U.S. ECONOMY STILL PAYING FOR PAST DEBT BINGE

The debt fight that played out in the nation’s capital this long, hot summer and the ensuing U.S. credit downgrade by Standard & Poor’s was the latest chapter of a painful story that began years ago.

In the 2000s, banks, homeowners and consumers became bloated on too much leverage, or borrowed money. The end result: a dramatic shrinkage of credit throughout the economy, a phenomenon known in economic circles as “deleveraging.”

It’s a situation the government and the Federal Reserve have been grappling with ever since, throwing trillions of dollars at the problem. Tuesday, the Fed’s policy committee is meeting to assess the current state of the economy. While last week’s July jobs report was slightly better than expected, the economy still isn’t adding enough jobs to keep pace with population growth.

Still, despite abundant signs that the economy is losing steam — starkly highlighted by gut-wrenching market plunges Monday and last week — few expect policymakers to unveil new stimulus plans.

Skeptics say that while the Fed may roll out new stimulus plans down the road, the problems weighing on the economy, such as a moribund housing market and a zombie consumer, are beyond the central bank’s powers to fix. “The Fed in terms of monetary enticement has done about all it can do,” says Bill Gross, co-chief investment officer of Pimco, one of the world’s largest bond funds.

Is the arsenal empty?

While the Fed appears to be running out of bullets, the government is also low on ammunition. As the fractious debt fight in Washington demonstrated, deleveraging has spread to the government itself. State and local governments are instituting draconian cutbacks. Congress voted last week to trim $2.1 trillion from the federal deficit in the next 10 years, a remarkable move toward austerity at a time that the economy is barely growing.

The result for America could mean the slowdown that has led to an unemployment rate north of 9% will last for years. With increased government spending largely sidelined as a result of the debt-ceiling debate, there’s little cushion for the economy if it slips again into a recession.

“The government balance sheet took the place of corporations and private households,” says Gross of Pimco. “But now there’s no balance sheet that’s not suspect in the current year or future years.”

Pimco has taken a negative stance on U.S. Treasuries, in part because they yield a very low rate of interest. Instead, Gross prefers the debt of countries with higher rates, such as Canada, Mexico, Brazil and Germany.

No quick cure for credit busts

The fact that the economic quagmire is the result of deleveraging helps explain why the recovery has been so weak and long-lasting, economists say. A 2010 study by the McKinsey Global Institute called “Debt and Deleveraging,” a study of 45 historic episodes of credit busts, found that it takes an average of six to seven years for an economy to emerge from a deleveraging process.

One reason is that deleveraging has powerful self-reinforcing effects. If consumers aren’t spending because of a high debt load, businesses stop hiring, further hurting consumer spending. Banks grow cautious because of the uncertain environment, making it hard for both consumers and businesses to get loans.

When faced with such a dire situation, the government will typically provide the economy with a shot in the arm through tax cuts or spending projects. Trouble is, the government appears to be out of stimulus bullets. The recent budget plan hammered out by Congress contains plans to cut spending by about $22 billion in fiscal 2012, which will have a moderate negative impact on the economy.

Now, the Fed appears to be the final backstop for the economy. The central bank has gone to extraordinary lengths in the past three years to spur growth, cutting short-term interest rates to nearly zero, putting shaky mortgages on its balance sheet, and buying hundreds of billions’ worth of Treasury bonds.



ADRIANA ALVARADO