Diane Swonk: Chance of a Double Dip Now More Than 20%

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Includes: DIA, QQQ, SPY
by: Harlan Levy

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Diane Swonk is a senior managing director and chief economist for Chicago-based Mesirow Financial. Last week she and other top economists attended the Federal Reserve’s annual policy retreat at Jackson Hole, culminating in Fed Chairman Ben Bernanke’s Friday speech pledging to revive the sagging U.S. economy.

H.L.: Bernanke said the Fed has more weapons in its quiver to fix the economy. Do you believe it?

D.S.: Bernanke made it clear that he would do everything he can to avert a double dip recession. I feel he will be forced to do something, which is unfortunate, and nobody knows in these uncharted waters whether it will be effective or not. That’s the real problem. Everyone keeps looking for a road map, but there is none.

H.L.: What is Bernanke most likely to do?

D.S.: He laid down a list of potential things to do, but only one rose to the top: increasing the size of the Fed’s balance sheet by buying more mortgage-backed securities, more agency debt, more Treasury bonds. The hope is that it will not only reduce interest rates, which are already extremely low, but will help the churn of the loans in that arena. They also want to make sure they don’t inadvertently tighten credit. They could buy another $300 billion of Treasury assets or private sector assets. They could buy commercial paper. Their ideal would be to somehow reignite small business and more consumer lending. But that’s the most difficult kind of lending to reignite.

H.L.: After last week have you changed your forecast of a 20 percent risk of a double dip?

D.S.: It’s close to 20, but it’s starting to move up. There’s a lot of angst. The hope is high that we can avert it with intervention by the Federal Reserve. But those people who aren’t optimistic about the economy wonder whether the Fed has the effectiveness to do anything about it.

The only good news last week was the revision to the second-quarter Gross Domestic Product data (from 2.4 percent growth down to 1.6 percent), which wasn’t as bad as it could have been. But you’re celebrating something that you can’t be popping Champagne corks over. The third quarter is going to be another stagnant quarter in the 1.5 to 2 percent range. We’ll probably cross 2 percent and approach 3 percent in the fourth, and that’s good news, but any way you cut it, this is a small fraction of what we should be seeing, given the depths of the declines, Unfortunately, and it was very evident from the conference, this is what’s to be expected, given the damage we did, running up the crisis. This is the payback, and it’s going to hurt people.

H.L.: What can Congress do?

D.S.: Anyone who has ever been through any kind of restructuring in a company or who has had to tighten their belts knows that pain has to be shared, spending has to be cut, and taxes have to be raised. To eliminate the healthcare bill will not solve our healthcare problems in our country. We have costs that are running out of control. We have a system that’s broken, and we keep trying to fix a broken system rather than come up with something different. And you cannot reduce the deficit just by cutting spending and cutting taxes. It doesn’t work that way. On the other side of it, you can’t reduce the deficit by spending forever. We have to stop electing people who continue to promise us the moon in terms of tax cuts or spending increases and start looking hard at our priorities.

H.L.: What should we do?

D.S.: First, you can’t do deficit reduction today, because it would undermine an already fragile economic situation. Frankly, we’ve got a little bit of a window because of the fact that we have a reserve currency, and we’ve got very low interest rates on our deficit. Those things are helping to cushion the blow to us of the fact that we’re financially irresponsible. That said, if you don’t make a plan for reducing the deficit today, you’re never going to get it down.

So you need to put things into place over the next five to 10 years. Taxes on capital gains are more productive for society than income taxes. You want to encourage capital gains taxes. We also know that high-income households save a lot, and if you reduce their taxes they don’t necessarily spend a lot more. Also, we should raise the retirement age for Social Security, which was based on a time when most people over 65 were not alive, and that is not the case any more. You can make Social Security solvent for 90 to 99 percent of Americans by restraining what the very wealthiest households get. For the top 1 percent, they’re not going to get it.

Those kinds of decisions need to be made more thoughtfully rather than the scapegoating that’s gone on, the simplistic decisions, the sound-bite solutions that we hear, because frankly they’re not going to get us where we need to go. And both parties in Congress have been incredibly bad at coming to any kind of a consensus. The partisanship is really undermining our ability to function as an economy going forward.

Democracy is such a downer in my view. It’s not even representational any more. It comes from years of gerrymandering districts so you only get extremists elected in certain districts, and they only represent a fraction of the whole. We have a government that represents pieces, and it’s certainly not willing to come to any decisions. That’s the worst of all, because indecision at this stage of the game is our enemy.

H.L.: How can we change that?

D.S.: That’s our responsibility. We’re the ones who elect these people. You have to think hard about sending a message to Washington about compromise.

Disclosure: No positions