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As an extension of previous arguments, it now appears that our greatest fears about the simultaneous appearance of two economic forces, inflation and recession, may become a reality in 2008. The actions of the Federal Reserve System and the federal government may be too little too late to prevent a recession, but they may be just in time for inflating an already troubled economy. The positive impact that the recent interest rate reductions and federal fiscal stimulus package may have on the nation's growth may be more than offset by the declining value of the dollar and the price inflation generated from higher oil, food, transportation, commodity, import, and consumer prices. Many economists are concerned about the issue of whether the technical definition of a recession (two sequential quarters of negative economic growth) will be met, and many political and business leaders doubt it. The reality is that the impact of a near recession and an actual recession will be difficult to distinguish in this marketplace. The dramatic slowdown in economic performance is a reality that will make us feel as if we are in a recession long before any announcement of a technical recession takes place.
In spite of the consensus forecast shown in Table 1, the economy continues to tilt toward slower economic performance in both 2008 and 2009. Few signals of a return to more solid economic growth are on the horizon. In fact, the abundance of negative economic news continues to put downward pressure on the economy. The negative implications of the long run structural changes taking place highlight the reduction in the economic dominance of the United States in the New World economy. The steady erosion of financial markets, the increasing internationalization of "American" industries, the persistent trend toward outsourcing manufacturing, and the new tendency to outsource services, including healthcare, finance, and insurance, are just a few examples of the structural changes that are impacting the domestic economy. The increasing dependence of the U.S. on foreign oil and the increasingly unstable set of OPEC leaders who have the power to influence the supply and subsequent price of oil make traditional monetary and fiscal tools more difficult to evaluate.
For example, one of the major areas of concern in the current slowdown has been the availability of credit and the role it plays in a downturn, which has been a concern in prior recessions. The current Federal Reserve Bank Chairman, Ben S. Bernanke, wrote about the 1990-1991 recession and the credit crunch in an article in the Brookings Papers on Economic Activity. In that article, entitled simply "The Credit Crunch," written with Cara S. Lown and Benjamin M. Friedman, Bernanke concluded the following:
Bernanke, Lown, and Friedman went even further in observing that "although a credit crunch will not render monetary policy impotent, it may make it more difficult to use conventional indicators to judge how tight or easy current policy is." (2) Bernanke and his coauthors concluded that even with their admitted meager evidence "the credit crunch--although not a myth--has not been a major cause of the recession." (3)
To some extent, fiscal policies that focus on increasing spending have been effective but difficult to evaluate. Because of significant variations in the details, the time lags involved in implementation, and the magnitude of the fiscal actions, the effectiveness of the policies are difficult to determine. For example, even in the face of large federal budget deficits, the current policy prescription for preventing the current slowdown from becoming a recession is to increase household spending by providing tax rebates similar to those given in response to the recession in 2001.
Some evidence does exist that supports the practice of giving households money as a fiscal stimulus. In a recent working paper published by the National Bureau of Economic Research (NBER) entitled "Household Expenditure and the Income Tax Rebates of 2001," the authors concluded that the $300 and $600 tax rebates sent to about two-thirds of households in 2001 were an effective tool against the recession and resulted in meaningful increases in consumption nondurable goods and food. Low-income and low-wealth families were the most likely group to spend all of their rebates. Consequently, rebates to those consumers were determined to be effective economic tools for stimulating the economy. (4)
While each recession is unique, some features seem common to each recession. For example, most recessions by definition have reductions in production, consumption, employment, and income; a build-up of inventories; reductions in capital investments; and some form of financial crisis. Whether it is the savings and loan crisis of the late 1980s or the Russian long-term capital financial crisis of the late 1990s, some form of financial crisis is typically associated with a slowdown or a recession.
The 2008 slowdown has many of the same cyclical features of other slowdowns plus some added features that may make this slowdown more difficult to address. Clearly, the economy is being buffeted by a storm of both structural and cyclical changes. The long-run trends are not new, and alone the trends might not signal the loss of U.S. economic power or performance. But working in conjunction with the meltdown of credit markets, the housing debacle, and a nearly jobless post-2000 period, the structural factors have compounded the cyclical slowdown. The meltdown of the stock market, the 2001 recession, the failure of many areas of the economy to generate new jobs since the late 1990s, and the absence of any meaningful increases in real income levels have created a weak economic environment. The economy has stagnated from an overwhelming abundance of debt, the absence of savings, the loss of wealth associated with the decline in housing prices, and the disastrous conditions in many housing markets.
We have passed the tipping point and have entered a period when the only questions are: How deep will the downturn be? How widespread will it be? How long will it last? The growth of the world economy has provided many companies with some protection from an economic downturn. While the advantages associated with market diversification benefit global businesses, market diversification has not provided the same advantages for domestic companies and workers. While it is true that the U.S. continues as the world's most powerful and influential economy, the dramatic growth of China, India, and other nations has diminished the leadership role played by the U.S. This is not an unprecedented change in position given the fall from economic grace experienced by most of colonial Europe (and more recently Japan), and it does not have to signal the long-term decline of the nation's economic power.
This diminished role does signal a change in the way we are perceived by the world, and it does change the way we are forced to interact with other nations. New issues, like the coupling and &coupling international events, are an outcome of the global nature of the "New World" economy. The domestic decisions that are made to address U.S. economic conditions have a clear and significant impact on our global trading partners. Decisions designed to improve the U.S. economy, like the recent interest rate reductions, may have a negative impact on other nations. For example, the lower domestic interest rates have had a negative impact on the value of the U.S. dollar, a positive impact on our exports, and a negative impact on our imports.
Nevertheless, the slowing U.S. economy has caused the Federal Reserve System to expand the money supply and reduce interest rates in an attempt to stimulate the domestic economy. Similarly, expansionary fiscal policies (in spite of the federal budget deficit) are intended to provide another form of stimulus. Time will tell if the dual stimulus efforts will provide a sufficient level of stimulus and yet not create excessive inflationary pressure. Ample evidence exists that the timing and effectiveness of federal actions are questionable at best. This time may be an exception, but evidence exists that the unintended consequences of both the monetary and fiscal policy initiatives will be negative. The actions and inactions of the Fed, bank regulators, and financial institutions in general were the primary cause of the housing explosion, the subprime market meltdown, and the subsequent credit crunch. But it is not clear that the Fed's actions can reverse the damage and that further interest rate reductions will offset the negative impact of declining home sales, starts, and prices. In fact, it is clear that interest rates are causing inflationary pressures to increase at the same time that the housing and credit markets remain in disarray. Similarly, it is not clear that providing more money to those most likely to spend it and those most deeply in debt will solve the problem of declining asset wealth, the illiquidity of homes, or the generation of new jobs. With the increasingly global leakages from our domestic economy, the size and the timing of any impact from increased spending are in doubt.
So what does this mean? Higher prices, slower growth, fewer jobs, less pay, and declining assets cannot be positive for the U.S. economy either this year or next year. The length of prior recessions shown in Table 2 clearly indicates that even modest recessions have a longer-term impact on the typical measures of economic activity. For example, following the July 1990 to March 1991 recession (eight months), unemployment rates that were 5.5 percent at the beginning of the recession continued to rise until June 1992 (fifteen months later) and peaked at 7.8 percent. Unemployment rates did not return to 5.5 percent until forty-four months later in December 1994. Similar time lags existed for the March 2001 to November 2001 recession when unemployment rates were 4.3 percent at the start of the recession, peaked nineteen months later at 6.3 percent, and returned to 4.4 percent after fifty-nine months.
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