I'm always trying to find just the right-sized nutshell to put things into. You want to capture the essential dimensions of the debate without oversimplifying, but without writing a novel either.
We have a recession because consumption and investment have fallen sharply (axiomatic).
Concurrently (or perhaps causatively), we've seen a precipitous fall in the level of indebtedness by individuals and private businesses (the "credit crunch").
The government is stepping into the breach, with far higher deficit spending. Some of this is automatic, as tax collections fall with the decline in private income, and some will be an intentional fiscal stimulus.
Now the world's investors still have a large appetite for assets. They've executed a gargantuan substitution, amounting to many trillions of dollars, from risk-bearing assets to relatively risk-free (and more dollar-based) assets. That's for sure, although it's not sure whether this is a cause or an effect of the overall economic weakness.
I'd love to see someone analyze whether the term structure of the world's financial asset base has changed along with the risk profile. I have neither the data nor the formal economic training for the job.
As a result, the
The unstated assumption of policymakers is that this
consumption indeed must be replaced. This assumption is natural with people
(including the President of the
The great fear is of a deflationary spiral and a repeat of the Great Depression or of the Japanese "lost decade." The objective of massive deficit spending is to reflate the economy.
But there are critical limits to this process, as the Japanese learned. Real interest rates need to rise high enough to attract enough capital to finance our reflation effort. At what point do those rates go high enough to choke off private industrial development, not only here but also elsewhere in the world? (To ask this question assumes that rates aren't ALREADY that high, which they in fact may be.)
At some point, increased deficit spending will not be enough to counteract deflation. And there are good reasons to suppose that this point will come at a level of GDP and unemployment that is well below the norms of the recent bubble years.
When we reach that point, the only way to continue is by explicit money creation, or direct inflation. (In fact, we'll probably be doing quite a bit of this anyway, as the Federal Reserve moves into activities designed to directly support the creation of private credit.)
At that point, we'll have reached a natural limit to economic growth, in the prevailing climate of low real, risk-adjusted rates of return on capital.
No one can predict where that level may be. Although I'm well known as the polar opposite of a goldbug, I suggest you watch the dollar price of gold, which might increase as we reach the balance point.
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