Tuesday, May 25, 2010

Long Term Versus Short Term Threats To The Economy

While US debt is expected to reach 60 percent of GDP this year, James Picerno describes the threat of a double-dip recession as a more urgent matter. The period following a deep recession tend to be dangerous times for a recovering economy, and the European debt crisis is making matters worse . See the following post from The Capital Spectator.

Everyone knows that the U.S., and most of the mature economies around the world, are swimming in a sea of red ink. The great unknown is the degree and form of the blowback. The optimistic view is that the pain will be relatively mild and that the recovery in the world economy will help nations grow their way out of the problem. But what if growth isn't sufficiently strong or durable? In that case, the future may be quite a bit less rosy than the optimists predict.

The bond market recently has been pricing in a somewhat darker outlook, as we discussed last week. Stock and commodities markets are now joining the party, as the selling bias of late suggests. The only thing worse than a load of debt weighing on the economy is a load of debt that triggers a general decline in prices. To the extent that a hefty debt load is a contributing catalyst, we can't yet rule out that possibility. As the sobering assessment of the Committee for a Responsible Federal Budget asserts,

The current fiscal path of the United States government is unsustainable. For the past forty years, our debt-to-GDP ratio has averaged around 40 percent. This year, it is projected to exceed 60 percent, the highest point since the early 1950s. Under the President’s budget proposals, the fiscal situation will continue to deteriorate even as the economy recovers. By the end of the decade, debt is projected to be 90 percent of GDP, approaching our record high of around 110 percent after World War II. Things will deteriorate further as the Baby Boom retirement accelerates. Ten years later, the debt is expected to be well over 150 percent of GDP. By 2050, it is projected to be over 300 percent and still heading upward.
But history reminds too that recoveries after unusually deep recessions are a precarious beast. Focusing on budget austerity at this juncture may be self defeating if deflationary risks are again percolating, as the Treasury market appears to be telling us. Yes, inflation is a long-run risk, but not now, not today. What's required now, more than ever, is growth. But as Robert Kuttner reminds, "Austerity does not produce prosperity." At least not at this point in the economic cycle, even if fiscal rectitude is necessary and essential for the years ahead.

Some analysts warn that we shouldn't rule out a double-dip recession. In fact, avoiding another leg down in the broad economy is priority one, two and three. The risk also looms for Britain and the eurozone.

Welcome to the proverbial rock and the hard place. A double-dip recession isn't fate, at least not yet. As we wrote yesterday, we still expect the economy to muddle through, although that may not suffice to keep the big risks at bay. In short, a sustainable economic recovery isn't guaranteed. Much depends on how governments and investors react in the weeks and months ahead.

The biggest test in the post-Great Recession era is... now. Forget the past 12 months. That was in many ways a misleading signal of what awaits. As we've argued many times on these pages and in The Beta Investment Report, bouncing off of end-of-the-world prices is a one-time affair. That's over and the real economic challenge is upon us. Exactly what that means has yet to be determined. The details are inextricably bound up with debt, and how much pressure it puts on the global economy.

There will be many twists and turns on the road ahead, rife with lots of questions that lack obvious and compelling answers in the here and now. The one that currently looms: Will the European fiscal crisis trigger a global retrenchment in economic activity? No, according to Treasury Secretary Timothy Geithner. But the markets aren't yet inclined to agree and prefer instead to discount the risk a bit more these days.

This Post has been republished from James Picerno's blog, The Capital Spectator.
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