Greater Opportunity Through Innovative Change
By: Greg Kaza
The U.S. economy, even before the recent terrorist attacks, was exhibiting signs of serious weakness. The Beige Book, a Federal Reserve survey of regional economic activity, observed reports "generally indicated that overall economic activity remained sluggish in August and early September, with several suggesting that activity slowed further." The Beige Book summarizes comments from businesses and other contacts outside the central bank. The report followed an earlier (Aug. 8) survey that concluded, "Reports from most Federal Reserve Districts point to slow growth or lateral movement in economic activity in June and July."
Despite these negative findings the National Bureau of Economic Research, the official arbiter of when the economy has entered recession has yet to make a formal announcement. Nor is the NBER likely to until 2002 because announcement dates lag recession's onset. The March 1991 trough of the last U.S. recession, for example, was not announced until December 1992 while the November 1982 trough was called in July 1983.
We observed in January the economy had already entered recession (see Donrey News Service, Feb. 2). Our forecast was based on developments including inversion of the yield curve in June 2000; contraction of industrial production--one of four key indicators used by the NBER to determine recession's onset--especially manufacturing output; declining credit standards and more fractures in the credit structure; and unsustainable consumer wealth effects from equity valuations based on a new and unrealistic metrics. On this latter point the words of former Fed Chair Paul Volcker appear especially prescient: "The fate of the world economy," Mr. Volcker said in late 1999, "is now totally dependent on the growth of the U.S. economy, which is dependent on the stock market, whose growth is dependent on about 50 stocks, half of which have never reported any earnings."
The Fed's findings are part of a trend readily apparent in 2001 to any Arkansan curious about economic conditions. The Beige Book (Jan. 17) stated, "Manufacturing activity weakened in all districts in December." Arkansas is part of the St. Louis Fed region, which reported (March 7) "noticeably lower economic activity," the only one of 12 regions in the U.S. to do so. "Almost all districts report a slow pace of economic activity ... Manufacturing activity continues to weaken across districts, with demand having fallen in most industries," the May 2 report said. The June 13 report said: "Most districts report that economic activity was little changed or decelerating in April and May."
Some observers, predominantly state officials, counter these reports matter little because Arkansas' economy is largely agricultural, not manufacturing-based. A spokesman for one, a top Republican politician, characterized as "economic doctors of doom and gloom" those who share our viewpoint. The fact is recessions increase effective tax rates when officials raise fees and taxes rather than restructure government. These officials should consider the following observation (May 2) concerning agriculture in the St. Louis region: "Most crop prices remain depressed and continue to adversely affect farmers." Denial and indifference are cruel responses to recession, characterized by the elimination of jobs, human suffering and higher effective tax rates if the fiscal policy response is inappropriate or misunderstood.
Allowing markets to eliminate malinvestments, and a combination of monetary (Fed easing) and fiscal (tax and budget) policies, are the appropriate response to recession. There is a lag between the time monetary policy is enacted and when it takes effect in the short-run. Mr. Volcker once said, "The Federal Reserve is often not in control of things, particularly in the short run. Sometimes the markets are in control of events rather than the other way around." There is also a fiscal policy lag. The 1981 Reagan income and capital gains tax cuts did not have a major impact until late 1982.
The Fed has eased and Washington has cut taxes--the proper fiscal response--while Little Rock has raised more than $85 million in new fees in 2001. Fortunately, there are signs Washington is prepared to cut taxes even further to stimulate capital investment. Recessions are deeper and more severe when the proper fiscal policy response is not implemented. Expect more capital flight if Arkansas fails to reduce its effective rates in response.
There has been an overabundance of optimism for most of 2001. Much of this sentiment is a carryover from the so-called 'New Paradigm' thinking of the late 1990s that argued the business cycle had been repealed. Today, conditions have reversed and there is an overabundance of pessimism regarding the U.S. economy. Best-selling books forecasting Dow 36,000 and popular news accounts of Internet stock billionaires heading firms with no earnings have been replaced with stories like "Dow Headed Toward Worst Week Since Depression." The terrorist attacks were cowardly and destructive and have increased fear and uncertainty in many quarters. Given recent events it is important to remember economic recovery always follows the recession phase of the cycle upon us. Historical perspective, not panic and fear, are called for under the circumstances.
Post-war recessions have lasted an average of 11 months, with the November 1973-March 1975 and July 1981-November 1982 contractions lasting nearly a year-and-a-half (16 months). The last recession, July 1990-March 1991, lasted eight months. Seven of the nine recessions in the post-war era lasted less than a year. Expansions, by contrast, have lasted an average 50 months since 1945. Entering 2001 the U.S. economy had been in expansion for a record 118 months, surpassing the gains of 1961-1969 (106 months) and 1982-1990 (92 months).
Average quarterly economic growth (real GNP) exceeded four percent in the year following four of the last five recessions. The exception was the year following the 1990-91 recession when average quarterly GNP was 1.9 percent. Growth was most explosive in the four quarters following the two most severe recessions (1973-75 and 1981-82), averaging 6.6 percent per quarter following the former and 6.9 percent after the latter. The trend has been for the most severe contractions to be followed by the strongest upturns in the economy.
The weakness in the U.S. economy so apparent late last year and throughout 2001 will not be solved by happy talk or collective denial. Fiscal stimulus, including a reduction in federal and state capital gains tax rates is necessary to address the current economic downturn. Economic recovery, like recession, is inevitable. But recovery will occur sooner, and more dramatically, if policymakers act forcefully and without hesitation.
Greg Kaza is executive director of the Arkansas Policy Foundation.