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January 22, 1991
"Tackling Deficit Risks Aggravating Recession"
San Jose Mercury News

By Timothy Taylor
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MACROECONOMIC POLICY doesn't make sense in two opposite ways.

The first way, the one you hear most about, is that if all the economists in the world were laid end-to-end, they wouldn't reach a conclusion. That economists have predicted nine of the last five recessions. In short, that macroeconomic policy recommendations are nothing more than a quirky opinion of whichever economist is talking, dressed up in the voodoo of supply-and-demand curves.

The second way that macroeconomic policy doesn't make sense is more subtle. Jokes aside, most economists do agree on broad lessons about how the economy works. However, what makes sense to economists often doesn't make sense to politicians, or to the general public.

The key to understand is that sensible economic policy depends on context. Fighting budget deficits should have been a top priority five years ago, when the economy was growing rapidly, but it should be a lower priority for an economy in a recession. Stimulating the economy with lower interest rates probably would have worked well a couple of years ago, when the economy was growing slowly, but it might not work at all during the current recession.

Because they aren't taking into account that the fact of recession changes the lessons of economic policy, the nation's economic policy makers are running the risk of making the economic recession deeper and longer.

Consider the budget deficit. Most economists believe that raising government spending or cutting taxes to create large budget deficits will increase the buying power in the economy, stimulating growth in the short run. Conversely, cutting government spending or raising taxes, and thus reducing the deficit, will reduce national buying power and reduce growth in the short run.

The policy implication of this analysis is that larger deficits make more sense when the economy is in a recession, to help stimulate it, and smaller deficits (or surpluses) make sense when the economy is in a boom, to save and invest for the future and avoid the dangers of inflation. To oversimplify a bit, the federal government should spend like a drunken sailor when times are bad, but play Ebenezer Scrooge when times are good.

This analysis may not seem overly complex, but politicians have managed to get it precisely backward. They were unable to feel enough urgency to reduce the budget deficit during the mid-1980s, because the economy was doing so well. But as soon as recession threatened last fall, they decided it was time to tighten the nation's belt, and found a way to raise taxes and cut spending. Of course, that will make the recession deeper.

The hope seems to be that the Federal Reserve will bail the economy out of the recession by making more money available. A greater supply of money means that banks can charge lower interest rates, which will stimulate borrowing for business investment and consumer purchases of housing, cars and durable goods. Last month, the Fed took several steps (cutting the discount rate and the reserve requirement) to expand the money supply.

But using monetary policy to cut interest rates may not work in stimulating the economy out of a recession. When economists talk about monetary policy in a recession, they sometimes say that "you can't push on a string." What they mean is that while the Fed can certainly provide banks with more money to loan, it can't guarantee that lenders will want to lend the money or borrowers will want to borrow it.

After all, defaulting on loans becomes more likely in time of recession. Lenders and borrowers become more reluctant to borrow and lend, and the Fed's additional money supply may have little effect in encouraging economic growth. In the good economic times of a few years ago, having the Federal Reserve use monetary policy to stimulate the economy through lower interest rates might have worked well. Right now, in a recession, it's not clear that it will work at all.

Don't get me wrong here. Reducing the budget deficit (and thus increasing the nation's savings) is extremely important to increasing the long-run growth of the U.S. economy. But there are better and worse times to tackle any problem. It would have been wise to attempt the policies of lower budget deficits and higher money supply a few years ago, when the reduced government economic stimulus would have hurt less, and the lower interest rates would have been more likely to stimulate the economy.

But Congress and the Reagan and Bush administrations flubbed their cues in the late 1980s, and now, in the current recession, there aren't many good options for macroeconomic policy. The budget deficit is so already huge that increasing it further to stimulate the economy isn't a realistic option. Monetary policy isn't likely to have a large effect.

Right now, U.S. economic policy consists of hoping that the war in the Persian Gulf is relatively short and does not cripple world oil production. Then, national economic policy makers can hope that the U.S. economy has the resilience to climb back out of recession fairly quickly on its own, no thanks to them.

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