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http://www.businessweek.com
OCTOBER 22, 2001
BUSINESS OUTLOOK
U.S.: Why Washington Can Contain This Recession
Tax and rate cuts are helping households--and more aid is on the
way
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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