Bernanke, Bush Fail to Build Better Economy With Cuts, Stimulus

By Rich Miller


Feb. 25 (Bloomberg) -- Even if Ben S. Bernanke, George W. Bush and Congress win the battle to avert a recession this year, they risk losing the war to strengthen the economy for the long term.

Growth will get a boost in the second half of this year as consumers spend some of the $107 billion in tax rebates passed by Congress and signed by Bush this month. The U.S. may suffer a letdown afterward as the kick from the stimulus wears off, leaving the economy vulnerable to its underlying weaknesses: a retrenching financial industry, indebted consumers and slowing productivity growth.

``This is not a one- or two-quarter phenomenon,'' says economist Neal Soss of Credit Suisse Group, who worked as an aide to former Federal Reserve Chairman Paul Volcker. ``This is not a V-shaped event. It's a slow-growth scenario.''

Fed officials see growth picking up to more than 2 percent next year as inflation ebbs to 2 percent or below. Fed Chairman Bernanke, 54, is slated to discuss the central bank's forecast in testimony to Congress Feb. 27 and 28.

So far, the Fed's deepest interest-rate cuts since 2001 haven't helped the financial markets or the economy. What they have caused is an increase in inflation expectations, with the price of gold soaring to a record $958.40 an ounce last week.

`Not Easy'

``The Fed is trying to stabilize the financial markets, the real economy and the price level with a single interest rate,'' says Louis Crandall, a former Fed official who's now chief economist at Jersey City, New Jersey-based Wrightson ICAP LLP. ``That's not easy to do.''

What's more, say economists Soss and Ethan Harris of Lehman Brothers Holdings Inc., policy makers face structural changes in the economy that aren't so susceptible to the traditional tools of interest-rate and tax cuts. As a result, Soss sees the economy expanding just 1.3 percent in 2008 and about 1.5 percent in 2009. Harris is even more pessimistic. He sees growth easing to 0.9 percent in 2009 from 1.1 percent in 2008 and 2.5 percent in 2007.

Fed officials acknowledged in the minutes of their last meeting Jan. 29-30 that they were having trouble getting ahead of the credit squeeze in financial markets.

The financial industry is curtailing credit and conserving capital after a decade-long boom in profits went bust in the third quarter. Following mounting losses on past loans, banks have already taken write-offs of $163 billion since the beginning of 2007.

Stingier

A Fed survey released Feb. 4 found that banks had become stingier in granting credit during the previous three months. Fed officials say they expect that to continue, making it harder for the central bank to stimulate the economy through lower borrowing costs.

``The Fed's policy tools may not be very well suited to deal with this particular situation,'' Robert McTeer, former Dallas Fed president and a fellow at the National Center for Policy Analysis in Dallas, said in a Bloomberg Television interview Feb. 20. ``The Fed can give liquidity to the markets, but the Fed cannot do much if the markets are afraid of solvency risks.''

Consumers, until now the driving force behind the expansion, are feeling the squeeze. While households will get a short-term boost from the coming tax rebates from Washington, their longer-run finances look shakier.

Households reduced their savings rate to virtually nil in December from close to 10 percent of disposable income 15 years earlier. That trend may reverse as credit becomes scarcer and home prices fall.

Credit-card companies are adopting stricter lending standards and making it harder for consumers to borrow, says Robert McKinley, president of Ft. Myers, Florida-based Cardweb.com, a research organization that tracks the industry.

Home Prices

That comes on top of the hit homeowners are taking from the drop in housing prices, which fell 7.7 percent in 20 metropolitan areas during November from a year earlier, according to the S&P/Case-Shiller price index.

Allen Sinai, chief economist at Decision Economics in New York, calls the pullback by consumers ``a seismic shift. For several years, the growth of consumer spending is going to be significantly below its long-run average of 3.5 percent.''

Consumers have also been pinched by the rising cost of food, fuel and other necessities. Inflation, as measured by the personal consumption price index, clocked in at a 3.5 percent year-over-year rate in December, the highest for that month since 1990.

Benchmark

The increase is stoking fears of more to come. The yield on the 10-year Treasury note, which acts as a benchmark for mortgage rates, rose to 3.80 percent on Feb. 22 from 3.44 percent a month earlier, even though the Fed reduced its overnight lending rate by 1.25 percentage points during the period.

Behind the heightened inflation concerns: slowing productivity growth, making it harder for companies to recoup higher costs through increased efficiency.

Robert Gordon, a professor at Northwestern University in Evanston, Illinois, says the surge in productivity that began around 1995 was a one-time event sparked by the advent of the Internet. He pegs the underlying growth rate of productivity at about 1.8 percent, down from a high of 2.9 percent earlier this decade.

Nobel laureate Edmund Phelps says there's little the Fed can do when faced with such a structural change. ``We've had a series of booms, and it seems to me they are now over,'' says Phelps, an economics professor at Columbia University in New York. ``As a result, we're going to see a period of slower growth than in the past.''