Can the U.S. Lead Us Out of This Crisis?

Martin Feldstein, former leader of the Reagan economics team and one of the leading economists in the U.S. has a deeply pessimistic piece on the Project Syndicate site today. So at a time when many are suggesting that this recession is no worse than the 1981-82 debacle, Feldstein argues that while the numbers may not yet be as bad, the nature of the recession is entirely different and much more frightening in that

[p]revious recessions were often characterized by excess inventory accumulation and overinvestment in business equipment. The economy could bounce back as those excesses were absorbed over time, making room for new investment. Those recoveries were also helped by interest rate reductions by the central bank.

This time, however, the fall in share prices and in home values has destroyed more than $12 trillion of household wealth in the United States, an amount equal to more than 75% of GDP. Previous reactions to declines in household wealth indicate that such a fall will cut consumer spending by about $500 billion every year until wealth is restored. While a higher household saving rate will help to rebuild wealth, it would take more than a decade of relatively high saving rates to restore what was lost.

This is a recession that will not resolve in the short term, or even in the foreseeable future, by itself. And as Paul Krugman has been arguing for some time, and as is now obvious, monetary policy has reached its limits, or as Krugman puts it, "it’s the zero lower bound, stupid"

As Feldstein notes, much of the massive stimulus package being implemented in the U.S. is in the form of tax cuts, which are likely to go into savings as households try to rebuild their balance sheets. And many of the public works projects will take years to implement. This, he suggests will require a further, equally sweeping stimulus package, but one much more targeted at immediate increases in demand.

The problem is that sooner or later, stimulative spending in the U.S. (and the rest of the world) will begin to push up interest rates, which could in turn choke off any recovery. Thus Feldstein closes on a note of uncertainty:

So it is not clear what will occur to reverse the decline in GDP and end the economic downturn. Will a sharp dollar depreciation cause exports to rise and imports to fall? Will a rapid rise in the inflation rate reduce the real value of government, household, and commercial debt, leading to lower saving and more spending? Or will something else come along to turn the economy around. Only time will tell.