Volcker: Bottom approaching, but tough road remains

When a casual observer of economics and the markets makes a comment, that's something that investors can take with a grain of salt. But when one of the economic world's heavyweights speaks, investors need to listen.

Former U.S. Federal Reserve Chairman Paul Volcker, speaking this past weekend at a policy maker conference at Vanderbilt University, said the rate of the economy's decline is set to slow, aided by unprecedented efforts to keep credit flowing. However, Volcker added that the U.S. economic recovery will be difficult and slow. Volcker, who now serves as a senior economic advisor in the Obama administration, said the economy faces a "long slog" ahead.

Mirrors latest CBO analysis

Volcker's comments mirror the Congressional Budget Office's most recent analysis that forecasts that the U.S. economy will contract 3 percent in 2009, with a 2.9 percent growth rate forecast for 2010 (pdf). If the latter occurs, that would represent a below-norm U.S. GDP growth rate for the immediate year after a recession -- one with a considerable output gap. Also, the CBO expects the output gap -- the difference between actual and potential output of goods and services -- to not close fully until about 2014 -- something that is, again, consistent with a slow recovery, or as Volcker put it, a "long slog."

Further, Volcker said the financial crisis and consequent global recession stemmed from serious and prolonged imbalances in the international economy that created "extremes" in financial markets.

Volcker, who served as Fed Chairman from 1979 to 1987 during the Carter and Reagan administrations, is widely credited with ending the United States' stagflation period (high inflation, high unemployment), during which the nation's double-digit inflation rate in 1979 fell to about 3 percent in 1981.

Economic Analysis: Volcker at Vanderbuilt University touched on many of the themes that economists and public officials have coalesced around in the past six months, as the nature of the financial crisis became more-clear. Dangerous unsustainable structural imbalances, long ignored so long as GDP growth in the U.S. and abroad continued -- kind of like a fishing boat with too many fisherman on one side of the boat -- have been unwinding for about a year, and will continue to keep U.S. and international GDP growth well below capacity.

Those structural balances include: 1) China's oversaving and lack of consumption, 2) U.S. overconsumption, undersavings, and its trade deficit and budget deficit, 3) inordinate leverage and borrowing, 4) excessive commodity prices (boosted by leverage), 5) too many national economies dependent on exports, and 6) overproduction of manufactured goods.

How quickly the global commercial arena is able to correct these imbalances will say a lot regarding how soon GDP growth returns to normal levels. Moreover, perhaps the biggest factor in the above will be how fast consumption outside the United States, particularly in Europe, China, India, Japan, Russia, Brazil/Latin America, and the Middle East, expands. If these economies increase consumption, many have the potential to become engines of growth for the global economy, and will help to offset what will surely be underconsumption by the United States in the five-year period ahead, perhaps longer.

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