Top Economists Paint Bleak Picture For US Economy; Rap Fed

Top economists offer different diagnoses on what's wrong with the U.S. economy, but they agree on one thing: the prospects look pretty bad.

Many economists meeting here for the annual conference of the American Economic Association believe the Federal Reserve has not done a good job in steering the economy, with at least one predicting the Chinese yuan will supplant the U.S. dollar as the world's dominant currency.

"The age of American predominance is over," said Simon Johnson, a professor at the Massachusetts Institute of Technology and formerly a top economist at the International Monetary Fund. He believes the yuan will become the world's reserve currency in two decades. The global financial crisis caused by the U.S. never ended, he told a panel on the causes of the crisis, because big and powerful banks can still bring down the U.S. economy by going under.

John Cochrane, an economist from the University of Chicago, said he believes the financial crisis is over. But he fears the outcome will be "goodbye financial crisis, hello sovereign debt crisis," he said, warning that California may become for the U.S. what Greece was for Europe.

Myron Scholes, the Nobel-prize winning economist on the board of futures market CME Group Inc. (CME), believes that now that banks are semi-public institutions, innovation will suffer and, with it, the economy.

Raghuram Rajan, another University of Chicago professor who was a senior IMF economist, believes the U.S. will continue to be a "prime mover in financial markets for a long time." But he agrees that the age of U.S. dominance in the world economy is nearing an end.

Rajan said the U.S. central bank contributed to the recent crisis by encouraging risk-taking with low interest rates, and is skeptical of the Fed's latest attempt to boost the economy by buying government debt.

Fed Chairman Ben Bernanke Friday offered a slightly better outlook for the economy, but speaking after data showed the unemployment rate plunged to its lowest point in 19 months at 9.4%, cautioned the improvement in the labor market will be slow. He once again defended the central bank's bond purchases, saying the Fed has the tools to pull the money back at the right time to prevent inflation.

Several economists question this point. The Fed's easy money policy is a "serious mistake," said Ronald McKinnon, a professor at Stanford University, who is presenting a paper here.

By driving rates so low the Fed has made the global economy less stable, the paper argues, leading to beggar-thy-neighbor policies reminiscent of the international currency chaos that worsened the 1930s Great Depression, with the end result possibly high inflation around the world.

The Fed's line is that, had it not slashed short-term rates close to zero to fight the financial crisis at the end of 2008 and kept long-term rates low by buying bonds, consumer spending and business investments would have collapsed, plunging the economy into a new depression.

The Fed's latest effort to boost the economy by buying $600 billion government bonds, which started in November 2010 and is due to run through June, has led countries from Germany to Brazil to accuse the U.S. of igniting a currency war by depreciating the dollar. The Fed counters its aim is to keep borrowing rates low and drive investors into riskier assets like stocks so that the world's largest economy can continue to recover from a deep recession, something that will benefit all countries.

But a byproduct of the Fed's decision is a weak dollar and lower yields for U.S. assets, prompting an outflow of money from the U.S. as investors search higher returns into the rapidly-growing economies of emerging countries. To prevent their own currencies from rising excessively, countries like Brazil and Mexico have bought dollars with real and peso, forcing their own interest rates down and inflation up.

McKinnon drew a parallel with the policies the U.S. followed under President Nixon in the early 1970s, when an easy U.S. monetary policy accompanied by a weakening dollar forced other industrial countries to appreciate their currencies against the dollar.

"If most peripheral central banks expand simultaneously, the result is generalized worldwide inflation," the economist said.

-By Luca Di Leo, Dow Jones Newswires; 202 862 6682; luca.dileo@dowjones.com

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