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Economist David Levy says the U.S. government will have to continue to finance the economic recovery with its balance sheet.
Vincent Ryan, CFO.com | US
March 9, 2010
Don't worry about higher interest rates or inflation, said one economist today. But also don't expect huge government budget deficits to shrink anytime soon.
The Federal Reserve won't be able to tighten interest rates for several years, and the U.S. government will have to continue easy-money policies and deficit spending for a lengthy period, said David Levy, an economist and chairman of The Jerome Levy Forecasting Center, on Tuesday at the CFO Rising conference in Orlando.
The reasons why current monetary policy will continue are purely economic. Economic healing will be slow, Levy told conference attendees, with the private sector unable to sustain any expansion on its own because it is still dealing with excess capacity and the need to shrink balance sheets.
Levy's assertions echoed statements made by economic policymakers elsewhere today. Christina Romer, a member of the Council of Economic Advisers, said in a speech that pulling back government spending would nip a nascent economic recovery in the bud. On another rostrum, Charles Evans, president of the Federal Reserve Bank of Chicago, stated that weak labor markets would justify low interest rates for quite a while.
"We're totally dependent on this federal government, no matter how clunky or clumsy; it is saving the day here," said Levy.
Last December Levy explained to CFO how the U.S. economy had entered into a period of "contained depression" — a transitional stage of debt reduction and asset deflation in which the federal government has to prop up the private sector with its own balance sheet. Today Levy said this economic stage could last as long as a decade.
The roots of today's problem were planted in the postwar period, according to Levy, when balance sheets grew faster than incomes. "The problem is that asset values have to be justified by returns they can earn," he said in December, "or by expectations of future capital gains, and that's where you get into bubbles."
Even now balance sheets are still clearly too large, and there is no more room for the Fed to cut interest rates, Levy said today. "We also aren't moving to easier, more-forgiving financial standards, but in the other direction," he noted. "So we've started to reverse this balance-sheet expansion process, but it's going to take a long time."
The problem is that an economy cannot produce profits without balance sheets expanding, Levy explained. "This is not a theory, this is not an observed correlation, this is a hard cold fact." So while companies reduce their debt-to-income ratios and the prices of assets come back into line with their earnings power, the U.S. government will be forced to continue to finance the recovery.
But contrary to popular wisdom, Levy said a sustained period of low interest rates will not spur inflation. "The most important long-term determinant of inflation is labor costs, and right now because of unemployment you're seeing compensation rates getting squashed," he said. "Unemployment will not go away quickly; it's going to keep the pressure on."
"Why would the Fed tighten?" Levy added. "You have high unemployment and disinflation, and financial stability is a constant threat."
The bright side to this sustained period of economic woes is that it will "clean things up," said Levy. "It reduces debt and debt-service burdens, brings asset prices down, brings returns on assets up, and reduces excess capacity. All that creates huge pent-up demand for reinvestment."
As household and corporate debt burdens shrink, a lack of fixed-capital investment will create the potential for an economic boom equivalent to what happened immediately after World War II, Levy said.
"My advice is to be very cautious," Levy told CFOs, "but recognize what's happening, and understand it. Realize there will be terrific opportunities for investing and for making strategic business decisions on the other end of this."