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The Next Recession

Opinion pieces and speeches by EPI staff and associates.


The Next Recession

by Jeff Faux

A decade of prosperity has convinced a fair portion of the punditry that the new hi-tech service economy has lifted us into an economic orbit beyond boom and bust, where recessions are history. Unfortunately, there is little evidence that the laws of economic gravity no longer apply. Indeed, sensible people should now be preparing for the possibility that Alan Greenspan’s effort to slow down the economy will overshoot and that we will soon face rising unemployment and a sinking stock market.

To begin with, the length of the current expansion is less a product of some epochal transformation of the American economy than it is of the convergence of temporary economic trends and political events whose influence may have run its course. During its first five years, the current upturn was at best ordinary. After having fallen in 1991, the GDP rose at an average of a little above 3 percent annually through 1996, about the same as the previous two expansions and considerably less than earlier upturns. What made this recovery different was its “second wind,” averaging over 4 percent through 1999.

The most important contributor to this second wind was what did not happen: an inflation shock that would have induced the Federal Reserve Board to raise interest rates. Despite Greenspan’s constant lecturing of the dangers of wage-driven inflation, every major episode of inflation that cut short a recovery over the past century has been triggered by either war or increases in global oil prices. The last price flare-up was generated by a short-lived panic in oil markets when the 1990 Gulf War was launched. Global oil prices also sparked the inflation of the 1970s. The previous price run-up was kicked off by Lyndon Johnson’s refusal to raise taxes to pay for the Vietnam War. The inflation spell before that was ignited by the Korean War, the one before that by the lifting of price controls after World War II, and the one before that by the impact of World War I.

But the absence of inflation has not always stopped the hypersensitive Federal Reserve from choking growth when wages have started to rise. So why this time was Greenspan willing to watch the unemployment rate fall to 4 percent without tightening the money supply earlier?

The answer lies in the implicit understanding that Bill Clinton and Alan Greenspan reached midway in Clinton’s first term. Greenspan gave Clinton a faster economy to satisfy Clinton’s re-election needs. Clinton gave Greenspan deficit reduction and the suppression of discretionary spending to satisfy Greenspan’s conservative agenda.

The confidence that Greenspan would keep rates low helped maintain the stock market boom that turned into a speculative frenzy, pumping more air into the recovery. The “wealth” effect of paper profits spurred a consumer borrowing and spending spree. Among other things, consumers splurged on imports, and the trade deficit ballooned.

With a personal savings rate at zero, the deficits had to be paid for with foreign capital. Fortunately for the United States, the world’s investors had limited opportunities in slow-growing Europe and stagnant Japan. And as luck would have it, more money fled to the United States in the wake of the 1997 Asia collapse. The sustained, high levels of consumer spending and the flood of capital provided a market for the array of computer technologies that were ready to be commercially exploited–e-commerce, desktop publishing, computerized design–keeping the economy hot through the end of 1999.

The odds against continuing this benign environment grow longer by the day. There are still no signs of inflation. But with the Democratic Party leadership now committed to paying off the national debt and with Clinton a lame duck, a triumphant Greenspan is reverting to form. He has raised interest rates almost two points over the past year while core inflation remains stable.

As U.S. growth slows relative to a reviving Europe, and as the emerging markets and perhaps even Japan recover, short-term capital that was parked in the U.S. safe haven will begin traveling to foreign lands once more. This will put further pressure on U.S. interest rates to rise in order to attract enough funds to finance the trade deficit.

In a mature expansion with a growing debt burden, pauses or dips in growth that might have been shaken off in the early stages of the cycle become more problematic. Thus, for example, with so many Americans working at the maximum to make their monthly payments, a rising unemployment rate–or even a cutback in hours–could dramatically undercut consumer confidence. Reform of the welfare system, which used to provide countercyclical support of purchasing power, adds to the vulnerability. Having the poor more dependent on a paycheck for their income will magnify the depressing impact of a rising unemployment rate. Throw in negative investor reaction to a financial landscape strewn with dot-com bankruptcies, plus an unluckily timed spike in the price of oil, and we have a somewhat new recipe for an old-style recession.

There is no great mystery as to how the U.S. government should respond.

The first task is to start running a deficit once more in order to offset the deflationary impact of cutbacks in private consumer spending and investment. In fact, an economic downturn represents an opportunity for the public sector to make those investments in infrastructure and human capital that have been “crowded out” by the demands of the private sector for labor and capital during boom times.

Unfortunately, both Democrats and Republicans are telling the American people that deficits are the devil’s work and that running surpluses until the national debt is reduced to zero is essential in order to save Social Security. This will make it hard to get political support for needed spending in a downturn if those with jobs believe that spending to help the unemployed will come at the expense of the employed’s future Social Security checks.

When asked by The Wall Street Journal in January how he would respond to a recession, Vice President Al Gore said that he would cut back on government spending, “just as a corporation has to cut expenses when revenues fall off, and that sometimes turns out for the long-term benefit of a company.” Calvin Coolidge couldn’t have said it better.

It may be too late in the election season for the Democrats to revise their message, but the Clinton administration should at least be developing projects to address public investment needs–in transportation, housing, health, education facilities, the purchase of computers for impoverished kids, etc. That spigot should be ready to be turned on when the unemployment rate starts to rise. Without that planning, when the inevitable decision to raise spending is finally made, the rush to appropriate money can be wasteful, haphazard, and–perhaps most important — late in achieving its impact.

Secondly, the administration ought now to be liberalizing the “automatic stabilizers”–entitlements that expand spending in an economic downturn, such as unemployment compensation. Lulled by good times, state and federal governments have actually been tightening up eligibility and reducing efforts to educate laid-off workers on their rights. The five-year limitation on welfare benefits should also be made more flexible.

The third task concerns the dollar. The U.S. Treasury and Federal Reserve should encourage the dollar to fall to revive export and domestic markets that compete with imports. In the short run, because a falling dollar will raise the price of imports, this will cause some uptick in inflation. But this is the inevitable price for years of neglecting the trade deficit, and no effort should
be made to raise interest rates in response.

On the contrary, Alan Greenspan and the Fed need to lower interest rates. If Greenspan is still concerned that more air needs to come out of the stock market, he has other instruments available such as margin requirements, which slow financial speculation without sandbagging the whole economy. Lower interest rates would both stimulate the economy at home and contribute to a cheaper dollar globally.

Despite the Fed’s independence, it is not invulnerable to political pressure. Unfortunately, Wall Street’s worship of Greenspan has spread to Washington, allowing him to get away with the bailout of a Wall Street hedge fund while lecturing Congress on the virtues of leaving working people’s fate in the hands of the global market. The lonely voices of senators Byron Dorgan, Paul Sarbanes, and Tom Harkin, and Congressman Barney Frank, need to be joined by a larger chorus.

Finally, the U.S. government needs to exert its considerable influence to support those in Europe who want the European Central Bank to keep interest rates low to stimulate further growth. With Japan still paralyzed by consumer caution and a debt-ridden banking system, the task of being the engine of global growth in the event of a U.S. downturn must fall to Europe–where finances are healthy and labor markets have plenty of room to expand.

Ten years ago, few would have predicted that Japan, the world’s most dynamic economy, would remain mired in a recession for a decade. A few early mistakes–such as trying to keep the budget balanced by raising sales taxes as the economy began to slide–and the Japanese economy started to take on water. Fortunately for the Japanese, their big trade surplus with the United States helps keep them afloat. Unfortunately for us, there is no other economy big enough to provide the United States with a life preserver. We are not in a recession yet, but it’s not too soon to start planning strategies to make the next downturn shallow and brief.


Jeff Faux is president of the Economic Policy Institute in Washington, D.C.

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