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
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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