Bad policy put the "Great" in the Great Depression. Protectionism, Hooverism, and a central bank that sat on its hands while markets seized up and banks failed aggravated an already grim situation. Government officials didn't understand how policy would affect the economy.
Thankfully, the U.S. has learned from those and other less spectacular policy mistakes. That's why, barring any further shock, this recession should be mild. Because of the sound policy decisions of the past decade, the U.S. now has an unprecedented reserve of policy resources to draw on. As a result, Washington has embarked on the most rapid and aggressive response to economic weakness in modern times.
When all is said and done, that effort very likely will include government spending and tax cuts totaling between 1.5% and 2% of gross domestic product, along with interest-rate cuts totaling an expected 4 1/2 percentage points. In coming months, this stimulus will provide protection for households buffeted by the traditional forces of recession, such as weak labor markets and shaky confidence, and new head winds, such as stock market uncertainty.
Already, $38 billion in tax rebates are lifting savings, and debt loads are decreasing, especially through mortgage refinancings (chart). Households will get more help from brand-new tax cuts and spending programs that could total up to $70 billion, on top of some $45 billion in immediate post-September 11 stimulus and next year's $30 billion in tax-law changes.
Moreover, the full boost of Fed rate cuts is yet to be felt, and households are getting a windfall from cheaper energy. The fall in gasoline prices, from $1.70 per gallon in May to $1.42 in early October, suggests a savings of $25 billion (at an annual rate). Consumer finances are the key to the outlook because the degree to which households rein in their spending will determine the severity of this recession.
KEEP IN MIND THAT the current situation is much different from the 1990-91 recession. Back then, fiscal policy was hamstrung by the prospect of $300 billion deficits as far as the eye could see. It wasn't until after the downturn that Washington eliminated the federal budget deficit that was crimping private investment and elevating long-term interest rates. Those efforts produced more investment and high economic growth that boosted tax revenues.
Of equal importance are the preemptive moves of the late 1990s to contain inflation, which have given the Federal Reserve maximum leeway to err on the side of accommodating growth with minimum concern about future price pressures. Inflation-fighting efforts also went beyond monetary policy. Less regulation of private industry and freer trade encouraged competition, cost-cutting, and innovation. Together, low inflation and a budget surplus give Washington great freedom to fight economic weakness without mortgaging the future.
It's not only the flexibility of policy, however, that will keep this recession contained. It's also the fortuitous timing. Large packages of stimulus from the Fed and the White House were already in place prior to the terrorist attacks. The central bank started cutting rates back on Jan. 3 and had trimmed the federal funds rate by three percentage points before September. The tax rebate plan was approved by Congress before Memorial Day, and the first checks were sent out in late July. The timing of these moves means that policy was already helping the economy to stabilize before the attacks on New York and Washington.
NOWHERE IS THAT HELPING HAND more evident than in the consumer sector--and that stimulus should offset some of the burdens weighing on shoppers. The uncertainty of war has rattled confidence and postponed some buying plans. Households are grappling with this year's plunge in the stock market, which has caused some $3.6 trillion in wealth to evaporate since January. These two factors will be key determinants of future consumer spending, but their influence pales when compared with the labor markets. Consumer spending is affected most by the job markets (chart).
That's why the September employment report was so ominous. Nonfarm payrolls plunged by 199,000 last month, and the jobless rate remained at a four-year high of 4.9%. The Labor Dept. said it conducted its survey during the same week as the attacks, but that it counted people as employed if they worked even a small part of the survey week. As a result, the report said, the tragedy likely "had little effect" on the data.
That implies the October report will be a disaster. A job decline of another 250,000 or more cannot be ruled out. Jobless claims have soared since the attacks, and retailers, hotels, airlines, and entertainment companies have announced massive layoffs because fallout from the attacks curtailed their business. The October jobless rate is likely to jump above 5%.
YET AMID ALL THIS BAD NEWS, there is hope for the household sector. Consumers had already begun the process of shoring up their balance sheets and freeing up money for more spending later on. This reliquefication process is possible only because of fiscal stimulus and the extremely accommodating moves by the Fed that were in place before September 11.
First, the downturn in mortgage rates, triggered partly by Fed rate cuts and partly by federal surpluses, produced a wave of refinancings this year that have lowered monthly mortgage payments. For instance, a homeowner with an old, 30-year mortgage of $100,000 at 8% could save $100 per month by refinancing at the current 6.5% rate.
Second, consumers seem to be using their tax rebates to improve their balance sheets. The savings rate jumped to 4.1% of aftertax income in August thanks to the inflow of rebates. Moreover, consumers are hardly using their credit cards to shop. Installment debt did not grow over the summer (chart). This means that, in the future, less of the average consumer's monthly budget will have to be used to repay old debts.
Lastly, Washington seems to understand the need to focus policy on helping consumers. Extended jobless benefits and tax cuts are geared to keeping households afloat in these treacherous times. The danger is that Congress will go overboard, if special-interest groups bloat the stimulus package with pork-barrel projects. That could lift long-term interest rates and curtail private investment.
More likely, however, fiscal prudence will prevail, and weak demand will allow inflation to edge lower, enabling long-term rates to decline. Indeed, the Fed has learned a key lesson over the years: Low inflation creates great policy flexibility. That room to maneuver, plus past fiscal discipline, means that Washington can concentrate its energies on pulling this economy out of its downturn.
By James C. Cooper & Kathleen Madigan
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