The U.S. economy has been felled by a deadly one-two combination delivered by Saddam Hussein of Baghdad and Alan Greenspan of Washington, the Mike Tyson and Evander Holyfield of economics.
Although it isn`t widely perceived, Greenspan clearly packed the most powerful punch.
Still on a crusade to beat inflation into absolute submission, the chairman of the Federal Reserve Board and his colleagues have continued applying strong monetary restraint to the economy, fending off calls to ease up as Hussein`s oil shock smashed consumer confidence and sent the economy south.
The central bank`s halting performance during the bleak fall of 1990 now threatens to make the recession deeper and longer, raising troubling questions about its ability to manage a fragile economy over the long haul.
Beyond this, Washington`s wisdom of leaving so much economic power in the hands of an unelected, unaccountable, nearly invisible group of central bankers with an austere strategy all their own seems increasingly risky as the American economy struggles to become more productive in the 1990s.
Indeed, the long-term squeeze the Fed is applying to the economy is making the job of state and local governments more difficult in finding funds to pay for more investment in education and infrastructure required to make the U.S. economy competitive.
”The quality of the labor force is a key issue in today`s global economy,” said John Silvia, economist at Kemper Financial Services in Chicago. ”But how do you get that quality when state and local governments face budget squeezes because of a weak economy. You`re not going to get the investment you need.”
The central bank has been tarnished since the invasion because it has been slow to ease up supplying money and credit to the economy when the downturn was clearly becoming worse.
Some analysts believe that the reappointment of Greenspan, named chairman by President Ronald Reagan in 1987 to replace Paul Volcker, is no longer a sure thing, especially if the recession lingers until his term expires in the middle of next year.
”He has been behind the curve in easing,” said David Jones, an economist for Aubrey G. Lanston & Co., a large government securities dealer based in New York. ”Greenspan by nature is a cautious person, but it`s time to be dramatic, not cautious. He tends to view the economy through the rear-view mirror.”
But there`s more to the criticism than the issue of mere caution. Silvia and Jones are not alone in believing that the central bank has been taken over by a group of inflation hawks determined to bring the price level down much too soon and too steep considering the fragile nature of the economy.
”Say the economy is a wagon, and the driver is in a straightjacket, the horse is wearing blinders, and Saddam Hussein has just blown up the bridge in front of you,” Silvia said. ”Well, that`s what has happened. The budget has a straightjacket on, the Fed has blinders on, and the economy is on the precipice.”
While the Fed continues this stingy stance, the critics point out, Congress has approved a budget package that quashes government spending for any kind of new or innovative programs that could foster a more productive economy.
For example, Robert Eisner, professor of economics at Northwestern University, said the budget constraints will force the country to forego spending for new transportation systems and other public projects, the development of new technology through expanded research and for education.
Most economists believe the country is in a mild, six-month recession. The slowness of the Fed`s action could make the recession last nine months and could add to the unemployment and profit misery now beginning to hammer the economy. Jones said it could well last until 1992.
The Fed, independent from political influence, set out to cure many of the excesses of the 1980s, including the massive budget deficit run up because of tax cuts and heavier military spending.
But it has gone about its job like no other Fed of the past. After the 1981-82 recession, inflation remained tame during the mid-1980s, only to creep up again after Greenspan`s appointment in 1987. Prices were rising at an annual rate of about 5 percent when Hussein invaded Kuwait.
Left to its own devices by the politicians, the central bank in late 1987 or early 1988 embarked on a long-term strategy of keeping interest rates up in order to squeeze inflation out of the system over several years. This would necessitate holding the economy back, keeping the engine well below its cruising speed. Although the economy in this day and time might have the capacity to grow by 2.5 percent a year after inflation, the Fed decided to hold it lower than that.
The aim was to bring the economy to a ”soft landing” sometime around the time of the next presidential election. If it worked, there would be no recession, inflation would be down to the range of 3 percent a year, and there would be enough slack for the economy to take off and grow indefinitely.
The Fed went about its job single-mindedly as if it were on a holy mission. Yet it moved cautiously, haltingly, in baby steps, in what has become to be known as fine-tuning.
The credit-tightening came at a time when both banks and savings and loan associations were forced to end their high-flying lending policies of the 1980s. With the S&L bailout, Congress forced the thrift industry to tighten speculative lending.
Banks, meantime, which had lent heavily to finance real estate lending in the 1980s, suddenly saw prices collapse because of overbuilding. The retrenchment in lending created a credit crunch that accelerated the economic downturn.
So when Iraq invaded Kuwait on Aug. 2, the economy already was in a weakened state, skirting on the edge of recession. Hussein tipped it over.
And through it all, inflation barely moved a whit.
Although many people panicked after the invasion, Greenspan`s Fed didn`t. It gradually pushed down short-term interest rates, and it lowered reserve requirements on some bank instruments in order to expand loans.
It was said to be between the proverbial ”rock and a hard place”
because to ease interest rates dramatically might drive the dollar down, and cause Japanese investors to abandon the U.S. economy. To keep Japanese money flowing to the U.S., the central bank was forced to keep interest rates high. But the Fed`s hands are not tied as tightly as is widely believed when it comes to fears about Japan yanking its money from the U.S. for this reason:
Japan won`t abandon its biggest market so easily. All during the 1980s, when the U.S. ran a big budget deficit, Japan helped finance the economic recovery by lending heavily to the U.S. government and U.S. financial institutions. It raised the specter that it could yank this money from the U.S. in a flash, sending the country into a recession.
Yet Japan`s self-interest dictates that it move in a way to keep the American economy afloat, since a sharp economic downturn here will only lessen the market for Japanese goods. Thus both nations have developed a symbiotic economic relationship requiring that, within certain boundaries, they both behave responsibly.
The Fed`s tough stance against inflation is a surprise since the board is made up of appointees named by Reagan and President Bush, both of whom have been highly critical of tight-money policies.
Jones of Aubrey G. Lanston said Greenspan is so patient that the more aggressive members of the central bank, especially some of the hawkish regional bank presidents, have dominated monetary policy. Some of the regional presidents-whom Jones called ”young Turks”-have been stressing a policy that would bring inflation down to zero by 1994.
”The young Turks have been willing to risk a recession to do it,” he said.
Greenspan, on the other hand, is seen as a Fed chairman obsessed with economic indicators that give a snapshot of conditions in the past. Jones said he lacks the instinctive feel for the economy that Volcker appeared to have.
Silvia of Kemper Financial Services said inflation is a ”lagging indicator,” and that the central bank may be so cautious that it will have to see inflation declines before it eases dramatically. Silvia said he sees negative inflation numbers occurring in January. But now is the time to act, he added, although the Fed has continued to be stingy.
The Federal Reserve`s job is to ration money and credit to the economy in a way that will promote noninflationary growth. It does so by buying and selling government debt securities in the open market. To expand the supply of money and thus lower interest rates, it creates money out of thin air by writing a check on its own account to buy government securities from financial institutions. Institutions take the money and make new loans.
Its gyroscope is something called the federal funds rate, the interest rates that banks charge each other for overnight loans. It has gradually cut this rate as the economy has slowed, yet other short-term interest rates have not come down in proportion. For example, the rates on commercial paper-the main source of corporate borrowing-have not come down nearly as much, said Silvia.
The economy`s key problem is lagging productivity, or efficiency, according to economists. There are many reasons for this problem, including poor savings rates by Americans, a reluctance to invest by corporations, and the high cost of capital itself.
The central bank, however, assumes no responsibility for improving the competitive nature of the economy. It believes its main job is to keep inflation under control. If that happens, the private economy will take care of itself. Manipulating the supply of money chiefly affects prices of goods and services, its defenders say.
The way to have stable, low long-term interest rates is to bring inflation down and keep it down, said Lyle Gramley, a former Federal Reserve Board governor who believes that Greenspan is being unfairly criticized and thinks the central bank`s policy is superb.
But many others say tight money is not the only way to tackle rising prices. Indeed, because it slows down the economy and forces businesses to lay off workers and put off investments, it may postpone the required restructuring of the economy to bring about more efficiency.
With money tight, the cost of capital is high, and businesses are reluctant to invest.
Few would challenge the notion that the Fed`s job is to bring down the rate of inflation, and to make sure that the U.S. does not have a Latin-style hyperinflation. The criticism now is chiefly over it the pace and aggressiveness at which it is going about it, even in the face of a major downturn.
So far, the central bank has been able to pin the blame on Saddam Hussein. Increasingly, however, this recession looks homemade-and it may be counterproductive to improving the economy in the long term.
