Following two years of modest but positive economic growth, the past few weeks have been unsettling. The U.S. government came unnervingly close to a self-induced default. Real sovereign debt crises at a number of European countries threaten another banking crisis in Europe. Standard & Poor’s downgraded the U.S. long-term credit rating.
Wild gyrations in the stock markets were accompanied by a record low rate on the 10-year Treasury bond. The Fed announced that it will keep the federal funds rate on the floor for at least two more years.
Any one of these alone would be cause for serious concern, but taken together in such a short span they are alarming. Underpinning most of the issues is the growing concern that the U.S. economy might be slipping back into a double-dip recession. Let’s look at each item, and then turn to the implications.
The debt ceiling debate. Those European countries verging on default are in that position because they are running huge budget deficits and no one is willing to lend to them anymore. In contrast, investors all over the world are more than willing to lend to the U.S. Nevertheless, we almost defaulted on our obligations voluntarily, when we came close to not crossing a self-imposed limit on our national debt.
Two days after the Senate vote, the stock market fell by almost 5%. That was probably due to concern about a weakening economy coupled with investors figuring out that any fiscal stimulus in response is politically off the table.
European sovereign debt crises. Three of the smaller European countries appear to be unable to meet their obligations without a bailout from the rest of the Euro zone: Greece, Portugal and Ireland. Two larger countries considered too big to fail are also running out of options: Italy and Spain. These debt crises weaken near-term growth prospects in Europe, weakening the outlook for U.S. exports to Europe. More acute is the chance that one or more of the very large European banks that have loaned substantial amounts to these weak countries could themselves fail as a result.
U.S. debt downgrade. As S&P describes it, the downgrade had everything to do with politics and almost nothing to do with economic fundamentals. The dysfunction revealed in Congress’ inability to come to a long-term deficit reduction plan, despite the underlying strength of the U.S. economy, was the reason for the downgrade.
Tellingly, the day after the downgrade, the stock market tanked while Treasury interest rates dove.
That’s curious, because debt downgrades usually cause the debtor’s borrowing costs to rise, not to fall. In this case, investors know there is no chance the U.S, will default (keeping Treasury rates low), but they also know that near-term fiscal austerity will weaken the economic outlook (reducing stock prices) and keep inflation expectations low (lowering Treasury rates.)
Wild financial market gyrations. The recent string of 3% to 5% daily changes in stock values are very unsettling to households. Unless we end this volatility with a series of positive changes restoring most of the latest declines, consumer confidence will suffer.
The Fed’s two-year announcement. The Federal Reserve’s announcement about keeping the Fed funds rate low until mid-2013 has frequently been mischaracterized. What they actually said was weak economic conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” The Fed does not expect sufficient improvement in the economy to raise interest rates for at least two more years. If the economy surges before then, it will raise rates sooner.
So what does all this mean for credit unions? The revelation of the past month is not that we have mounting debt problems around the world. We already knew that. The real news is that the world economy is weaker than previously expected, with the possibility of falling back into recession. Credit unions can expect a weaker economy going forward because of this. The odds are still for a resumption of modest growth, but a double dip is more likely than we previously thought.
The stock market’s effects on consumer confidence will dampen loan growth for credit unions. With 10-year Treasury interest rates bouncing along record lows, 30-year fixed-rate mortgages are also approaching unheard of levels. Credit unions should expect a flood of refinancing of mortgages not underwater, unless rates quickly recover.
The debt ceiling mess and the debt downgrade tie the hands of the federal government in promoting an expansionary fiscal policy at a time of economic weakness, further lengthening the time until economic recovery. The overwhelming majority of mainstream economists understand that in an economy with substantial excess capacity (high unemployment), fiscal stimulus will get an economy back on its feet faster, or at least will slow further deterioration.
Most of us economists believe that what’s needed now is a dual policy: short-term fiscal stimulus coupled with long-term changes to entitlements and revenues to bring future deficits down. The fiscal stimulus would promote immediate growth.
The long-term deficit reduction would encourage expansion by a private sector not burdened by fears of future deficits. Unfortunately, the first part of this strategy is politically verboten, and the longer-term portion seems for now to be beyond the ability of our elected officials.
Bill Hampel is chief economist for CUNA.
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