The Congressional Budget Office’s announcement Wednesday that 2009’s budget deficit was going to be $1.19 billion - before a nickel of President-elect Barack Obama’s stimulus plan has been included - raises a crucial question for the U.S. economy: Is there too much stimulus, and what effect would too much stimulus have?
There is certainly more stimulus than in any previous recession. The benchmark Federal Funds rate is essentially at zero, which has never previously been attempted, while inflation is still positive. The money supply has been increased by almost 20% in the last three months, which one would normally expect to lead to higher inflation.
On the fiscal side, the $1.19 trillion deficit forecast by the CBO is 8.3% of gross domestic product [GDP], considerably higher than the previous record of 6% of GDP in the recession-ridden year of 1983. And that deficit calculation doesn’t include President-elect Obama’s stimulus plan, which at $800 billion over two years could add $400 billion to the deficit and push it to more than 10% of GDP.
With both monetary and fiscal stimulus stronger than ever before in peacetime, the government is running the economy absolutely flat-out. Only if you thought the government had no effect at all on economic activity could you believe that recession and deflation would continue.
The initial rationale for all of this stimulus was the unprecedented nature of the housing finance disaster, with drops in market prices and loan-loss levels not seen since the Great Depression. Had the U.S. banking system imploded - as it seemed destined to back in September - the resulting recession could indeed have rivaled the Great Depression.
However the $350 billion from the first tranche of the Troubled Assets Relief Program [TARP], mostly invested directly into bank capital (although a number of banks admittedly used the taxpayer-provided infusion to play "let’s make a deal"), appears to have stabilized matters.
JP Morgan Chase & Co. (NYSE:JPM), for example, is expected to make losses of around $2 billion in the fourth quarter of 2008 - a nasty result to be sure but by no means unexpected in a quarter when stock markets dropped 20% and illiquidity was at its height. With $25 billion of new capital from Uncle Sam, JP Morgan now has plenty of wiggle-room to survive - even in an extended downturn.
In 2009, further trouble may lurk for the weaker U.S. banks, but strong banks like JPM should gain market share and do quite well.
With liquidity now largely restored by both the TARP and by federal asset purchases, there would seem no reason why the banks’ corporate lending should be any more restricted than in previous moderate recessions. In those circumstances, the unprecedented fiscal and monetary stimulus should, in the short-term, produce a stock market bounce, an economic recovery, a dramatic run-up in the price of gold, and soaring inflation, in that order.
The conventional wisdom is that the U.S. economy will have a very difficult first half, but that recovery may appear in the second half of 2009.
These things are very difficult to predict, but my money would be on precisely the reverse scenario: The stock market will be strong in the short-term, and economic numbers will turn around quite rapidly, perhaps even producing modest first-quarter GDP growth, and quite robust economic growth in the second quarter.
By late summer, however, the resurgence in inflation and financing difficulties in the U.S. Treasury bond market will cause an increase in long-term interest rates, accompanied by a reassessment of the U.S. Federal Reserve’s 0% short-term interest rate policy.
That will cause the stock market to reverse direction and head downward.
Serious consumer price inflation will take longer to appear. But by the end of the year and in the first half of 2010, prices will be rapidly rising. Accordingly, both the Fed and the Obama administration will have to begin reversing their stimulative policies, raising interest rates and cutting public spending - or even raising taxes. The policy reversal will cause a second economic downturn, but one that’s of a very different nature from the first.
The current downturn has been caused by a collapse in asset prices, and has been reversed by exceptionally strong monetary and fiscal stimulus policies. However, the second downturn will be sparked by a crisis in the long-term bond markets, will be more concentrated on the real economy than on just the financial sector, and is likely to be much more prolonged since fiscal and monetary policies will be forced to be restrictive.
Monetary policy will have to be tightened to fight surging inflation, while fiscal policy will foster a lengthy battle in the administration and in Congress between the economic necessity of austerity and its hugely unattractive political effects.
Reversing such extreme fiscal and monetary policies will be exceptionally painful, and the second leg of the recession will thus be exceptionally damaging to U.S. corporate profits and to U.S. stock prices. The stock market is likely to take out its November lows by a considerable margin, although at its nadir it will offer patient investors an exceptional long-term bargain - just as it did in 1932, 1949 and 1982, with high real long-term returns for those bold enough to invest.
Currently, the balance of probabilities favors a rising market in the short term - perhaps even rising quite sharply because of the exceptional strength of the current monetary and fiscal stimulus. Gold and gold-mining shares should do particularly well.
Let’s enjoy this projected short-term bull run while it lasts!