Averting recession in the US

Prof Martin Feldstein has written about what America should do to avert a recession. The article captures one of the major dilemmas facing policymakers worldwide - the role of monetary and fiscal policies in stimulating an economy facing recession. Let us list out the possible dangers facing the American economy today

1. Liquidity crisis arising from the bursting of the sub-prime mortgage bubble - corporate debt market drying up
2. Inflation concerns arising from the weakening dollar and peak oil (this would force up interest rates, and thereby cause more home mortgage defaults)
3. Fall in consumption due to weakening of the wealth effect from asset bubbles (this is serious given that consumption formed 2.1% of the 3.9% Q3 2007 GDP growth of the US economy)
4. Asian and other Central banks moving towards other more remunerative assets, thereby causing rise in interest rates and further weakening of dollar. Foreign governments and investors now hold some $2.23 trillion — or about 44% — of all publicly held U.S. debt worth $5.1 trillion. That's up 9.5% from a year earlier.
5. Rising import prices as the dollar depreciates, thereby hurting consumption.
6. Rising public debt and weakening dollar puts upward pressure on interest rates. National debt touched $9 trillion in November 2007, and is growing at $1.4 bn a day!
7. All or some of the aforementioned could throw up recession, inflation and unemployment.

Prof Feldstein forecasts a 50% chance of recession in 2008. He recommends a twin strategy of loose monetary policy and fiscal stimulus to reduce the risk of recession in the coming year. He explains, "What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level."

He finds two benefits in such a stimulus, "First, it would immediately boost the confidence of households and businesses since they would know that a significant slowdown would be met immediately by a substantial fiscal stimulus. Second, if there is a decline of employment (and therefore of output and incomes), a fiscal stimulus would begin without the usual delays of the legislative process."

On monetary policy, he writes, "The current 4.5% fed-funds rate is essentially neutral - not low enough to stimulate growth and not high enough to reduce inflation. Although there are risks that the rise in oil prices and the falling dollar will raise the inflation rate, the greater potential damage of an economic downturn calls for a more stimulative policy. The Fed should reduce the fed-funds rate at its December meeting and continue cutting toward 3% in 2008, unless there is a clear sign of an economic improvement."

The rationale for lower rates are, "Lower interest rates will still reduce monthly interest payments for the one-third of homeowners who have adjustable rate mortgages, thus freeing up cash to spend on other things. When banks make new loans, they will do so at lower interest rates, encouraging more business and household borrowing."

The reasons for favoring a conditional fiscal stimulus as against a loose monetary policy are
1. The lurking dangers of inflation and a plunging dollar.
2. A loose monetary policy is likely to sustain the asset bubble or even worsen it.
3. Lowering interest rate may not yield the desired results, given the "lack of confidence in the creditworthiness of counterparties and in the accuracy of asset prices."
4. This problem is now being compounded by the banks' loss of capital as they recognize past losses, and by their need to use large amounts of the remaining capital to support existing off-balance-sheet credits that have to be shifted to their balance sheets.

But this twin track approach faces numerous objections.
1. If the recessionary expectations become substantial, the fiscal stimulus is likely to be saved in bank deposits and not productively spent. Private investment is also likely to be put off in anticipation of a recession.
2. If oil prices continue to rise and imports becomes dearer, inflationary expectations get energised. This coupled with a sliding dollar and widening public debt, will bring upward pressure on the interest rates. The Fed will have limited room to manouvre with monetary policy.
3. Just as a loose monetary policy has the potential to sustain the asset bubble and even initiate a new one, the fiscal stimulus has the potential to continue the unsustainable consumption boom. It would encourage Americans to continue living beyond their means.
4. The fiscal stimulus would further postpone facing up to the hard reality of very low household savings (negative) and high current account deficits. It would only paper over the structural distortions that have crept into the US economy over the past decade.
5. The financial system is not facing a liquidity crisis, which can be overcome by lowering rates. Significant sections of the financial markets are facing a "solvency problem", which cannot be tided over by merely relaxing the monetary policy.

The aforementioned policy prescription by Prof Feldstein would appear to be aimed at sustaining the consumption led economic growth, and not concerned at addressing the deeper problems associated with the US economy. While this strategy may help avert an immediate recession, it may fuel even more distortions and take the economy further away from any sustainable growth equilibrium. There is an immediate precedent here. In the aftermath of the tech stocks bubble, Alan Greenspan effectively pumped up the real estate and mortgage loan bubble by lowering interest rates 13 times, over a three year period to a historic low of 1% in June 2003. Another way of looking at the situation would be to see it as an opportunity to take the steam off an excessively consumption dependent and bubble based economy, which is living far beyond its limits, and prepare the ground for a soft landing. The is to be achieved without stoking off a recession.

The challenge is to use the soft landing to correct the many structural distortions. The current account deficit and trade deficit has to be brought down by a two-pronged strategy of increasing exports and decreasing imports (atleast consumption based imports). The over dependence on Chinese and other Asian Central Banks to finance deficits has to end. The solution to recession is not to simply consume more! In the final analysis, the dilemma is to make a choice between the following two choices
1. Using the tools of fiscal and monetary policy to avert a recession now, while opening up the distinct possibility of sustaining and even continue building up the distortions.
2. Eliminating or atleast reducing the distortions by preparing for a soft landing. This strategy comes with uncertainty about the extent of a possible recession.

Given that both options face considerable uncertainties, and any Government intervention will be on the basis of many debatable assumptions, I am inclined to believe that it may be better to face a mild recession now, rather than prepare for a major one later!