The answer, I suggest, is three big things: first, the debt-encumbered
economies of the high-income countries remain extremely fragile; second,
investors have next to no confidence in the ability of policymakers to
resolve the difficulties; and, third, in a time of high anxiety, investors
prefer what are seen as the least risky assets, namely, the bonds of the
most highly rated governments, regardless of their defects, together with
gold. Those who fear deflation buy bonds; those who fear inflation buy gold;
those who cannot decide buy both. But few investors or corporate managers
wish to take on any longer-term investment risks.

Welcome, then, to what Carmen Reinhart, senior fellow at the Peterson
Institute for International Economics in Washington, and Harvard’s Kenneth
Rogoff call “the second great contraction” (the Great Depression of the
1930s being the first). Those less apocalyptic might call it the “Japanese
disease”.

Many ask whether high-income countries are at risk of a “double dip”
recession. My answer is: no, because the first one did not end. The question
is, rather, how much deeper and longer this recession or “contraction” might
become. The point is that, by the second quarter of 2011, none of the six
largest high-income economies had surpassed output levels reached before the
crisis hit, in 2008 (see chart). The US and Germany are close to their
starting points, with France a little way behind. The UK, Italy and Japan
are languishing far behind.

The authoritative National Bureau of Economic Research of the US does definea
recession as “a significant decline in economic activity spread across the
economy, lasting more than a few months”. This is to focus on the change in
output, rather than its level. Normally, that makes sense. But this
recession is not normal. When economies suffer such steep collapses, as they
did during the worst of the crisis (the peak to trough fall in gross
domestic product having varied between 3.9 per cent in France and 9.9 per
cent in Japan), an expansion that fails to return output to the starting
point will not feel like recovery. This is especially true if unemployment
remains high, employment low and spare capacity elevated. In the US,
unemployment is still double its pre-crisis rates.

The depth of the contraction and the weakness of the recovery are both result
and cause of the ongoing economic fragility. They are a result, because
excessive private sector debt interacts with weak asset prices, particularly
of housing, to depress demand. They are a cause, because the weaker is the
expected growth in demand, the smaller is the desire of companies to invest
and the more subdued is the impulse to lend. This, then, is an economy that
fails to achieve “escape velocity” and so is in danger of falling back to
earth.

Now consider, against this background of continuing fragility, how people view
the political scene. In neither the US nor the eurozone, does the politician
supposedly in charge - Barack Obama, the US president, and Angela Merkel,
Germany’s chancellor - appear to be much more than a bystander of unfolding
events, as my colleague, Philip Stephens, recently noted. Both are - and, to
a degree, operate as - outsiders. Mr Obama wishes to be president of a
country that does not exist. In his fantasy US, politicians bury differences
in bipartisan harmony. In fact, he faces an opposition that would prefer
their country to fail than their president to succeed. Ms Merkel, similarly,
seeks a non-existent middle way between the German desire for its partners
to abide by its disciplines and their inability to do any such thing. The
realisation that neither the US nor the eurozone can create conditions for a
speedy restoration of growth - indeed the paralysing disagreements over what
those conditions might be - is scary.

This leads us to the third big point: the dire consequences of soaring risk
aversion, against the background of such economic fragility. In the long
journey to becoming ever more like Japan, the yields on 10-year US and
German government bonds are now down to where Japan’s had fallen in October
1997, at close to 2 per cent (see chart). Does deflation lie ahead in these
countries, too? One big recession could surely bring about just that. That
seems to me to be a more plausible danger than the hyperinflation that those
fixated on fiscal deficits and central bank balance sheet find so terrifying.

A shock caused by a huge fight over fiscal policy - the debate over the terms
on which to raise the debt ceiling - has caused a run into, not out of, US
government bonds. This is not surprising for two reasons: first, these are
always the first port in a storm; second, the result will be a sharp
tightening of fiscal policy. Investors guess that the outcome will be a
still weaker economy, given the enfeebled state of the private sector.
Again, in a still weaker eurozone, investors have run into the safe haven of
German government bonds.

Meanwhile, stock markets have taken a battering. Yet it is hard to argue that
they have reached a point of capitulation. According to Yale’s Robert
Shiller, the cyclically adjusted price-earnings ratio for the US (based on
the S&P 500) is almost a quarter above its long-term average. In 1982, the
valuation was a third of current levels. Will markets avoid such a collapse?
That must depend on when and how the great contraction ends.

Nouriel Roubini, also known as “Dr Doom”, predicts a downturn. “A stopped
clock”, some will mutter. Yet he is surely right that the buffers have
mostly gone: interest rates are low, fiscal deficits are huge and the is
eurozone stressed. The risks of a vicious spiral from bad fundamentals to
policy mistakes, a panic and back to bad fundamentals are large, with
further economic contraction ahead.

Yet all is not lost. In particular, the US and German governments retain
substantial fiscal room for manoeuvre - and should use it. But, alas,
governments that can spend more will not and those who want to spend more
now cannot. Again, the central banks have not used up their ammunition. They
too should dare to use it. Much more could also be done to hasten
deleveraging of the private sector and strengthen the financial system.
Another downturn now would surely be a disaster. The key, surely, is not to
approach a situation as dangerous as this one within the boundaries of
conventional thinking.

What being bolder might mean and what should therefore be done will be the
topic for next week’s column.

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