In their most recent regional
report, several of the Federal Reserve banks reported that banks in
their regions were seeing a decline in credit demand. That's like the
Boston Strangler reporting that he noticed a decrease in the demand
for oxygen in his victims just after he had choked them to death. Like
the Strangler, the Fed has been too restrictive. Every small business
manager in America has thumbprints on his neck. The credit markets today
are not open for business, and as a result eight consecutive years of
economic growth are now over.
This will certainly be recorded as a recession, since both third- and
fourth-quarter GNP growth are likely to be negative. But it looks and
smells more like a financial panic than the traditional inventory recession
of the textbooks. Consumer durable demand is soft reflecting a rising
saving rate, but capital goods and exports are strong. Steel orders,
the traditional indicator of recession, are strong as well. The focus
of this downturn is finance, where falling real estate prices have eroded
collateral values and brought lending to a virtual standstill.
Not Just the Fed
It's not fair to blame the Fed for the entire problem. Not only is
the Federal Reserve Board deflating the economy's balance sheet, but
the Treasury Department has dispatched hordes of bank examiners across
the country, who have effectively dried up working capital for small
business. Meanwhile Congress, after refusing for a decade to restrain
its spending, is determined to raise every tax in the book now that
it has a president who is soft on taxes. And the president, after campaigning
brilliantly two years ago on a Son-of-Gipper (Giplet?) platform, has
decided he wants to be leader of the tax-raising pack. With the most
anti-growth set of policies since the late 1970s in place, the Middle
East crisis is almost redundant.
There's a song now making the rounds of the country music stations
called "Saddam Hussein, you're the one to blame." Although
he certainly qualifies as greatest villain of 1990 in every other way,
Saddam did not create the U.S. recession. The recession had already
been built into the economy by July. Forty dollar per barrel oil prices
have pushed growth down still further, of course, (by about a half percentage
point this quarter and next) and the risk of a shooting war has temporarily
raised the real cost of capital in the security markets. But when it
is all over, oil will turn out to have been a side show in this recession.
There is no oil price that is too high or low for an economy. What
matters is whether the price is what people thought it was going to
be when they built their businesses and organized their lives. When
the price of oil jumped in the 1970s, energy inefficient assets suddenly
sold at a discount in resale markets, and capital goods producers were
encouraged to design energy efficient assets in their place. So, gradually,
the finned Cadillacs and single-paned windows of the early 1970s gave
way to Hondas, smart thermostats and heat reflective glass, raising
the shadow oil price, the oil price embodied in the physical structure
of America's capital stock, from $3 per barrel in 1973, to about $24
per barrel today.
It is only to the extent that the economy believes that oil prices
will remain above the current shadow price of $24, that oil prices pose
a serious threat to the long-term growth rate of the U.S. economy. Today,
of course, prices are temporarily much higher. This has contributed
to our current slowdown by causing both consumers and corporate managers
to delay planned expenditures and by depressing stock and bond prices.
But the economy was already slowing sharply in July for entirely home
In chemistry class you learn that combining otherwise benign ingredients
can sometimes blow up the lab. Ironically, it is the combination of
three otherwise positive events, the Fed's newfound zeal for zero inflation,
the strong productivity performance of U.S. manufacturing companies
and the Treasury's desire to shore up the capital. structure of our
commercial banking system, that have cut the heart out of economic growth.
Zero inflation is a terrific idea. But in-flation of what? Analytically,
inflation is bad for an economy for the same reasons tax shelters are
bad: It distorts investment choices. Inflation artificially subsidizes
the real after-tax return on the ownership of tangible consumption assets
like cars, boats and houses, relative to the returns on bonds, stocks
and other financial assets. Over time, this causes people to rebalance
their portfolios toward the subsidized assets, diverting saving flows
away from new tools and factories and toward hotels, office buildings
and shopping centers.
But these analytical arguments only apply to physical, storable goods,
not to services like haircuts and guitar lessons. It is for real goods
prices that zero inflation is the right target.
Unfortunately, the Consumer Price Index, the deflator and most other
price Indexes used by the Fed to measure inflation are heavily weighted
toward services. More than half of the CPI, for example, is accounted
for by service prices. When goods and service prices diverge, as they
are doing now, the Fed is misled into crippling the industrial economy.
The problem is the productivity wedge between manufacturing and services.
For most of the past decade, U.S. manufacturing has turned out an impressive
productivity performance, with increases of more than 4% per year. The
service sector, in contrast, has had a difficult time raising productivity
at all. This discrepancy created the glut of manufactured goods that
caused the much-maligned employment shift out of manufacturing and into
service. sector jobs during the 1980s. (A shift that, as William Baumol
has pointed out on this page, has taken place in every major industrial
country in the world. ) The productivity wedge, in turn, has created
an inflation wedge: Real goods prices are consistently falling by 4%
to 5% per year relative to service prices.
For the first seven months of this year, for example, the goods component
of the CPI only grew at a 1.8% annual rate. But service prices grew
at 5.8%, so the CPI came in at 4.1%. The Fed, focusing on the CPI, thinks
inflation is too high and is reluctant to provide sufficient credit
for growth. It is possible, of course, for the Fed to tighten policy
hard enough, for long enough, to bring the CPI inflation rate down to
zero. Because of the productivity wedge, that can only be accomplished
by a deflation of goods prices of 2% to 3% per year. But the stock of
goods makes up the collateral of the nation's banking system. And deflating
the banking system's collateral does not make for a healthy economy.
For manufacturing companies this situation implies a chokingly high
real interest rate. A steel company I visited last week, for example,
had done a great job running their business during the past year. Real
volume had risen by. 5%. The price of the company's product, however,
had fallen by 7% over that same year. But the company's interest obligations
are not falling. The managers must therefore make their payments out
of declining dollar revenues and falling inventory valuations. For them,
the real interest rate-the difference between the interest rate they
pay (10%) and the change in the price of their product (-7%)--is a staggering
17%. For many managers today, the effective real interest-rate is much
higher than that, because they can't get capital at all.
What the Fed should be doing is targeting the long-term behavior of
goods, not services, prices--not just those of newly produced goods,
but those of goods in the resale markets as well, including real estate
and commodities. And right now those prices are either flat or falling.
It is easy to see that the Resolution Trust Corp. workout, which will
force the sale of hundreds of billions of dollars in real estate, is
going to put downward pressure on the prices of those assets. That will,
in turn, undermine the capital adequacy of the banking industry, of
life insurance companies and of corporate owners of fixed assets. These
balance sheet problems, and the regulators' response to them, have effectively
paralyzed the financial system's ability to provide working capital
to our businesses and led to a steady slowing of the economy all year.
It is fashionable in Washington these days to despair of the budget
crisis, and to talk about the need to raise taxes in order to balance
the budget and rescue the economy. But a world that is starving for
new capital is not going to allow lower interest rates in the U.S. whatever
its budget policy. In an environment like this, where companies are
gasping for the capital they need to run their businesses, it is the
height of folly to raise taxes.
Higher tax rates will only worsen the cash crunch that has brought
the economy to the brink of recession, slow growth further and shrink
tax collections. The budget imbalance does need to be solved, but not
through a Saturday night massacre of sin taxes. Rather, the U.S. must
take steps now to restore the smooth flow of credit to businesses, in
order to keep the financial panic from worsening.