Who You Gonna Call After the Next Bust?
By Louis Uchitelle
There will be a recession. That is inevitable -- if not this year, then next year or maybe the year after. The question is, how severe will it be? The answer is that despite all the fanfare about these prosperous times, the eight-year expansion walks on precarious legs, and when it collapses, getting the American economy back on its feet could be surprisingly hard and painful.
The odds are that the next recession will come sooner rather than later, and it will be different from other recessions since World War II. The response will be different, too. Many of the politicians, executives, financiers and prominent economists who have bet so heavily on the virtues of a market economy unhindered by government will probably look this time to government for extra help in mitigating the damage. Not just in cutting interest rates, but in stepped-up public spending as well as tax cuts.
"We will have to change the rhetoric," said Robert Pollin, an economist at the University of Massachusetts. "We can still say that markets play an important role, but they can't cure themselves. We will have to acknowledge that we need government for that. It's the stabilizer. And that acknowledgement will open up a broader debate about what government should do."
The strengths of this expansion are potentially destructive. They are chiefly consumer spending and business investment, both of which are based on debt. Unlike the Reagan-era expansion, which was driven by government borrowing, the current expansion is fueled by private-sector debt. Rising stock prices and, more recently, rising home prices, have encouraged the borrowing. Bubbles have developed in stock prices and real estate. And when they burst, particularly in the stock market, much of the collateral for the borrowing will disappear.
"I know of no time in the post-World War II period in which the welfare of the American economy, and for that matter the rest of the world, has hinged so much on the well-being of the American stock market," said Henry Kaufman, the Wall Street economist.
Some of the borrowing has paid for imports, which have given Americans a great variety of inexpensive goods and services. But the imports have also created a huge trade deficit that threatens to weaken the dollar, complicating future efforts to repair a damaged economy. The June trade deficit, for example, which was announced on Thursday, was a record $24.6 billion.
"We have been running the economy on private credit rather than government debt on a very large and unusual scale," said Wynne Godley, an economist at the Jerome Levy Institute who tracks the debt numbers.
When hard times come, households and companies will almost certainly pull back on spending, investing and borrowing -- a nightmare for an economy that has become increasingly dependent on such voluntary activity. Government -- mainly Federal, but also state and local -- will suddenly be expected to take up the slack. As Alan Blinder, a Princeton University economist, put it, "In the event of a recession, people turn to Government en masse."
nly this time, the government carries an unusual handicap, as if it were starting a one-mile race from 100 yards behind the starting line. It is deficit spending that stimulates an economy, whether it comes from the private or public sectors. Right now the private sector carries the load. In the next recession, today's cherished budget surpluses must be turned into deficits. The public sector, in effect, must replace at least some of the private sector's deficit spending.
In addition, the proposed tax cuts currently being sold as a reward for the shrinking government role in a highly successful market system must be resold to the public in an entirely opposite manner. They would become the government's way of prodding Americans to spend more and thus help revive the economy. That was the justification for tax cuts in the Kennedy, Johnson and Nixon Administrations.
More government spending on housing, public works, education and income subsidies also seems likely to accompany the next recession, given the unusual nature of the current expansion and the downturn it is likely to produce.
This stepped-up government spending would be a departure from the solution applied to recessions over the last 20 years. These earlier cycles have been variations on a different theme: The demand for goods and services outstrips the supply. Prices rise. The Federal Reserve, concerned about inflation, raises interest rates to cool the demand. If demand cools too much, unsold merchandise piles up and, as companies cut back production, a recession develops. The solution: the Fed cuts interest rates to revive demand. The Fed, in this way, has played the main government role in regulating the economy since 1980.
The late 1990's are different. Supply is no longer a problem. The output of goods and services in this country and abroad outstrips demand. The economy has been booming since 1995, but inflation is not a problem with so much supply. The labor force is fully employed, and in theory at least, labor shortages should be pushing up wages and prices. But neither is happening noticeably. The danger is not that demand will outstrip supply, but that demand will collapse if the stock market does.
The Federal Reserve can probably revive demand by lowering rates, as it has in the past.
But here is where the trade deficit complicates the picture.
Foreigners have been big lenders to America, partly financing the trade deficit. The percentage of Treasury securities and corporate securities held by foreigners, for example, has almost doubled since 1992.
When the next recession comes and the dollar inevitably weakens, the Fed's first instinct will be to lower rates. But it will also have to contend with the possibility that the much-needed foreign investors will seek out higher returns elsewhere in the world.
The way to revive the economy is to lower rates, but the way to keep foreign lenders on board is to raise rates, or not lower them. "We could get locked into a situation where we can't lower rates," said Lance Taylor, director of the Center for Economic Policy Analysis at the New School for Social Research.
Thus the door may reopen to the sort of government intervention that was commonplace until the 1980's, and that John Maynard Keynes, the British economist, first spelled out in the 1930's.
"It was Nixon who said we are all Keynesians," Mr. Blinder said. "It is true now, although many people shun the label."
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Carl