MILAN – The run-up to the economic crisis in the United States was characterized by excessive leverage in financial institutions and the household sector, inflating an asset bubble that eventually collapsed and left balance sheets damaged to varying degrees. The aftermath involves resetting asset values, deleveraging, and rehabilitating balance sheets – resulting in today’s higher saving rate, significant shortfall in domestic demand, and sharp uptick in unemployment.
So the most important question the US now faces is whether continued fiscal and monetary stimulus can, as some believe, help to right the economy. To be sure, at the height of the crisis, the combined effect of fiscal stimulus and massive monetary easing had a big impact in preventing a credit freeze and limiting the downward spiral in asset prices and real economic activity. But that period is over.
The reason is simple: the pre-crisis period of consuming capital gains that turned out to be at least partly ephemeral inevitably led to a post-crisis period of inhibited spending, diminished demand, and higher unemployment. Counter-cyclical policy can moderate these negative effects, but it cannot undo the damage or accelerate the recovery beyond fairly strict limits.
As a result, the benefits associated with deficit-financed boosts to household income are now being diminished by the propensity to save and rebuild net worth. On the business side, investment and employment follows demand once the inventory cycle has run its course. Until demand returns, business will remain in a cost-cutting mode.