With the global economic recovery floundering and policy-makers seemingly running short of kindling to kick-start growth, long-held economic beliefs are giving way to increasingly gloomy scenarios.

The financial crisis has already obliterated its share of market dogma. From bailouts for failing financial services firms to short-selling bans, governments and regulators used the resources of the state to protect supposedly ruthless capitalists. Central bankers and finance ministers found themselves co-ordinating monetary and fiscal policy to combat the synchronized worldwide recession that wasn’t supposed to happen amid globalization and economic decoupling.

Now, with the weakening of the U.S. recovery, other cherished dogmas are coming into question.

In recent weeks, the U.S. economic data flow has been mostly disappointing. Unemployment remains high, economic activity is soft and there are few signs that ordinary domestic demand is ready to resume driving growth.

All of this is fomenting economic pessimism. Some economists are suggesting that the risk of a double-dip recession is rising; others maintain that the economy hadn’t escaped recession in the first place. Even economists who were convinced of the recovery are now starting to concede that the risks it will fade are on the rise.

Talk has turned from gauging the strength of the recovery and calibrating the timing of the handoff from government stimulus to organic demand and toward the contemplation of far gloomier scenarios, such as the U.S. economy suffering through a long-term economic malaise similar to the “lost decade” that has beleaguered Japan in the wake of its asset market crashes back in the early 1990s.

In an article that is to appear in the September-October issue of the Federal Reserve Bank of St. Louis Review, James Bullard, president and CEO of the St. Louis Federal Reserve, observes: “The U.S. is closer to a Japanese-style outcome today than at any time in recent history.”

Bullard is concerned about the U.S. economy falling into a prolonged period of deflation accompanied by persistently low interest rates. In part, he says, the risk of this scenario is rising because of the U.S. federal open market committee’s decision to keep the key policy rate close to zero for “an extended period.”

This stance, he suggests, means that whenever the U.S. economy faces bad news or a negative shock (such as the European sovereign crisis earlier this year), market expectations for the return of more normal monetary policy get pushed further into the future. The risk, Bullard suggests, is that this encourages a “permanent, low nominal interest rate outcome.”

While it is far from certain that the U.S. is doomed to Japan-style stagnation, some economists see the parallels all too clearly. A recent report from Newport Beach, Calif.-based asset-management giant Pacific Investment Management Co. (more widely known as PIMCO) notes: “A comparison between the two countries reveals an uncomfortable similarity with respect to the roots of the crisis, the progression of economic turmoil and the policy response.”

While governments have been the primary supports propping up the global economy over the past couple of years — through various monetary and fiscal stimulus efforts — the limits of their ability to spark growth are becoming increasingly evident, particularly in the U.S.

Central banks have employed extremely low interest rates and unconventional policy tools, such as credit and quantitative easing — yet the recovery seems to be floundering. At the U.S. Federal Reserve Board’s latest rate-setting meeting, it lowered its economic growth outlook, left rates unchanged and revealed that it would take steps to prevent its balance sheet from shrinking.

Observes a recent research note from Bank of Montreal’s capital markets division: “The Fed’s decision suggests that tighter policy could be delayed for years rather than quarters.”

Moreover, the Fed, in announcing that it would not let its balance sheet shrink, has indicated that it still has tools available in case the recovery continues to disappoint. However, economists are raising doubts about just what the Fed can hope to accomplish with experimental measures that rock-bottom interest rates haven’t been able to achieve.

More quantitative easing by the Fed (by buying U.S. treasuries) is probably its biggest remaining weapon — which is the approach favoured by Bullard to keep policy stimulative without committing to perpetually low interest rates.
@page_break@Yet, it’s not clear that this would do much to spur growth. “Rates are already at extreme lows,” the BMO report says, “so there’s little holding back borrowers except creditworthiness and soft demand, and lower rates won’t solve either of those issues.”

It appears that central banks are almost out of tricks. “In recent decades,” the BMO report says, “markets have looked to the Fed and monetary policy to heal all economic and financial wounds. If the economy continues to slow, expect that belief to be challenged, as monetary policy is out of options.”

Instead, the BMO report suggests, more stimulative fiscal policy might be the way to go: “Short of blowing another hole in the deficit, we believe that there is a very strong case for the U.S. to open the fiscal spigots wider yet to make sure the recovery sticks. The long-term fiscal cost from a lengthy period of subpar growth would be much more damaging than a small down payment now.”

There is less of a need for more stimulus in Canada, the BMO report adds, but doesn’t rule it out, either — given the uncertain trajectory of the U.S. recovery and the fact that fiscal stimulus efforts have proven more effective and less damaging to government finances here in Canada. The BMO report concludes: “Policy-makers should keep their options open for the 2011 budget season, and not lock in a hard stop on stimulus just yet.”

Yet — in the U.S., at least — it appears that expansionary fiscal policy has not been any more successful than monetary policy in entrenching the recovery. Advocates argue that the initial stimulus wasn’t big enough and wasn’t targeted properly.

The question now is whether governments are willing to “double down” on their bet that fiscal stimulus can solidify the recovery. And, if they are, will it be any more successful the second time around?

Deficit hawks worry that more fiscal stimulus may simply amount to throwing good money after bad. A recent market commentary from Toronto-based Sprott Asset Management LP warns: “The stimulus programs are simply not producing their desired results, and the future debt costs associated with funding these programs may cause far greater strife in the future than the problems the stimulus was originally designed to address.

“Debt is debt is debt, after all,” the Sprott commentary continues. “It doesn’t matter if it’s owed by governments or individuals. It weighs on the institutions that issue too much of it, and the ensuing consequences of paying off the interest costs severely hinders governments’ ability to function properly.”

The PIMCO report points out the limits to fiscal policy: “Having too much debt relative to income results in the need to de-lever at the national level. And while the government can temporarily offset the economic contraction that comes from loss of private-sector demand, it becomes increasingly powerless over longer periods of time.”

Yet, as central banks seemingly have little left to try, more government spending and/or tax cuts are all policy-makers can really offer the stumbling recovery.

The apparent impotence of both monetary and fiscal policy to ensure the resumption of economic growth has some suggesting that a new economic reality is at hand, characterized by weaker growth and greater austerity for households and governments.

“What we are confronting,” says David Rosenberg, chief economist and strategist with Toronto-based Gluskin Sheff & Associates Inc. , in a recent report, “is nothing at all like the cycles of the post- [Second World War] era, when recessions were mild corrections in GDP in the context of a secular credit expansion and when lower interest rates could always be relied [upon] to revive spending on big-ticket durable goods. We are in the process of unwinding the excesses of a parabolic credit cycle of the prior decade. The first of the boomers are now retiring with nobody around to buy their monster homes, and the Fed is now fighting a deflation battle that is prompting comparisons to Japan for the past two decades.”

In this new world, both households and governments will become more frugal, Rosenberg suggests. Baby boomers will have to postpone retirement, making the job market tougher for new graduates, and house prices will face extended selling pressure.

Analysts at National Bank Fi-nan-cial Ltd. also foresee fundamental changes to the economic world order on the horizon as the result of shifting economic forces. A report from NBF suggests that most of the problems faced by developed economies are structural rather than cyclical. Further, the report warns of the emergence of a negative feedback loop between the faltering economic clout of the developed economies and their declining geopolitical influence.

Says the NBF report: “An increasingly competitive global economy, deficient economic structure, unsustainable government and consumer debt burdens, stagnant living standards, a populist backlash against spending cuts, the rise of protectionism and trade tensions, the escalating costs of accessing resources, unfavourable demographics and shrinking spheres of influence in the geopolitical realm will combine to act as a drag on long-term growth in the advanced
economies.” IE