Monetary and fiscal policies to the rescue?

Business Times - 29 Jan 2008

Monetary and fiscal policies to the rescue?

Observers worry that the policies' potential effects could plant the seeds of stagflation


FACED with a clear and present danger that the crisis in the sub-prime mortgage sector and the ensuing turmoil in the financial markets could transform the downturn spiral in the US economy into a long and painful recession, officials and lawmakers in Washington decided last week on strong doses of monetary and fiscal medicine.

Many economists remain doubtful that the monetary step - an emergency rate cut of three-quarters of a percentage point by the Federal Reserve (the largest in a quarter century, that was announced last Tuesday) - combined with the US$150 billion package of fiscal stimulus agreed by Congress are going to avert a recession, especially since it would take several months before these two moves could affect the economy.

Moreover, many observers are worried that some of the potential effects of these two combined moves - including an expanding federal budget deficit, the danger inflationary pressures and an additional weakening in the value of the US dollar - might even make things worse by planting the seeds of 'stagflation', a long period of inflation combined with stagnation in the form of low economic growth and rising unemployment. This had sent shockwaves through the entire American economy in the 1970s that also was experiencing a gigantic rise in global energy prices then.

But even those who remain sceptical about the steps taken by Washington last week seem to agree that American policymakers and lawmakers had no choice but to 'do something' so as to calm the growing fears of Wall Street and Main Street.

The unscheduled rate cut to 3.5 per cent by the Fed was announced before the US stock market opened on Tuesday in the aftermath of the Bloody Monday on stock markets around the world. The sell-off, which partly reflected rising concerns over the health of the US economy, could have triggered another bout of panic on Wall Street, where there were also signs of mounting anxiety over the financial fragility of the bond insurance sector.

At the same time, as the American people were entering what could turn out to be an historic presidential election campaign, opinion polls are pointing to rising economic insecurity among voters. The toxic mix of high oil prices, a dramatic rise in mortgage defaults, credit card delinquencies at record levels and creeping unemployment has taken its toll. It has produced not only falling consumer confidence, reflected in the major drop in spending, but has also contributed to what the New York Times described as the 'darkening of the country's mood'. Many Americans are sensing a 'jarring end of Pax Americana' and pressing for protectionist economic measures and restrictions on immigration.

Indeed, these depressing sentiments were only exacerbated in recent weeks as the media continued to highlight, almost every day, reports about East Asian and Middle Eastern investors bailing out American financial institutions like Merrill Lynch and Citigroup.

One could only imagine what would have happened if the bailouts by sovereign wealth funds (SWFs) would have taken place a year or two ago: in all likelihood, many members of Congress would have rushed to launch investigations and to conduct televised hearings on how to deal with the 'threat of the Communist Chinese and the Arabs taking control' of slices of the American economy.

The current extraordinary silence from Capitol Hill over this issue suggests that even the most ardent 'China bashers' in Congress understand that without the infusion of East Asian, Middle Eastern and even Russian investment, the US economy would have been in far worse shape than it is now.

Instead, the lawmakers, working together with Bush administration officials, came up with the US $150 billion economic stimulus package that would shower American consumers and businesses with cash in the hope that they would spend that money ASAP and thus help re-energise the teetering American economy.

Under the compromise deal which is expected to turn into legislation in the coming weeks, nearly every American who earned a paycheck in 2007 would receive at least US$300 from the Internal Revenue Service (IRS), making for a payout of US$103 billion in total.

Other provisions in the package would offer businesses one-time incentives to invest in new equipment, in the form of faster tax write-offs for corporate investment and immediate tax deductions for small-business investment in plants and equipment. The proposed legislation will also include some assistance to homeowners threatened by foreclosure.

But consumers will not start to receive the tax rebates until March and perhaps even later than that. And any impact that their spending will have on the economy - if at all - will not be felt until later this year after the recession has already started. And if a recession leads to more house foreclosures, personal bankruptcies and unemployment, Congress will probably be faced with new pressure to increase unemployment benefits and social services.

What is certain is that the federal budget deficit which in any case has been expanding due to the costs of fighting the wars in Iraq and Afghanistan will continue to increase as a result of the stimulus package, especially if and when a Democratic president and Congress are elected in November and start to push for more spending on social and health programmes.

It has been suggested that both the surprising interest rate cut last week - more could be expected next week when the Fed policymaking group gathers for its scheduled meeting - and the stimulus package could have a positive 'psychological' effect on consumers and investors.

But it's not clear how these moves could encourage consumers who are overwhelmed with debt and rising gas prices and whose houses and pension plans (consisting basically of shares in the stock market) are losing their value to go on a spending spree.

At the same time, it was the lax monetary policy of the Fed under Alan Greenspan that created the conditions for the bubbles in the housing and credit markets, which raises the question of whether continuing that policy and rewarding the irresponsible behaviour of consumers and investors makes much sense.

It's quite possible that both lower interest rates and the stimulus package could provide some boost to the economy and prevent the downturn from turning into a severe recession. But given the magnitude of the current housing and financial crises, at a time when the value of the US dollar is falling and inflation remains a threat, the outcome remains unpredictable.

Copyright © 2007 Singapore Press Holdings Ltd. All rights reserved.


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