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A New Kind of Downturn Brings Head Winds That Could Weaken Economic Recovery

A Policy of Precision

Government policy, which is bolstering the economy now, could prove to be another head wind in the years ahead.

The Federal Reserve has cut its target for short-term interest rates to almost zero and said it would leave them there for an "extended period." In addition, it is buying nearly $1.5 trillion in mortgage-related securities to push down long-term interest rates and has introduced programs to encourage lending.

To prevent a bout of high inflation in years ahead, the central bank eventually will have to draw down those programs and raise interest rates. When that day comes, it could pose a hurdle to recovery.

Fed leaders hope to exit at the precise time, only until the economy is on solid enough footing to grow even as the Fed raises rates. But if inflation expectations get out of hand, they could be forced to move sooner.

The course of fiscal policy is even more uncertain. The budget deficit is set to be about 12 percent of gross domestic product this year, as tax revenue has plummeted and as the government has spent widely to stimulate the economy.

The Obama administration has indicated that it wants to lower the deficit to around 3 percent of the GDP within years. If all goes well, the transition would be relatively painless -- a growing economy would boost tax revenue, and the stimulus package and financial bailouts would expire naturally.

But if the economy remains weak, the administration and Congress may face more difficult decisions and have less room to maneuver.

In this recession, U.S. leaders have had ample flexibility to spend as they see fit, since global investors have been eager to lend to the nation because of the perceived safety of its debt. An extended recession or weak recovery, however, could quash that confidence.

"If the recovery is a disappointing one, you could face a situation where you have to get the fiscal house in order before the economy has improved substantially," Reinhart said. "We are piling on debt at an incredible clip, but we have been able to because in times of stress there is a flight to Treasurys [Treasury bonds]. But that doesn't negate the fact that, down the road, we need a substantial fiscal adjustment."

Long Slog or Snapback?

Although widely held among top economists, the idea that all these head winds will weaken the recovery is not universal. The U.S. economy has proved resilient in the past, emerging out of deep downturns with force.

"There is only one reliable regularity in business cycle history in the United States," said Michael Mussa, a senior fellow at the Peter G. Peterson Institute for International Economics, in a presentation earlier this year. "Deep recessions are followed by steep recoveries and economic forecasts almost never take account of this regularity."

At the core of Mussa's argument that the recovery will be shaped like a "V," with a sharp snapback, rather than a "U," is a view that others put too much emphasis on the need for the system to stabilize.

In a recent interview, Mussa noted that the U.S. economy grew robustly in the mid-1980s despite the failure of savings and loans. "Korea experienced a spectacular recovery following the market collapse of 1997-98, even though the domestic financial system was a mess," he said. Similar story with Argentina, where the financial system collapsed in 2001-02, followed by five years of strong recovery.

Mussa, a former research director at the IMF, imagines the U.S. economy growing 6 to 7 percent over the coming year, as businesses rebuild inventories and as the housing and auto sectors edge nearer to their long-term potential (though still remaining far below their levels in boom years).

"The historical record is that when you have deep recessions, the recovery tends to be very sharp, with growth well in excess of the trend," Mussa said.

Even skeptics of that idea -- the crowd that thinks a long slog out of the economic wilderness is more likely -- are hoping Mussa is right.

"The honest truth is there's incredible uncertainty in the forecast right now," said Gertler, of New York University. "Recessions are periods where the negative surprises outweigh the positive surprises. We're overdue for some more positive surprises now."

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