial activity and work. In short, shift taxes away from work and investment (things we want more of) and onto consumption. Third, once we have placed the country on a sustainable fiscal path with reduced spending and pro-growth tax reform, make the tax regime as permanent as possible so that individuals and companies can make long-term decisions with some confidence that the rules won’t change in the middle of the game.

Larry DeBrock:  I am not sure of the true impact of the S&P downgrade. If you look at U.S. Treasuries, the yields have fallen steadily in the days since the announcement by S&P, which indicates that investors are still very much interested in purchasing U.S.-issued debt. Still, the downgrade did have a big impact on both consumer and investor psychology. The inability of Congress to show leadership in the recent debt limit spectacle combined with the formal announcement of a downgrade of the U.S. credit rating has certainly caused some unnerving volatility in the stock market.

Are we headed for another recession? Quite possibly. Americans are impatient and wish for a rapid return to full employment and strong growth in our country’s gross domestic product. But history indicates that the recovery from a deep recession such as we have just experienced is always a slow process. And, this “recovery” is different in that our government is responding in a manner we have not seen before. In other recessions, the government acted “counter-cyclically” in that it would increase its spending in the face of an economic slowdown. In the current climate, our 50 statehouses as well as our lawmakers in Washington are acting to decrease spending. This “pro-cyclical” response has undoubtedly contributed to the slow pace of job recovery and could contribute to factors that end in a double-dip recession.

The response of the Federal Reserve to announce a stable two-year plan to hold interest rates low is a movement in the right direction. However, interest rates have been low for quite some time. The flight away from risk, as indicated by the increase in prices of U.S. Treasuries despite the S&P pronouncement, is very real. The Fed may have to consider another round of quantitative easing, this time aimed at removing riskier assets from the market.

The most troubling economic news is really the debt crisis in Europe. Economists have long argued that having a single currency across multiple sovereign nations with independent fiscal policies was a recipe for disaster. As each week seems to highlight another example of this incompatibility, the Eurozone economies will continue to struggle. And if Europe experiences an economic slowdown, our economy will certainly share some of that pain.