What's Ahead for the Economy in 2012

02/27/2012 11:15 am EST

Focus: MARKETS

David Wyss

Adjunct Professor, Brown University

Noted economist David Wyss discusses the current state of the economy, pointing out what investors should look out for in the coming year and what roadblocks could jeopardize the recovery.

What do you see ahead for this recovery? It doesn’t seem to be much of a recovery, does it?

Well, as I said, the good news is the numbers have plus signs in front of them. The bad news is, the numbers are still small, and I think it’s going to stay that way. It’s a half-speed recovery—not unusual after these kinds of debt-deflation recessions, but very disappointing, and I think very disappointing particularly to a lot of the American voters.

How often have these debt-deflation periods occurred?

Well, if you look worldwide, they have them fairly often. We just haven’t seen one in the United States since the 1930s, really.

The 70s were a bit different. That was an inflationary period, but you had some in Europe in that period. You’ve had some in Latin America. They’re different, but they all tend to be periods where you’ve got to get debt back in line. Where people have been living beyond their means. It’s not fun.

How painful is it going to be in the private sector and on the government side?

I think the worst is over. Things are beginning to improve—and unless Europe falls apart, I’ll think they’ll continue to improve—but it’s taking us a lot longer to bounce back from this than usual.

Usually a couple of years after recession you’re back to where you were. We’re still almost 6 million jobs down from where we were at the peak.

And after the 2012 elections, are you expecting to see real cuts in government spending?

God only knows. I don’t know what’s going to happen after the next election, because at this point, I just don’t see Congress being able to agree on anything. They’ve got to agree on changes to make the cuts that you need in the entitlement programs.

Social Security and especially Medicare and Medicaid are just eating up bigger and bigger shares of the budget and of US GDP. We’ve either got raise taxes or figure out how to cut those programs.

Would the economy be able to withstand an increase in taxes that would be significant enough to make a dent?

Well, if you did it right, yes. You have to do it gradually over time—cut spending, raise taxes, and over time you can get things back in line. Obviously, the risk is if you had, for example, a failure to extend the Bush tax cut, so that it hit all at once on January 1. That would be a pretty tough hit to the first quarter of next year.

Indeed it would. Talk to me about what your concerns are in Europe.

The concern in Europe is obviously the arrangements around the Greek...effectively the Greek default. Greece is not going to be able to pay off its debt. They’ve been offered a 50% haircut. In most circles, that would be considered a default.

There are other countries that aren’t too much behind them in terms of debt problems, including Italy, Spain, and Portugal. They’re going to want some kind of a haircut of their own.

If that’s done in an orderly manner, then it can be withstood. After all, we went through it in United States when the Constitution was signed, and state debt was assumed by the federal government at 50 cents on the dollar. That’s basically what’s going on in Europe now.

But even then, there has to be a clear, believable, credible arrangement so that this doesn’t happen again. So they’ve got to have and make sure that those restrictions that they’re putting on government borrowing stay in place and have some real teeth behind them, and they’ve got to make sure that it doesn’t happen in a disorderly fashion.

If things break down—say, taxpayers in Germany refuse to pay their share of the bills—then there’s a real risk I think of a financial freeze. Probably not quite as severe as the fourth quarter of 2008, but potentially pretty bad

In Europe or worldwide?

It’d probably be worldwide, because Europe’s a big part of the financial market, and if Europe freezes, that’s going to affect US banks as well.

Well, Europe would be more proactive, having seen what happened in the United States.

Well, they’re trying to be, but you’ve still got the same kind of political problems.

In a sense, it’s the old grasshopper and ant problem. You’ve got those grasshoppers down in Greece and Italy that have been living beyond their needs, and the German ants don’t feel like feeding them for the winter.

What’s to become, then, of the €2 trillion euros, which is $2.6 roughly US dollars? All that monetary creation, QE bailout, whatever you want to call it, to take care of all this debt from Greece throughout the European banking system, which cannot fail and is very, very important to Europe.

What are the longer term implications? You’ve spoken to us for years about democracies and the political reality that the temptation is too great to inflate your way out of all this government spending.

Yeah, but to be fair, that’s not our immediate problem. I don’t think inflation is going to be a problem in the near term.

They’ve done the same thing we have. If you look at the increase in ECB assets, it’s pretty much in line with the increase in Federal Reserve assets. Quantitative easing in both regions has led to that inflation.

The Bank of Japan did the same thing back in the 1990s. Have you noticed any inflation in Japan over the last 20 years?

No.

Until the economy gets back to normal, this is not going to result in any inflation. But the central banks have got to be careful to withdraw that funding as the economy starts moving back toward normal...and there will be political pressure on them not to do it.

As I recall your colleagues, your former colleagues at Standard & Poor's are making projections going out toward 2014, I believe, being the first time they really see any pick up in the ten-year Treasury bond or in inflation. Is that your guess?

I think long range, it’s going to be a while, depending on what happens with the government budget. I think that you’ve probably got at least a year or two before we get back to anything that resembles normal. Until we get back to something that resembles normal, than other than commodity prices, it’s hard to see much inflation creeping into the system.

So I get what you’re saying David. What that tells me is markets are going to be very, very irritable, because if you’re going to have a very slow, stall-speed recovery and if you’re going to have an open question is still whether we’re going to be in a Japan-style deflation or an inflation, you will have a lot of volatility.

Yes, but we’ve had that for a while, and I do think it’s looking better now than it did.

Barring a failure of the European compromise, I think it will continue to improve. But it is going to be a very slow process, and I think that does mean markets don’t have their normal bounce. This is not the 1980’s.

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