On the second anniversary of the Lehman crisis, the world economy finds itself yet again at a very troubling juncture. The US economy now shows every signs of heading for a double dip recession and deflation. At the same time, the European sovereign debt crisis remains far from resolved, China's overheated economy has begun to slow, and the Japanese economy finds itself mired once again in deflation. More troubling still, as the clouds gather for what could be another perfect global economic storm, the industrialized countries' policymakers appear to be paralyzed by doubts as to what should be done. And protectionist pressures are once more on the rise.
The United States, still by far the world's largest economy, is about to pay dearly for the Obama Administration's policy mistakes over the past two years. Among the more important of these mistakes was the very poorly designed and overly back-loaded fiscal stimulus package. Together with a costly health reform initiative, this package has highly compromised the US public finances without succeeding in jump-starting the economy. Compounding matters has been an overly tentative approach to US bank reform and the lack of a coherent policy approach to deal with the country's chronic home foreclosure crisis.
Over the past year, the U.S. managed only a modest recovery from its deepest slump in the postwar period. And it did so mainly as a result of the fiscal stimulus package and inventory cycle, which together contributed practically all of the 3percent economic growth over that period. The anemic economic recovery to date has to raise a rather basic question. How will the U.S. economy avoid a double-dip recession once the beneficial impact of the fiscal stimulus has totally faded and once the present strong support from the inventory cycle has run its course?
Sadly, as the fiscal stimulus is fading, the U.S. economic recovery is facing a number of strong headwinds that make a relapse into recession all too likely. The most serious of these headwinds is the appalling state of the U.S. labor market, which is now weighing heavily on income growth so necessary for a revival in household consumption. If one includes involuntary part-time workers in the unemployment total, the overall U.S. unemployment rate has risen from 9 percent prior to the recession to a staggering 17 percent of the labor force at present.
Further clouding the U.S. economic outlook is the ongoing U.S. foreclosure crisis, which threatens another leg down in the housing market. In addition, the U.S. economy will now be weighed down by the prospective cuts in state and local government spending, the ongoing bust in the commercial real estate market, and the souring of U.S. export prospects as a consequence of the Eurozone sovereign debt crisis.
A marked slowing of the U.S. economy at this juncture must raise deflationary fears, since it will exacerbate the extraordinarily large labor and product market gaps that presently characterize the economy. The slowing would also be occurring at a time when U.S. inflation is already at a very low level.
In the recent past, the Federal Reserve has not distinguished itself either by anticipating economic downturns or by taking timely preemptive measures to cushion the damaging fallout from such downturns. Judging by the FOMC's latest policy statement, it appears that the Fed is again in danger of doing too little too late.
The eurozone's sovereign-debt crisis casts another pall over today's already-fragile global economic outlook. The recessions in Greece, Spain, Portugal, and Ireland will all likely deepen considerably in the year ahead as these countries attempt to undertake major fiscal adjustment programs without the benefit of currency depreciations that might spur export growth. Such a deepening will undermine their public finances by eroding their tax bases and it will heighten questions about those countries' ability to service their sovereign debt. This in turn will call into question the health of the European banking system, which has loaned around US$1.5 trillion to these countries.
In principle, large amounts of public financing could paper over the eurozone's sovereign-debt crisis indefinitely without resolving it--as has been occurring over the past six months. Politically, however, there are limits to the amount of financing that Europe's troubled southern countries can expect to receive from the financially stronger northern ones. Witness the May 2010 German state elections, in which the electorate sent a clear message to Chancellor Angela Merkel that it was not happy to see German taxes used to bail out Greece.
The more immediate threat to the continuation of the eurozone in its present form is the possible loss of political willingness in Europe's periphery to continue hewing to IMF-style austerity measures. At some point, as the recession deepens and as unemployment rises with no end in sight, serious questions must be expected to arise in the periphery as to whether these countries would not be better served by restructuring their debt and exiting the Euro. This is essentially what happened in Argentina in 2001 after several years of painful and not very fruitful austerity measures. There is little reason to expect a different outcome in the eurozone's peripheral countries, whose economic imbalances are far greater than were those in Argentina.
Against the backdrop of this gloomy world economic outlook, one has to be surprised about how sanguine global economic policymakers remain. Far from seeing the need for additional fiscal stimulus measures, in all too many countries they are now seemingly tilting towards early fiscal consolidation. And until very recently, both the Federal Reserve and the European Central Bank were still talking about an early exit from their unorthodox post-Lehman monetary policy measures.
One also has to be surprised by the Chinese government's seeming blind eye to the economic storm that is about to hit both the United States and Europe. Instead of allowing more flexibility in their currency to head off charges of "beggar-my neighbor" policies, the Chinese government persists in effectively pegging China's currency to the US dollar. One would have thought that the Chinese government would have learnt from the Japanese experience with "voluntary export restrictions" in the 1980s that it is not a good idea to invite a protectionist backlash by deliberately undervaluing one's currency particularly at a time of considerable weakness in the US and European labor markets.
Desmond Lachman is a resident fellow at AEI.