08/21/2011 12:08 pm ET Updated Oct 21, 2011

Why Washington Urgently Needs to Break America's Negative Feedback Loop

It has been a rough four weeks for America. Grim economic news, paralyzing political infighting, and the shocking loss of the sacred AAA sovereign credit rating. To make things worse, Americans' equity-heavy 401k's have suffered from a volatile 16 percent decline in the broad-based S&P stock market index.

It is tempting to dismiss all this economic, political and market volatility as just the usual -- volatility that constitutes irritating "noise" rather than insightful "signals". After all, economic data always fluctuate, politicians always posture, and markets overshoot both on the way up and on the way down. But, be very careful before you are opt for this seemingly comforting interpretation.

There is a lot in play today that, critically, requires a bold response out of Washington. Indeed, the last four weeks have rendered mission critical President Obama's economic speech scheduled for September 5th. If the speech disappoints and if Congress continues to squabble, both the economy and the market will become even more hostage to a harmful feedback loop involving the trio of deteriorating fundamentals, insufficient policy responses, and disruptive technicals.

This is not just an American phenomenon. Europe is in a much worse situation. And, if policymakers on both side of the Atlantic don't get their act together quickly, they will run out of tools that have a chance of being effective circuit breakers. In such circumstances, things could get a lot worse before they get better.

So, how does the negative feedback loop work? You can illustrate starting with any one of its three components (fundamentals, policies, and technical). Let us begin here with economic/debt fundamentals.

Recent data releases, including Friday's horrible fall in a regional indicator of manufacturing production, confirm that the American economy is rapidly losing growth momentum -- and, already, there wasn't much momentum to speak of.

Analysts are again rushing to sharply revise down their growth and job projections for the year as whole. Many are now converging to the notion of "stall speed" (1-2 percent annual growth), with a highly concerning increase in the probability that the US could tip into recession.

The problem with a sharp growth slowdown is threefold. First, initial conditions are very worrisome, including a very high and too persistent level of un- and under-employment. Second, other parts of the world are also slowing and, therefore, there are few engines of growth. Third, the over-indebted segments of this global economy desperately need high growth in order to safely de-lever otherwise they can tip into highly disruptive debt traps.

Normally, Washington would be responding forcefully to put the economy back on track. Also, given the synchronized nature of today's global slowdown, this bold national policy response would be supplemented by effective international policy coordination. Sadly, neither is happening today.

When it comes to economic policy substance, our elected representatives and their appointees have, until now, essentially been MIA. They have shown little understanding of the seriousness and urgency of the economic challenges. Endless political bickering has sapped their energy and focus. And, to make things worse, they are now positioning for next year's elections rather than today's realities.

This national policy disarray limits the scope for a global coordination process already undermined by disagreements on what ails the world economy (and, therefore, who is to blame and what should be done). Also, there is no effective conductor to credibly herd countries into cooperating.

America's standing on the global stage is weakened by domestic economic and political issues, including the debt ceiling debacle and loss of the AAA sovereign rating. Traditional alternatives, such as the G-7 or the IMF, lack legitimacy as they are still dominated by western interests. And the G-20 is yet to sufficiently establish itself.

These factors are behind the recent sharp stock market sell-off, leading to the third element of the feedback loop: undermining the sound functioning of a market economy.

In such environments, market liquidity becomes more elusive, counterparty risk concerns mount, and certain investors turn into distressed sellers. As illustrated in the 2008 global financial market meltdown, these issues can become disruptive in themselves, fueling a chaotic economic and technical de-leveraging process.

Fortunately, the recent volatility also reflects a notable area of strength -- multinational companies with pristine balance sheets and a string of impressive business results -- that could be a critical part of the recovery if other elements line up.

Until now, however, this healthy part of the global economy has been held back by economic and market uncertainties. Companies refrain from deploying their profits and cash hoards to new investments and additional hires. Witnessing this, it is understandable that households, already rattled by high unemployment and the policy debacle in Washington, are becoming more cautious about spending.

In policy circles, there is one group that recognize the need to break this terrible loop of weak economic/debt fundamentals, lagging policy response, and fragile market technicals. Indeed, in the last two weeks, central banks have made two dramatic (and controversial) attempts to act as circuit breakers.

The first came in the form of an unprecedented Sunday evening announcement by the European Central Bank that it will expand the purchasing of debt issued by member governments. The second was last week's previously unthinkable Fed statement suggesting that policy interest rates would be floored at zero percent for two years.

Unfortunately, these actions secured only a few days of market relief -- so much so that people are now looking to Chairman's Bernanke's Jackson Hole speech on Friday wondering whether the Fed has any effective tools left.

But central bank policies are a means to an end, and not an end in themselves. They can only provide a bridge -- and it is often a costly one -- to better policymaking on the part of other parts of government. That is why President Obama's September 5th speech is so critical.

It is encouraging that the media has been picking up signals from the White House that the President intends to take economic policymaking to a higher level. Last week's blog posting was my attempt to identify the content, process and areas that I believe are absolutely critical for restoring economic leadership at both the national and global levels.

America has little time to waste if it wishes to avoid years of insufficient economic growth, devastating unemployment, rising income and wealth inequality, and eroding social cohesion. Let us hope that a refreshed President Obama will return to Washington willing to respond and lead; and let us hope that, for their part, members of Congress will return in a much more constructive mood, able to work with the President to break an increasingly damaging negative feedback loop.