The U.S. can't dodge a slowdown

Plans to stimulate the economy are well-intentioned -- but thanks to pressure on the dollar, they may be doomed.

By Colin Barr, senior writer

NEW YORK (Fortune) -- The government is pulling out the stops to avert a recession this year. But there are signs that a protracted slowdown may be unavoidable - and that efforts to goose the economy may make matters worse.

Since mid-January, public officials have taken extraordinary actions to shore up confidence in the markets and the economy. Fed chief Ben Bernanke cut interest rates twice in the space of just eight days. Treasury Secretary Henry Paulson has thrown his weight behind a bipartisan stimulus plan that would put more than $150 billion in taxpayers' pockets this spring. The creation of that plan, which has yet to be approved by the full Senate, featured the rare spectacle of President Bush and Democrats in Congress actually agreeing on something.

The rate-cutting and stimulus plans aim to keep the U.S. economy from contracting this year. Signs that growth is faltering aren't hard to come by. Just this week, a government report showed that U.S. gross domestic product rose just 0.6% in the fourth quarter, while growth in personal consumption expenditures slowed to 2% from 2.8% a quarter earlier. Meanwhile, the Case-Shiller index of big-city home prices plunged 7.7% from a year ago in December. Companies from shipper UPS (UPS, Fortune 500) to online retailer Amazon.com (AMZN, Fortune 500) and coffee house chain Starbucks (SBUX, Fortune 500) have offered up soft 2008 profit forecasts or set plans to slow their growth as consumers retrench.

It's clear that with food and energy prices rising sharply, many people are having trouble making ends meet - which is why government officials are acting decisively. "I don't think the Senate is going to want to derail that deal," Paulson said of the stimulus plan. "And I don't think the American people are going to have much patience for anything that would slow down the process."

The rush to action suggests time is of the essence. But even with quick action to boost the amount of money floating around the economy, it's far from clear that the government's initiatives can overcome the growth-slowing effects of an overburdened consumer and a capital-impaired banking system. "We're in an unusual situation," says Don Brownstein, chief investment officer at Structured Portfolio Management in Stamford, Conn. He says officials are moving quickly in a bid to limit the damage from the stock and housing bubbles that have distorted the U.S. economy over the last decade. But he cautions that the scale of the stimulus plan, for instance, pales in comparison to the amount of wealth being lost as house prices decline. A 10% decline in house prices, he notes, wipes $1.5 trillion off U.S. household wealth.

Howard Simons, a strategist at Bianco Research in Chicago, warns that while the rate-cutting and stimulus plans are well intentioned, they are unlikely to result in a recovery any time soon. He says a look at currency markets suggests the U.S. economy is on the path to repeating Japan's so-called lost decade - the years of economic stagnation that followed the 1989 peak in stock and property prices. The problem, he says, is the weakening dollar.

And that's why the government's attempt to save the economy could actually be damaging it. Lower rates and more government spending tend to undermine the value of the dollar, which has already fallen sharply in recent years. By reducing interest rates even further, the Fed's rate-cutting policy invites hedge funds and other investors to participate in the so-called dollar carry trade - the practice of borrowing money at low U.S. rates for the sake of investing the proceeds in countries with higher interest rates, and pocketing the difference.

The dollar carry trade hurts the United States in two ways. First, it adds to pressure on the value of the dollar, because carry traders borrow in dollars and then sell the dollars to invest the proceeds in other, higher-yielding currencies. A weaker dollar reduces Americans' purchasing power. Second, dollars borrowed to invest in euros or Canadian loonies aren't available to be invested in U.S. enterprises. This deprives the economy of needed capital in the same way that overseas ownership of U.S. assets tends to enrich foreigners rather than U.S. citizens.

"The implications of this are very negative," says Simons. He says that by repeatedly cutting rates in the face of negative economic data, the Fed "is trying to do the right thing," but the "cumulative effect will end up being hideously negative." He warns that rate cuts and stimulus don't feed real economic growth. Meanwhile, inflation is on the rise - and keeping rates low is likely to leave the United States "in a seriously inflationary mode."

Of course, deciding just what course the Fed should be steering now isn't easy. Thanks to the massive global economic imbalances of recent years,developing nations such as China have been effectively subsidizing U.S. overconsumption, Brownstein notes. He says getting the U.S. economy back on its feet will take years of painful work -- starting with Americans admitting their mistakes and trying to live within their means. But no one should expect that process to be easy or pain-free, Brownstein adds.

"Let's face it," Brownstein says, "we're the crack addicts here."