Falling back to earth

The depth of the contraction and the weakness of the recovery are both result and cause of the ongoing economic fragility. They are a result, because excessive private sector debt interacts with weak asset prices, particularly of housing, to depress demand. They are a cause, because the weaker is the expected growth in demand, the smaller is the desire of companies to invest and the more subdued is the impulse to lend. This, then, is an economy that fails to achieve “escape velocity” and so is in danger of falling back to earth.

Now consider, against this background of continuing fragility, how people view the political scene. In neither the US nor the eurozone, does the politician supposedly in charge – Barack Obama, the US president, and Angela Merkel, Germany’s chancellor – appear to be much more than a bystander of unfolding events, as my colleague, Philip Stephens, recently noted. Both are – and, to a degree, operate as – outsiders. Mr Obama wishes to be president of a country that does not exist. In his fantasy US, politicians bury differences in bipartisan harmony. In fact, he faces an opposition that would prefer their country to fail than their president to succeed. Ms Merkel, similarly, seeks a non-existent middle way between the German desire for its partners to abide by its disciplines and their inability to do any such thing. The realisation that neither the US nor the eurozone can create conditions for a speedy restoration of growth – indeed the paralysing disagreements over what those conditions might be – is scary.

This leads us to the third big point: the dire consequences of soaring risk aversion, against the background of such economic fragility. In the long journey to becoming ever more like Japan, the yields on 10-year US and German government bonds are now down to where Japan’s had fallen in October 1997, at close to 2 per cent (see chart). Does deflation lie ahead in these countries, too? One big recession could surely bring about just that. That seems to me to be a more plausible danger than the hyperinflation that those fixated on fiscal deficits and central bank balance sheet find so terrifying.

A shock caused by a huge fight over fiscal policy – the debate over the terms on which to raise the debt ceiling – has caused a run into, not out of, US government bonds. This is not surprising for two reasons: first, these are always the first port in a storm; second, the result will be a sharp tightening of fiscal policy. Investors guess that the outcome will be a still weaker economy, given the enfeebled state of the private sector. Again, in a still weaker eurozone, investors have run into the safe haven of German government bonds.... The risks of a vicious spiral from bad fundamentals to policy mistakes, a panic and back to bad fundamentals are large, with further economic contraction ahead.

Yet all is not lost. In particular, the US and German governments retain substantial fiscal room for manoeuvre – and should use it. But, alas, governments that can spend more will not and those who want to spend more now cannot. Again, the central banks have not used up their ammunition. They too should dare to use it. Much more could also be done to hasten deleveraging of the private sector and strengthen the financial system. Another downturn now would surely be a disaster. The key, surely, is not to approach a situation as dangerous as this one within the boundaries of conventional thinking.