Fred Carstensen: We're in for a Lost Decade

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by: Harlan Levy

Economist Fred Carstensen is a professor of economics at the University of Connecticut and executive director of the university's Center for Economic Analysis.

H.L.: What do you predict is the real effect of the Federal Reserve’s plan to buy $600 billion worth of Treasurys – and what do you think of Fed Chairman Ben Bernanke’s defense of the move against other countries’ negative reactions?

F.C.: It’s exactly what the late economist Milton Friedman, the great guru of conservative economic thought, would want him to do. There’s no question that it’s the right strategy, and there’s no question that it’s actually working. The American stock market is up 14 percent since Bernanke announced in August that he would do this. And it’s gotten investors to switch from government debt to equities. Household wealth has increased $1.3 trillion as a consequence, and households feeling somewhat wealthier will consume somewhat more.

The hope is that the shift in investments will also help convince companies to expand. So insofar as the Fed police can actually influence financial markets, it’s worked.

But there are two issues: First, it may not be large enough to really have a sufficient impact on economic performance. Second, monetary policy is like pushing on a string, because ultimately businesses respond to demand not supply. So, Bernanke has successfully improved the supply of credit, but American demand is still very weak. In fact, some significant share of the benefits from the policy flow out of the country and flow abroad. And because so much of what we consume is imported, it increases capital exports to China, Viet Nam, South Korea, and Germany and increases imports of merchandise, and those two processes tend to drive the value of the dollar down. It diminishes the demand for dollars and increases the demand for foreign currencies, because when you invest in China you have to convert your dollars into Chinese currency. The consequence is the demand for dollar falls. That’s why foreign countries are complaining about this, because it’s working. Meanwhile, the foreign countries that I mentioned are pursuing dynamic economic development strategies, improving their workforce, investing in education, investing in infrastructure. The U.S. is pursuing none of these strategies in any coherent way.

But let’s get this into perspective. The depreciation of the dollar is much, much less than the depreciation that occurred during the Bush administration. There is no historical basis on which to complain about the change in the value of the American dollar or about the Fed’s policies by other countries or by the Republicans who are criticizing it and asking that it be stopped. The only reason they would want it stopped is because they want to thwart economic recovery. I do mean that the only motivation that I can understand is they want to thwart recovery. But the data demonstrate that the policy has been successful, but in a large sense, the policy has not and will not improve American economic performance.

H.L.: Where is the U.S. economy headed?

F.C: In general, the economy is going to grow at an anemic pace, and as a consequence it will generate relatively few new jobs. We will therefore continue to have relatively high unemployment rates for several years. I don’t see how we’re going to get unemployment rates below 8 to 10 percent in the foreseeable future. I don’t see where the job creation is going to come from.

Most forecasters have downgraded their projections for U.S. economic growth for the next two or three years from a range of 2.5 to 3 percent growth down to 2 to 2.3 percent annually. That is such a slow growth rate it will create very few jobs. We will not get a job recovery in the near future, and we are not making the kinds of strategic investments that are likely to strengthen our economic performance further out. Frankly, I think we’re in for a lost decade. I can easily see us limping along through the entire decade.

H.L.: What’s going to change it?

F.C.: It’s just a matter of effective political leadership and getting the people to understand the kind of perverse policies that we’re currently pursuing. There’s a huge mythology that’s been out there over the last 30 years that government doesn’t do anything useful, Yet it’s public-sector investment in human capital and infrastructure that is at the heart of America’s historic economic success and it is precisely the strategy that these competitive economies are now pursuing. India and China are in fact making massive investments in education, rfeserach and development, and infrastructure. It is making them progressively more competitive, even as America becomes less competitive.

H.L.: Is the economy threatened by deflation -- the downward cycle of prices, leading to lower profits, then lower wages, then fewer new jobs, and more layoffs -- that feeds on itself, drains the economy, and keeps it flaccid?

F.C.: No. There is some small threat of deflation, but the Federal Reserve is going to do everything imaginable to prevent that from happening. If we got into a deflationary cycle it would be extraordinarily destructive.

H.L.: Will the resurgent Republicans solve our economic problems with the plans they’ve announced, or will their goal of blocking all Democratic initiatives paralyze the economy and the nation even more than they already are?

F.C.: Yes. I have seen nothing in the Republican proposals that suggest anything, any strategies or initiatives that would help to drive economic recovery. They talk about budget cuts. Well, budget cuts are going to reduce the number of people who are employed, reduce the demand for goods and services, so inherently what the core set of proposals that Republicans seem to be committed to enacting would clearly be a drag on the national economy.

H.L.: So you seem to think that the deficit hawks are wrong in their approach to healing the economy?

F.C.: Reducing the deficit in the short term in the face of a weakening economy inevitably weakens the economy further. That’s simply basic economic analysis that has nothing to do with ideology.

H.L.: Should all the Bush tax cuts be extended or just those for people earning less than $250,000 a year?

F.C.: Keep them, kill them, it won’t make much difference either way. The reason is that the Bush tax cuts themselves delivered very little benefit to the American economy. Following the Bush tax cuts we had the lowest level of business investment in 50 years. We had a very weak job recovery. The benefits of the Bush tax cuts both in consumption and in investment largely flowed out of the country. They benefited the global economy. They did not benefit the American economy. We import our consumption goods and the attractive investments are in emerging markets, so the money did not stay here.

Disclosure: No positions