Significant progress has been made in repairing the economy in the United States over the past three years. Consumers and businesses have both substantially reduced their debt, and corporate profits remain strong. Manufacturing is making a comeback in the United States as the weaker dollar and a growing middle class in the emerging markets are creating a demand for American products, and American banks are much healthier after being forced to write off bad loans and raise additional equity.
Despite these positive developments, recently released economic data indicates the recovery has been waning. With uncertainty surrounding Europe's debt crisis and indecisive politicians in the U.S. and around the world, consumer confidence is fading.
Although inflation remains low, the drought in the Midwestern U.S. is beginning to push up food prices. Unemployment continues to remain stubbornly high, at 8.1 percent, and businesses aren't investing as much because of all of the uncertainty. There is the real possibility that the U.S. will fall into another recession.
In an effort to stimulate the economy, the Federal Reserve has kept interest rates near historical lows. While this policy has prevented the economy from falling back into a recession so far, they have been largely unsuccessful in spurring consumers and businesses to spend and invest more.
Does this mean the economy is headed for a recession? More importantly, will the debt burdens faced by the United States and other developed countries create enough political and economic turmoil to plunge us into another depression?
A recession is a period of at least two consecutive quarters of negative GDP growth, which usually results when a period of economic expansion leads to an oversupply of goods produced. When growth begins to slow, businesses cut back on production, lay off workers, and lower their prices. This is a normal part of the economic cycle.
Each recession is unique, but all are characterized by a reduction in borrowing, spending and investing. The most common culprits are inflation and rising interest rates, but a reduction in bank lending because of an increase in bad loans can also contribute to a recession. A global crisis has the potential to bring about a recession as well if it causes rampant pessimism regarding future conditions.
Any one of these factors by itself typically would not cause a recession. A recession is likely when one or more of these factors are present when business activity is high, or is combined with an external shock to the economy.
Currently many of these factors are not present in the economy. Inflation remains low because of the increasingly global nature of the economy. Companies cannot raise prices so they continue to find ways to keep their costs low. Interest rates also remain low, and banks are finally beginning to lend again. Finally, the dollar is cheap relative to the currency of most of our trading partners.
However, the debt crisis in Europe, combined with nervousness surrounding the political climate in the United States, is causing consumers and businesses to be pessimistic about future conditions. This could be the catalyst that pushes the economy into a recession in 2013. Some believe the contraction could become so severe it turns into a global depression, but this scenario is unlikely as long as the federal government avoids making the policy mistakes that contributed to the depression in the United States in the 1930s.
In 1928 and 1929, the Federal Reserve raised interest rates to curb Wall Street speculation. Some economists believe this was the catalyst that turned what could have been a normal cyclical downturn into the stock market crash in 1929. Then, a series of policy mistakes allowed the crash to lead to the Great Depression.
After the stock market crashed, total spending and investment fell drastically because of rampant pessimism. Businesses responded by reducing production, and unemployment soared to 25 percent. Economists believed that the economy would quickly adjust with a drop in the wage and price levels, and gradually the lower prices would entice consumers to resume spending and the economy would return to full employment.
However, the Federal Reserve wanted to punish Wall Street for their speculative practices in the 1920s, so the Fed refused to bail out the failing banks. As many banks went under, a panic ensued leading to runs on previously healthy banks, causing many of them to fail as well.
In order to resurrect the economy the federal government passed President Roosevelt's New Deal Acts from 1933 through 1938, and while the legislation did much good, it also included controls on wages, prices, and production.
These controls, along with protectionist trade policies, prevented the economy from recovering because businesses could not lower prices, wages and production levels for the economy to adjust to the lower demand.
America's experience during the Great Depression can give us some insight into what policies should be followed today. During the election of 1936, Roosevelt decided to reduce the deficit because many feared the country would go bankrupt if the government kept increasing spending. After the election, government spending was cut and payroll taxes were introduced to fund new social programs. Many economists believe these moves caused the nation to sink back into the depression in 1937.
If we want to prevent history from repeating itself the last thing that is needed in the current environment would be to repeat the restrictive economic policies that were enacted in 1937. Increasing taxes or reducing government spending now could potentially turn a normal slowdown in business activity into a recession, or worse.
Some believe that we can accomplish immediate deficit reduction while spurring economic growth. They believe that cutting government spending would cause interest rates to fall, which would encourage private investments and economic growth through an increase in business and consumer confidence. This theory has several holes.
Interest rates are already near zero, yet economic growth remains anemic. Initially, a reduction in government spending would remove much-needed liquidity from the economy and likely cause tax revenues to fall, forcing the government to raise taxes in order to balance its budget. The combination of spending cuts and tax increases would reduce consumption, lower investment and lead to higher unemployment. In effect, it would likely bring about the very recession we are trying to avoid.
Those who believe in immediate deficit reduction also believe any additional government spending will lead to the dollar being devalued and eventually replaced as the world's reserve currency. This would be catastrophic because the resultant selling of U.S. Treasuries would cause interest rates to skyrocket and bring economic growth to a halt.
However, although the United States is in a difficult budgetary position, the dollar is still much better than the alternatives. Europe is a mess, and many believe the Euro will cease to exist in its present form. China's government is too corrupt for the world to trust the Yuan. China is also the largest holder of U.S. Treasuries, so they are very reluctant sell them on a large scale because that would hurt the value of their remaining holdings.
The government debt in the United States is around $16 trillion, which is about 100 percent of our Gross Domestic Product (GDP). However, this is not the highest debt to GDP ratio in the history of the United States. America's Debt/GDP reached 117 percent after World War II. Although the total debt continued to climb in the United States, the Debt/GDP dropped to 36 percent by 1973. It was strong economic growth which brought the ratio back in line, not cuts in government spending.
Again in the 1990s an economic boom, this time spurred by innovation in the technology industry, brought down Debt/GDP to 56 percent by 2001 after being as high as 66 percent in 1993, despite a rise in the nation's total debt.
In contrast, look at Japan's experience in the late 1990s. At that time Japan attempted to reduce its deficit during a period of weak demand and near-zero rates. Most economists say the move brought about a prolonged period of weak growth which became known as Japan's Lost Decade.
Still, the U.S. government cannot continue to run trillion-dollar budget deficits forever. In my opinion the appropriate course is shor-term government spending that is targeted in a way that generates a high return on investment, such as through building infrastructure, combined with a long-term reduction in entitlement spending that would reduce the deficit.
This strategy would enable us to repair our aging highways and bridges while creating jobs and generating additional tax revenues. Longer term, we need to settle on a credible deficit plan that includes cuts to entitlement programs which would take place when the economy is on firmer ground.
Using history as a guide, our leaders should be able to form a set of common sense solutions that would reduce the deficit over the long term while allowing the frail economic recovery that is under way to continue.
Guest columnist Sommers is a director and portfolio manager at Fusion Investment Group, LLC in Pittsburgh. He has an MBA from the University of Pittsburgh's Katz Graduate School of Business, is a Chartered Financial Analyst and a member of the Pittsburgh Society of Financial Analysts and the CFA Institute. He is often invited to speak about investment and economic topics by business groups, television and radio stations and has been featured in The Wall Street Transcript.