The conventional Washington wisdom is that the key to economic policy today is deficit reduction for 2011, and battles over spending cuts almost certainly will dominate our politics for the next several months. This so-called wisdom is the economic-policy equivalent of snake oil.Â Britain and Germany both tried it, and now both are struggling with significant slowdowns. The U.S. recovery remains modest, and the tax stimulus passed last December is the main reason why our economy should be able to take the fiscal drag from spending cuts without stumbling â€” and might well pick up if we forgo significant reductions. Donâ€™t take my word for it â€” just look at recent economic data.
Â The most important signals are coming from finance and housing, the two areas that ignited the financial meltdown of 2008â€“2009 and the deep recession that followed. The Federal Reserve knows the real story, which is why it pumped another $200 billion into the long end of the bond market early this year. The Fedâ€™s goal is to keep long-term interest rates low so housing and business investment can pick up. Well, itâ€™s not working, at least not yet. John Mason, a Penn State economist, has sifted through the latest banking data and found, as expected, that the cash assets at commercial banks increased by some $280 billion since early January. Hereâ€™s the rub: Only one-third of that increase shows up on the balance sheets of American banks, while two-thirds are logged to the accounts of foreign-owned banks operating here.
The second round of the Fedâ€™s â€œquantitative easingâ€ program has made foreign banks here cash flush, but they arenâ€™t serious lenders to American businesses or consumers. The main business of these foreign-owned banks is to keep credit flowing for the American operations of their big corporate customers from back home. As for our own banks, loans and leases generated by the 25 largest U.S.-chartered banks dropped by $50 billion since the New Year, mostly in shrinking consumer lending. The loan portfolios of the rest of the U.S. banking system expanded a little, but not in residential lending or commercial real estate, which each declined by more than $20 billion. More important, overall commercial bank lending is contracting. The big banks also dumped $67 billion in Treasury securities since the first of the year, while smaller U.S. banks expanded their Treasury holdings nearly as much. The big banks know what theyâ€™re doing: They sold to take their profits as Treasury rates inched up.Â
The data on business investment since January 1, 2011, arenâ€™t out yet, but the trend isnâ€™t very bullish. Business investments (not including inventories) grew throughout 2010. But their rate of growth has slowed since mid-year, from gains of over 17 percent in the second quarter of 2010 down to 10 percent in the third quarter and down again to 4.4 percent in the fourth quarter. That trend closely tracks the winding down of the 2009â€“2010 stimulus, which was largely spent out by mid-year. Consumer spending has been rising since the end of 2009 â€” again, thanks largely to the stimulus â€” but the increases have been too modest to drive strong gains in business investment or jobs.
The main reason why consumer spending remains pretty weak, even with the big stimulus, is housing. Once again, you can take the Fedâ€™s word for that. The primary asset of most Americans is their homes â€” the bottom 80 percent of U.S. households hold 40 percent of the total value of all U.S. residential assets, compared to just 7 percent of the total value of all U.S. financial assets. And the value of those residential assets continues to fall. According to the latest data, housing prices fell another 0.5 percent last December and stood 2.4 percent below their levels a year earlier. Thatâ€™s why 27 percent of all single family homes with mortgages today are worth less than their outstanding mortgage loans. And the most powerful force driving down those home values are the home foreclosures which have been rising steadily since 2008 â€” and are expected to increase another 20 percent this year. The Fedâ€™s latest $200 billion quantitative easing was designed to revive housing and business investment. But that canâ€™t happen when two-thirds of it is taken up by foreign-owned banks to meet the weekly credit needs of foreign-owned companies here.
There is another cloud forming on the economyâ€™s horizon, and thatâ€™s rising energy prices. The uprisings in the Middle East have rattled oil markets, and oil prices are up 25 percent since Thanksgiving. Four of the last six U.S. downturns were triggered by oil price shocks, including the first phase of the 2007â€“2009 recession. If the revolutions stop at Libya, they shouldnâ€™t have any major economic effects on our economy.Â But if they spread to the really big producers like Iran and Saudi Arabia, an economy still beset by weak business investment, falling housing prices, and fragile consumer demand could take a big hit. The most positive news is that last Decemberâ€™s tax stimulus â€” which, by the way, doesnâ€™t include the Bush tax cuts, since they were already in place â€” should bolster consumer and business spending later this year. The only reasonable conclusion is that the last thing the American economy needs right now is more spending cuts.