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Crisis Focus
UPDATED: September 13, 2010 NO. 37 SEPTEMBER 16, 2010
The Second Day of Reckoning

On the second anniversary of the Lehman Brothers' failure, the world economy finds itself yet again at a "troubling juncture." The U.S. economy shows every sign of heading for a double-dip recession and even deflation and the European sovereign debt crisis remains far from being resolved, said Desmond Lachman, resident fellow of the American Enterprise Institute, in an article for Beijing Review. Edited excerpts follow:

Over the past year, the United States has managed only a modest recovery from its deepest slump in the post-World War II era. And it did so mainly as a result of the fiscal stimulus package and inventory cycle, which together contributed to practically all of the 3-percent economic growth over that period. The anemic economic recovery raises a rather basic question: How will the U.S. economy avoid a double-dip recession once the benefits of the fiscal stimulus and the present support from the inventory cycle have run their course?

Sadly, as the fiscal stimulus fades, the U.S. recovery faces a number of strong headwinds that will make a relapse into recession all too likely. The most serious is the appalling state of the U.S. labor market, which is now weighing heavily on income growth necessary for a revival in household consumption. If one includes involuntary part-time workers in the unemployment total, the overall U.S. unemployment rate has reached 17 percent.

Further clouding the U.S. economic outlook is the ongoing U.S. foreclosure crisis threatening the housing market. In addition, the U.S. economy will now be weighed down by the prospective cuts in state and local government spending, the ongoing bust in the commercial real estate market, and the souring of U.S. export prospects as a consequence of the euro-zone sovereign debt crisis.

A marked slowing of the U.S. economy at this juncture must raise deflationary fears, since it will exacerbate the large labor and product market gaps that presently characterize the economy. The slowing would also be occurring at a time when U.S. inflation is already at a very low level.

The euro-zone's sovereign-debt crisis casts another pall over today's already fragile global economic outlook. The recessions in Greece, Spain, Portugal and Ireland will all likely deepen in the year ahead as these countries attempt to undertake major fiscal adjustment programs without currency depreciations to spur export growth. Such a deepening will undermine their public finances by eroding their tax bases and it will heighten questions about those countries' ability to service their sovereign debt. This in turn will call into question the health of the European banking system.

In principle, large amounts of public financing could paper over the euro-zone crisis indefinitely without resolving it. Politically, however, there are limits to the amount of financing that Europe's troubled southern countries can expect to receive from the financially stronger northern ones.

The more immediate threat to the continuation of the euro zone in its present form is the possible loss of political willingness in Europe's periphery to continue hewing to IMF-style austerity measures. At some point, as the recession deepens and as unemployment rises, serious questions will arise in the periphery as to whether these countries would not be better served by restructuring their debt and exiting the euro zone.

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