Posted: November 30, 2012
The policy basin: Part 1
It's not all badBy KC Mathews
The looming tax cut expirations and budget cuts, often referred to as the fiscal cliff, are set to play out at the end of this year. My forecast suggests that we will not experience the full fiscal cliff in 2013, which would be a 4 percent to 5 percent hit to our economy, but rather we will be caught in a “policy basin” for an extended period of time.
A basin can be defined as a low and sometimes sinking region. Over the next several years, we may be subject to an economic environment that will experience low growth or even sinking growth due to the following:
- Ineffective monetary and fiscal policies
- Growth challenges due to excessive debt levels
If a policy basin comes to fruition, I believe it can still be an environment that is modestly supportive of the U.S. economy and equity markets. This forecast calls for Gross Domestic Product (GDP) growth to be less than 2.5 percent for a three to five year period. While the policy basin may ensure low growth, it avoids a recession. A contraction of GDP could be set into motion if politicians mishandle the delicate fiscal situation and lead the economy back into a contraction, much like the double-dip recessions of 1937 and 1982.
Despite unprecedented policies enacted to support the economy since the Great Recession, GDP is barely growing and our debt-to-GDP ratio is near 100 percent. Simply stated, accommodative fiscal and monetary policies have not yet worked to the extent desired. The Fed has aggressively pursued unconventional monetary policies as more traditional policy tools, but these have failed to move GDP back to normal levels.
These unconventional measures included: purchasing equity in banks via the Troubled Asset Relief Program (TARP), three rounds of quantitative easing (QE), and a program designed to lower long-term interest rates known as Operation Twist. With all of these actions, the Fed’s balance sheet has expanded by nearly $2 trillion since the recession began. Fiscal policy has also been accommodative. Congress passed an $800 billion fiscal stimulus package in 2009 known as the American Recovery and Reinvestment Act, in an attempt to spur aggregate demand.
While the overall impact of monetary policy action on growth is debatable, it is clear that fiscal policy is now serving as a drag to growth. Excluding the Q3 2012 GDP reading, in which defense outlays increased significantly on a one-time basis, reduced government expenditures have detracted from economic growth for eight quarters in a row.
Furthermore, while monetary policy may not be a drag on growth, it has proven largely ineffective in stimulating aggregate demand to any meaningful degree. Some suggest the ineffectiveness of monetary policy can be attributed to what is known as a liquidity trap. A liquidity trap essentially means that interest rates are close to zero, but the rapidly expanding monetary base (savings) does not get translated into a growing money supply. As such, the low rates fail to stimulate economic activity.
Lastly, as a result of expansionary fiscal policies, the budget deficit (relative to GDP) is at an unsustainable level. The total government debt-to-GDP ratio, which caused Standard & Poor’s to downgrade our debt from AAA in the summer of 2011, will likely negatively impact growth in the years ahead. Lastly and unfortunately, the debt ceiling debate will once again come to the forefront in March 2013.
The U.S. is currently muddling through the weakest economic expansion since World War II. Normally following deep recessions, economies tend to grow at an above-trend growth rate for several quarters to make up for the lost economic output during the recession. For example, after the deep recession in the early 1980s, during which both unemployment and inflation were running in excess of 10 percent, economic growth eclipsed 3 percent for 13 consecutive quarters.
By comparison, since the most recent recession ended in 2009, we have only grown in excess of 3 percent in two quarters, total. This forces the question as to why growth has been so anemic relative to past recoveries and what type of economic growth can be expected in the future. I would submit that the household and financial sector deleveraging process seen over the past couple years helps explain the slow rate of economic growth.
Economies that enter recessions in conjunction with or due to a financial crisis typically exhibit slower recovery rates as the mechanism by which capital flows through an economy (banking/financial system) is impaired and households/corporations/governments tend to focus on the repair of their balance sheets. The latter typically involves an increased savings rate (deleveraging) that inhibits the normal quick rebound from the recession.
Research suggests that for both advanced and emerging economies, the relationship between growth and debt seems relatively weak at “normal” debt levels, median growth rates for countries with public debt more than 90 percent of GDP are roughly 1 percent lower than normal and average (mean) growth rates are several percentage points lower.
This phenomenon can be explained by the necessity of either raising taxes, lowering spending, or both, to bring down the deficit and debt. The 90 percent of GDP threshold can be partially attributed to rising risk premiums in the bond markets that call for fiscal contraction to maintain credibility in terms of willingness and ability to pay creditors.
To highlight the predicament of the U.S. with respect to public debt, Moody’s recently stated the following: “Moody's views the maintenance of the Aaa [debt rating] with a negative outlook into 2014 as unlikely. The only scenario that would likely lead to its temporary maintenance would be if the method adopted to achieve debt stabilization involved a large, immediate fiscal shock—such as would occur if the so-called "fiscal cliff" actually materialized—which could lead to instability.”
Monday: Part 2 -- More on what's ahead.
KC Mathews, CFA is executive vice president and chief investment officer of UMB Bank.