Can Anything Cure the Ailing American Economy?

Republicans in Congress have embraced further tax cuts and less spending as the answer to the weak economy, while accusing the administration of squandering stimulus spending on efforts that brought little gain. Some conservative analysts liken the government’s reliance on spending and credit to imbibing another cocktail to take the edge off a hangover. In this view, the weak economy should be welcomed for the discipline it imposes, forcing a paring back of unsustainable spending, while building up savings that can finance investment and later feed healthy economic growth.

“The recession is the cure for the disease that affects the economy, but the politicians don’t have the stomach for it,” says Peter Schiff, president of Euro Pacific Capital, a Connecticut-based brokerage house. “They’re going to keep stimulating the economy until they kill it with an overdose. The hyper-inflation that results is going to be far worse than the cure.”

Germany, which has long harbored particularly powerful fears of inflation, has done relatively well in the current downturn without large stimulus spending, and that experience is now cited by adherents of austerity. But it can be argued that the Germans had two advantages over Americans: A more extensive social safety net to give consumers more money and the confidence to spend it, and a vibrant manufacturing base to churn out more goods for export.

Most economists who are close to the policy making arena for both parties take the position that austerity is the wrong medicine for what ails the American economy, and they dismiss warnings about inflation as akin to focusing on the side effects of chemotherapy in the face of cancer. First, they argue, take the medicine and stave off the lethal threat; then deal with the collateral problems.

Regardless, inflation fears persist, constraining what limited prescriptions might otherwise be thrown at a weakening economy.

The impending elections in November — with control of Congress hanging in the balance — has further narrowed the contours of political possibility

Six months ago, Alan Blinder, a former vice chairman of the Federal Reserve, and now an economist at Princeton, dismissed the idea that America’s political system would ever allow the country to sink into a Japan-style quagmire. “Now I’m looking at the political system turning itself into a paralyzed beast,” he says, adding that a lost decade now looms as “a much bigger risk.” Congress and the Obama administration have ruled out further stimulus spending. The Fed appears to be running out of powder. “Its really powerful ammunition has been expended,” Mr. Blinder says.

Even after the November election, few expect a different dynamic. “We’re already in a gridlock situation, and nothing substantive is going to change,” says Bruce Bartlett, who was a Treasury economist in the first Bush administration. “Clearly, a weak economy in 2012 will be very good for whoever the Republican presidential candidate is. It’s hard to see how the Republicans lose by blocking stimulus.”

On the other hand, if deflation emerges as a verifiable menace, many economists expect Mr. Bernanke — an expert on the Great Depression — to again champion aggressive measures, perhaps expanding the Fed’s balance sheet to buy pools of auto loans or credit card debt.

“It’s very likely the Fed will bend in that direction if the economy stays soft, especially if they are starting to see deflation,” says Kenneth S. Rogoff, a former chief economist at the International Monetary Fund, and now a professor at Harvard. “That’s really starting to loom.”

On Friday, Mr. Bernanke, whose board can operate independent of politics and the government, offered assurance that he still had powerful therapies to use should conditions worsen. Yet he also expressed concern about the potential side effects, underscoring a reluctance for more action.

“The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation,” he said. “We do.” Then he added: “The issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.”

Right now, many homeowners owe the bank more than their homes are worth, prompting some to abandon properties, adding inventory to a market choked with vacant addresses. An Obama administration program aimed at slowing foreclosures has prolonged trouble, say some economists, by failing to relieve borrowers of unsustainable debt burdens or making transparent the extent of losses yet to be confronted by the financial system.

“The big question is, who’s going to swallow the losses,” says Mr. Stiglitz. “It should be the banks, but they don’t want to. We’re likely to be in paralysis for years if they prevail.”

The Treasury sits in the middle, concerned by the continued weakness of housing, yet unwilling to pressure banks to write down mortgage balances.

Like their Japanese counterparts a decade ago, Treasury officials worry that forcing the banks to take losses could weaken them and risk another crisis.

By default, muddling through has emerged as the prescription of the moment.