[This is an English version of an article that appeared the Italian newspaper Il Sole 24 Ore on the 24th September.]

Today, the U.S. economy stands poised between persistent inflation and slowdown. Even as many measures in the production side of the economy signal continued strength in the economy, forward looking indicators such as housing prices, residential investment, and the yield curve point to substantially weaker growth going forward.

The question of whether the U.S. encounters something more serious than a slowdown, and falls into a recession, takes on a heightened importance given that the glimmers of sustained growth in other parts of the global economy are threatened by cost pressures, and the scope for counter-cyclical fiscal or monetary policy in the United States is more circumscribed than it has been at any other time in the past decade.

On the first point, most analysts agree that the U.S. economy is facing a period of slower, albeit still positive, growth somewhere between one and two percent in the second half of 2006, with perhaps an acceleration to between two and three percent in 2007. On the plus side is the ever resilient consumer, as well as still strong non-residential construction. Furthermore, while oil prices remain quite high by historical standards, the recent fall-off has relieved pressure on household budgets, and is likely to reduce the drag on output growth coming from the trade deficit.

On the negative side are a complicated — and perhaps unprecedented — combination of factors and constraints. First is the deflating housing boom. While the official statistics still report year-on-year increases in housing prices in the second quarter, the extent of the deceleration has surprised many analysts. Anecdotal evidence pertaining to the period since the second quarter suggests falling prices in a number of regions. The consensus view is that the wealth effect working through housing prices is sufficiently small that consumption growth will be only moderately affected, and this may turn out to be the case. However, the run-up in housing prices has occurred during a period when there has been substantial financial innovation in mortgage markets, so that the effect on the marginal mortgage owner that has taken out — think about those “zero-interest” loans — may be quantitatively different from what has been seen in the past.

If the U.S. economy slows down, but maintains sufficient momentum to continue growing, the resulting outcome may actually facilitate the process of global rebalancing. Slower growth in the United States shrinks the trade deficit, maintains the downward pressure on oil prices and takes the pressure off central banks to keep on raising policy rates further. But in order to avoid a serious global slowdown, the economy must tread a very narrow path; if the U.S. economy falls into recession, then the recoveries in Europe and Japan may sputter out. If at the same time the measures undertaken to cool off the Chinese economy are more effective than anticipated, that may mean another source of world demand will be removed at exactly the wrong time.

The current episode is distinguished from previous ones by a set of constraints on policy that did not exist before 2001. First, using fiscal policy — aside from automatic stabilizers — is much less plausible than it was at the beginning of the last recession in March 2001. As many recall, before the implementation of the Economic Growth and Tax Relief Reconciliation Act of 2001, the Congressional Budget Office was projecting enormous surpluses as far as the eye could see. Even if in hindsight some of those projected revenues were unlikely to materialize because of the transitory nature of the stock options phenomenon, there is no denying that the budget surplus was slightly over 1% of GDP in fiscal year 2001, while in fiscal year 2006, with the economy running at near full employment, the budget deficit is projected to be around 2%. Furthermore, the deficit is likely to rise even if the economy maintains growth at consensus rates. But it’s not only the budget deficit that places constraints on discretionary fiscal policy. The stock of Federal debt held by the public has increased enormously, from $3.3 trillion to a projected $5.6 trillion (end of fiscal years), at exactly the same time that the prospect for even greater funding requirements for entitlements looms on the near horizon. The addition of an enormous new prescription drug entitlement (officially called Medicare Part D) only worsened the long term fiscal position of the U.S. Government. Indeed, GAO estimates that this single provision added $8.7 trillion dollars worth of contingent liabilities to the Federal government’s exposure, fully 50% larger than the estimated Social Security exposure. Hence, borrowing for expansionary fiscal policies — either tax cuts or increased transfers — may encounter weaker demand on the part of foreigners, as well as domestic residents, as these future borrowing needs loom. This in turn means that expansionary effect of budget deficits may be much smaller and costlier at exactly the time that we need the help of fiscal policy.

What about monetary policy? It is an economic truism that you cannot hit two separate target variables with one instrument. With fiscal policy hamstrung, monetary policy needs to make tradeoffs in order to hit inflation and output targets. If energy prices continue their slide, it may be that monetary policymakers will have the leeway to drop the Fed Funds rate. But if, for instance, energy prices do not continue their fall, or a decline in the dollar’s value leads to a rise in import prices, then the Fed will be forced to choose between inflation stabilization and output stabilization. With Ben Bernanke at the helm, I think I know on which side he would err.

In fact, the choice may be more painful than what I have suggested in this scenario. In the wake of the dot-com collapse, monetary policy was successful in spurring economic recovery by encouraging a massive boom in residential investment. With the stock of housing at the end of last year 45% larger than it was at the end of 2001 2000 [change made 10/28 — mdc], it is not clear that a repeat performance is possible.

What I see as one possibility for monetary policy to work is by way of facilitating the shift of labor and capital to the export and import-competing sectors (mostly manufacturing, and some services). Expansionary monetary policy could accelerate the dollar’s decline, and lower interest rates might result in stimulating higher investment in plant and equipment in those sectors so that we avoid a recession. How a sharp descent in the dollar will affect economies abroad remains an open question.

Now, several studies have documented the fact that in the past, large current account imbalances in industrial countries have usually been unwound with few serious consequences to either output or asset prices. But I have to stress, these are uncharted territory. The textbook model I laid out above may not apply this time around. By virtue of the fiscal and monetary policies of the last five years, the U.S. is ever more dependent on foreign capital inflows to determine interest rates; and indeed the United States is as dependent as it has ever been (at least in the post-War era) on foreign official or quasi-state — not private investor — financing. How all the ties binding the world’s single largest economy will be unwound is something nobody can be certain of. What we can be certain of is that the choices made by policy makers in the past five years have circumscribed our ability to manage a downturn.

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