Policy paralysis a horror show

Financial Review

PUBLISHED: 09 Jun 2012

Anna Bernasek 

Conservatives in the United States have argued for years that the government should get out of the business of managing the economy. A prominent Republican presidential candidate even wrote a book in 2009 entitled End the Fed. Now it looks like conservatives have gotten their way.

The signs couldn’t be any clearer that the US economy is slowing to a crawl. A mere 69,000 jobs were created in May with monthly jobs growth averaging only 96,000 in the past three months. At that rate, employment growth is too weak to keep up with population growth. Economic growth was also revised down in the first quarter to an annual rate of 1.9 per cent.

What’s more, the European crisis and incipient recession combined with the slowdown in China and India are all but certain to weigh on the US economy. Chief executives here express their concern about the outlook and some say they are putting hiring and investment plans on hold.

At best, the US economy is going nowhere. Yet policymakers have indicated they won’t do anything unless it gets a lot worse. Does that surprise you? It should. Until recently American policy was to make pre-emptive corrections when needed to fight a potential downturn or unwelcome change in inflation before it took hold.

But now, even as it’s readily apparent that we’re facing a major global downside risk, policymakers have painted themselves into a corner. On both the fiscal and monetary policy front, decision makers have effectively tied their own hands. Willingly or not, we have embarked on an historic experiment in laissez-faire economics.

Take a look at what’s happening at America’s deeply divided Fed. This week, several top officials spoke publicly about their positions. James Bullard, president of the St Louis Federal Reserve Bank, and Richard Fisher, president of the Dallas Fed dismissed the need for greater economic stimulus.

“The outlook for 2012 has not changed significantly so far,” Bullard said at a conference. “A change in US monetary policy at this juncture will not alter the situation in Europe.” And Fisher remarked: “Short of an implosion, I cannot support further quantitative easing.”

On the other hand, Charles Evans, the President of the Chicago Fed said this week: “We should be providing more accommodation.”

The problem for the Fed though is that with interest rates already as low as they can go, its main policy instrument, official interest rates, is simply not available or effective. While official rates are close to zero, the yield on 10-year Treasury bills fell to a record low of 1.44 per cent after May’s disappointing jobs numbers were released.

About the best the Fed can do is keep official rates near zero. But it’s already done that, promising rates will stay where they are until 2014.

What about quantitative easing? Much has been made about it as a radical way to stimulate the economy. The problem is that even if QE drives market rates lower, unless lots of borrowing ensues, the Fed hasn’t done a thing except energise its critics. That’s the thing about a liquidity trap. Policies that drive rates down ever lower lose their effectiveness.

There’s another thing the Fed can do. It could nudge up inflation expectations. But a deep ideological chasm divides not only politicians but American economists. There’s no sign – at all – of a purposeful increase in inflation.

So with the Fed effectively out of commission, that leaves things up to Congress and the President. Which isn’t much help because each party is hoping to gain in November’s election. Neither Democrats nor Republicans look to compromise now and potentially lose support from their base. Short of a full-blown financial crisis, don’t expect action from Washington.

Even worse, profound divisions in Europe have created a similar paralysis. That means the major chunk of the developed world is sitting on its hands at a time when prudence counsels action.

Welcome to a world we thought was a thing of the past. Forget about managing the global economy this year. It’s both terrible and fascinating to watch.