RUDI DORNBUSCH (FEBRUARY 2002): THE US RECOVERY

Chairman Greenspan’s flip-flop – was this about staying popular or did he have a weekend epiphany—should not be interpreted as assurance for a strong and sustained upswing. That there is a bottom and that a recovery is about to emerge is not in question; but how strong and lasting it will be is the big issue ahead. There are good reasons to be skeptical on the vigor of the upswing and that makes timely fiscal stimulus is all important. The present partisan stalemate on a fiscal package is bad for the US economy

If we do get a recovery by the second quarter, as is commonly assumed, can we count on it widening and deepening with job creation and investment feeding back to incomes and spending? Because there are plenty of doubts on this score using Secretary Powell's doctrine of "overwhelming force" is a sound policy approach. For most Americans having a recovery is far more important than Sen. Daschle's personal political agenda and ill-conceived or at least untimely criticisms of a growth strategy. Of course, there are justifiable partisan differences. But can it be so hard to agree on a package of temporary investment tax credits to melt the deepfreeze in the investment goods sector as well as targeted tax cuts for low income workers who will spend much of it and surely deserve a shot in the arm? The Kennedy package might be a good script.

Of course, Republicans have their own versions of voodoo-capital gains tax cuts are not known as a short-term growth booster - but the Daschle proposition that tax cuts raise long-term interest rates in a financially sound economy is certainly a novel one, to put it kindly. The reason for an urgent fiscal package is that there are a number of reasons to fear a late and weak recovery, which as such carries its own seeds of destruction. The US is nowhere near Japan but it must do its outmost to ensure that it doesn't get remotely into that neighborhood. With little left on the shelf for monetary policy, a short-term growth-targeted fiscal policy must come into play.

The ten postwar recessions have all followed much the same pattern. At some point in the recovery inflation fears lead the Fed to murder the upswing. Demand falls, unwanted inventories rise, and production is cut. Faced with recession and rising inflation, monetary and fiscal policies are activated to revive demand. Unfailingly they succeed, demand turns up, inventories are worked off and in time production resumes, unemployment falls and capacity utilization rises and soon we start all over again. We have been through the inventory run-off-discounted away by give-away automobiles and Christmas sales starting in November. Monetary policy has been at work for a full year now to stimulate demand. The rule of thumb is that a percentage point cut from the Fed, after a year or so, translates into an extra percent growth. On that count a lot of growth-4.5 percent are in the pipeline, ready to blast away any remnants of recession. Indeed, retail sales are keeping up and confidence has shown an upward blip, welcome signs of a recovery on the horizon.

But here are a few reasons to doubt the timing and especially the vigor of the upswing. The Fed's monetary policy has pushed down short rates, But long rates have not declined at all. The forward curve shows an assumption of recovery and vigorous rate hikes from the Fed. How effective is monetary policy if it just works the short end? Sure it helps, but it is plausible to cut the estimate of its effectiveness to half. That would take us to stimulus in the pipeline of barely 2 percent, unimpressive and much below central forecasts today.

But add to this a second concern. We already experienced in the recovery from the 1992 recession what then was called a jobless recovery. The situation this time round is much more tricky because, even in the present recession, productivity growth proceeds at an astounding 1.5 percent and is bound to rise with some upturn. New Economy high productivity growth means demand growth needs to be even higher - by a full percentage point because of labor force growth, to avoid rising unemployment.

The risk then is that a weak upturn is an upturn with rising unemployment. That of course means spending power is not expanding much and confidence even less. Such a recovery will not go far before it peters out. And there is yet another reason to be concerned about the weak forces driving growth. We can think of excess that needs to be cleared out before demand, orders and production resume. Unfortunately, excess capacity is the highest since the 1982 recession, the biggest question then is whether consumers and the rest of the world's demand can carry the recovery with vigor, waiting so to speak for the cavalry to catch up?

The rest of the world of course offers only the bleakest prospects-Japan bankrupt and in permanent recession, Europe in a slump from an accumulation of supply side strangulation and obstinacy on the use of policy, emerging markets mostly on the rope from over borrowing and reform fatigue. That leaves us with home consumers who have done their best to borrow and spend. They are not about to cave in. But surely they are not about to drive a vigorous upswing in the face of rising job losses. And if the upswing does not come, much of the borrowing that has kept us going will go sour and with that the prospect of prosperity any time soon. Lets call that unfortunate prospect the
Daschle recession.

Finally, who can give us assurance that an upswing just by monetary policy in fact will work. Surely there is no precedent and hence every reason to be skeptical. Fiscal policy-targeted to fight recession rather than serve long run structural objectives, works with big multipliers and within a quarter or response where monetary policy takes its time and has far more questions once a capital glut is part of the landscape. Faced with the choice of only one instrument, most economists surely would favor a targeted temporary fiscal package rather than rate cuts; of course, far better to have both.

Of course, a meek upturn with rising unemployment and the sheer absence of inflation frees the hands for the Fed to cut rates and, if necessary all the way to zero. In time long rates will fall as it is recognized that there is no prospect of rate hikes from the Fed and that near-deflation is the issue. All that will help and may limit the defensiveness on the side of consumers and business investment. But suppose then, as always happens, there is another shock. By that time monetary policy is gone here, and abroad where it is already gone. Fiscal policy is gone in Japan and by Maastricht strictures in Europe. The world that had an ample reservoir of policy suddenly falls back on just one thing: US fiscal policy. That is not much with which to keep the world out of potentially serious trouble.

The risks of a weak upswing are far too large to yield to the Daschle agenda, to untried monetary policy-only; its time for a bipartisan overwhelming strength strategy to move the economy back to the grand performance of the past decade which will only be read as a bubble if we make the mistake of letting it die. Its time to blast away the recession.