Three tough choices: The Fed, the euro, and the US


A man walks past a stock quotation board outside a brokerage in Tokyo September 12, 2012. Japan's Nikkei average hit a two-week closing high on Wednesday and edged toward the key 9,000-mark on expectations that the Federal Reserve will announce measures to stimulate the U.S. economy and that a German court will approve the legality of the euro zone's bailout funds.

Article Highlights

  • .@AEI economists offer their thoughts on 3 tough choices currently facing policy makers: the Fed, the euro and the US.

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  • ”We have reached a period of central bank overreaching in both the US and Europe,” according to @AEI’s John Makin.

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  • Greece is the main risk to continued calm in Europe, but there are many other factors that could complicate matters.

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  • A downgrade in credit rating would signal that the US economy is headed towards another downturn, says @AEI’s Mathur.

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With the FOMC meeting Wednesday and Thursday, European leaders parsing the details of new rescue packages, and Moody's threatening to downgrade the U.S.' credit rating, AEI economists offer their thoughts on the difficult choices facing policy makers.

John Makin: Fed and ECB overreach means inflation will rise

Fed Chairman Ben Bernanke said at Jackson Hole that if the economic data don't improve, the Fed would take additional steps to boost the economy. He indicated particular concern about the labor market.

The employment report for September fulfilled the Bernanke criterion for taking those "additional steps", but it also served to remind us that the "additional steps" won't do much good. Job growth was only 96,000 in September and previous months' figures were revised down, revealing a much weaker job market than most analysts had expected. The unemployment rate did come down a bit, from 8.3 to 8.1 percent, but that result was due to a departure from the labor force of discouraged workers giving up on job searching. The labor force participation rate fell close to a record low.

The persistently weak U.S. labor market is evidence that the Fed's efforts to boost the economy and employment using quantitative easing and Operation Twist are no longer effective . But the same labor market weakness will be used to justify another round of easing that probably will be announced at the conclusion of this week's Fed policy meeting.

We have reached a period of central bank overreaching in both the United States and Europe. Monetary easing, including expansion of the Fed's balance sheet and promises to hold policy rates lower for longer, had a temporary positive impact on growth and employment at first that was sustained as long as it surprised markets. But now that markets expect additional measures from the Fed, they have little if any impact on hiring decisions. The ECB's decision, announced last week, to purchase unlimited quantities of bonds issued by weaker European government borrowers will also provide a temporary boost, largely through higher stock prices, but once that boost is over, markets will want more, facing the ECB with cries for another round of buying weak government bonds, perhaps as inflation and inflation expectations are rising.

Central bank emergency liquidity measures in response to a financial crisis are justified to contain the negative fallout on the real economy. But monetary policy can't persistently boost growth and employment or provide unlimited financing for government spending that is well in excess of revenue. The result of such measures is higher inflation. We haven't seen it yet, but we will see it by next year.

Desmond Lachman: A European storm before the election?

"The most important of the challenges is the ongoing Greek economic crisis, which could very well see Greece exiting the Euro before election-day in the United States." -Desmond LachmanOn July 26, 2012, in response to severe market pressure, ECB president Mario Draghi announced that the ECB would do whatever it takes to save the Euro. That announcement has succeeded in considerably calming European financial markets. However, whether that calm will last through the U.S. election cycle remains to be seen since the next few weeks contain a host of potential European developments which could sorely test Mr. Draghi's commitment to defend the Euro.

The most important of the challenges is the ongoing Greek economic crisis, which could very well see Greece exiting the Euro before election-day in the United States. The very fragile Greek government currently in office simply does not seem to have the resolve to secure parliamentary approval of the draconian public spending cuts that are being demanded of it by its IMF and EU taskmasters by early October. And without the passage of those measures, the IMF and EU will have little option but to cut off funding to Greece, which would almost certainly lead to a Greek exit from the Euro with dire consequences for the rest of the European periphery.

While Greece is the main risk to continued calm in European financial markets, there are a number of other factors that could complicate matters in Europe over the next month or two. On September 12, the German constitutional court could substantially weaken the ESM, the new European bailout fund, by requiring that all loan decisions of that fund receive prior German parliamentary approval. On the same day, the Dutch electorate might vote in favor of a new Socialist government, which must be expected to strongly resist any notion of the Netherlands surrendering any budget sovereignty to Brussels. And in Italy one must expect the start of its election season ahead of the April 2013 Italian parliamentary elections, which will very much limit Prime Minister Mario Monti's room for maneuver.

President Obama could be lucky and dodge the Greek exit bullet before election-day. However, he would have to be extraordinarily lucky to dodge all the other European bullets that could roil U.S. and global financial markets before voters go to the polls on November 6.

Aparna Mathur: Moody's puts the U.S. Congress on notice

Moody's Investors Service announced yesterday that unless lawmakers in Congress are able to come to a bipartisan agreement on policies that would stabilize and eventually reduce the percentage of debt to GDP in the medium term, the U.S. may lose its top credit rating. Moody's statement comes almost exactly a year after S&P, another major ratings agency, downgraded U.S. debt to AA+ following the last minute deal on the debt ceiling. Major stock indexes sank by 5 to 7 percent following that action, the worst drop in equity prices since the 2008 financial crisis.

As we repeat last year's debacle, it is clear few lessons were learned. One reason lawmakers care little about what the ratings agencies say is that the downgrades have little impact on the demand for U.S. Treasuries in the post-AAA world. In recent weeks, the yield on the 10-year Treasury note has fallen to a record lows below 1.7 percent relative to 2.6 percent a year ago. The 30-year yield has dropped to less than 2.8% from almost 4% last August. In the minds of most investors US treasuries are still a safe haven compared to the turmoil in Europe.

But a downgrade would signal that the U.S. economy is headed towards another downturn, and policymakers would be wise to heed the warning signs. The CBO warned in August that federal debt will reach 73 percent of GDP by the end of this fiscal year. If we plunge over the fiscal cliff of spending cuts and tax hikes, the economy is headed towards a recession in 2013, with GDP growth shrinking 0.5 percent and unemployment above 9 percent. Alternatively, if Congress can agree on extending tax cuts and spending cuts do not occur, real GDP growth should be stronger in 2013 and the unemployment rate should not rise above 8 percent. The choice seems pretty clear from the outside. Will anyone in Congress take heed?

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