By sgoldstein[at]marketwatch[dot]com (Steve Goldstein), MarketWatch
WASHINGTON (MarketWatch) — Bank reserves swelling, and commodity prices surging — that’s the situation that the U.S. economy is now confronting.
But it also was the case back in 1937. And that’s what worries Ethan Harris, North American economist at Bank of America Merrill Lynch.
He fears, now like then, that tightening of monetary and fiscal policy could cause a recession, so much so that he thinks a temporary default on U.S. Treasury obligations may be preferable to overly swift spending cuts.
His view stands at odds with the rest of Wall Street, which has frequently communicated to congressional Republicans as well as the White House their desire to see the $14.3 trillion debt ceiling increased. See related story on Wall Street warnings.
They fear a temporary default could disrupt the $4 trillion Treasury financing market, could spark a run on money-market funds and increase mortgage rates.
It’s also at odds from the broader public: 70% say a default would be bad for the economy, and 56% say failure to cut spending is worse, according to a telephone survey from Rasmussen Reports of likely U.S. voters.
But Harris is concerned about the parallels from the “recession within a Great Depression” of the late 1930s.
Back then, the Federal Reserve increased reserve requirements, and a federal government “exhausted” by deficit spending hiked tax rates and slowed spending on the Works Progress Administration, Harris said.
The rhetoric of newly elected President Franklin D. Roosevelt also scared businesses.
Harris said the current Fed, and in particular Chairman Ben Bernanke, has learned that expansion of reserves is only inflationary if it prompts a boom in bank lending. And the more business-friendly tone of late from the Obama administration has shown the president “has recognized how negative rhetoric can damage business confidence and hiring.”
But he’s worried about fiscal tightening.
“Today, as in the mid-1930s, fiscal fatigue has set in. The debate has shifted from keeping the recovery going to removing fiscal support,” Harris said.
He points out that even if Congress takes no action, programs comprising more than a percentage point of gross domestic product are due to expire next year, and that the debate about austerity can hurt even before the cuts kick in.
“The risk of a bad outcome is high,” he said. “We are not sure whether it is worse to do nothing, and temporarily default on the debt, or to do too much and enact big front-loaded deficit cuts.”
Harris said the best policy outcome would be modest upfront spending cuts with a commitment to deal with long-run structural deficit concerns after the 2012 presidential election.