Government Actions Will Drag Out the Recession

To state that economic policy has come a long way in recent decades is not necessarily a compliment to government policy-makers.

In earlier days, the focus of discussions on economic policy used to be on whether the federal government was embarking on a sufficiently activist counter-cyclical policy. The slightest sign of economic weakness seemed to provide encouragement for those perennially seeking a larger public sector.

By contrast, many conservatives believed that, given the frailty of human decision making, the economy would be in better shape if government would keep its hands off. In this latter view, government should let market forces operate more fully.

Whatever your position in the earlier debates, the relationship between government policy and economic performance in the current business cycle is ironic. It’s hard to argue that the federal government is doing too much to deal with recession. But it’s also hard to argue that government is not doing anything.

To the contrary, the folks in Washington have been and are scheduled to continue taking a series of strong actions--but this time each of them is likely to prolong the recession and delay and weaken the subsequent upturn.

Let us take fiscal policy as a good example. In the middle 1980s--when the American economy was booming--a bipartisan array of economists repeatedly urged Congress to take the tough actions necessary to reduce triple-digit budget deficits. Our distinguished representatives listened to us politely, often agreeing “in theory,” but really doing nothing.

But come 1990, when the longest peacetime expansion in American history was petering out, Congress belatedly began to cut spending and raise taxes (just the opposite of the counter-cyclical policy of earlier decades).

To some degree, the lack of political courage by Congress is minimizing the economic damage. That is so because the five-year package of deficit reductions is “back loaded.” Very little of the impact will be felt either this year or next. However, the recent history of the Gramm-Rudman-Hollings efforts to reduce the flow of federal red ink demonstrates that invariably back loaded budget approaches wind up as a two-step process. In the latter years, they are revised--and watered down--before the really tough cuts have to be made.

The conduct of monetary and banking policy shows a similar tendency to delay necessary actions to the latest--and worst possible--time. It became evident in the 1980s that many financial institutions were departing from traditional practices of caution and concern with the safety of their depositors’ money. Raising the limit on federal deposit insurance to $100,000 per account from $40,000 meant, of course, that rash actions with depositors’ funds mainly increased the ultimate likelihood of a federal bailout of the institutions involved.

Once again, remedial action was deferred until 1990 when bank regulatory standards were tightened in an extremely arbitrary manner. In fact, senior government officials quickly felt obliged to take the unusual action of informing the managers of the nation’s banks that the new policy was not meant to discourage lending generally.

One sensible action that the Federal Reserve recently took--lowering the reserves required by banks--underscores a continuing shortcoming in the conduct of monetary policy. To state that each bank should hold an equivalent to “X%” of its deposits in the form of secure balances with the Federal Reserve system sounds like merely a sensible precaution. But if the same requirements were described--more accurately--as forcing every bank to put “X%” of its funds on deposit in noninterest-bearing accounts with the Federal Reserve, the policy would strike many people as arbitrary, if not unfair.

The simplest solution is to require the Federal Reserve to pay market interest rates on those compulsory reserve deposits. However, this approach would have two conflicting effects. First of all, paying interest to banks would have the commendable impact of shoring up the weak financial condition now characteristic of quite a few financial institutions. Secondly--because 90% of the Fed’s profits are paid into the Treasury--requiring the Fed to pay interest on deposits by banks would simultaneously increase the federal deficit.

On another policy front, Congress waited until 1990 to begin enacting a new wave of costly and burdensome social regulation. Back in 1981, an unsuccessful effort was made to extend the Clean Air Act (the single most expensive regulatory law on the books) and to do so in a more cost-effective manner. No agreement could be reached. Finally, in 1990, Congress passed a new clean air statute estimated to add $25 billion a year or more to the $100 billion that the nation spends annually for a cleaner environment.

The point is not to oppose efforts to clean the air we breathe, the water we drink and so on, but to lament the fact that, over a nine-year period, Congress did not take advantage of a major opportunity to regulate in a more efficient and economical manner. This far-reaching law will directly inhibit the new business undertakings that are vital to generate the forces for the next economic upturn.

Indirectly, but powerfully, the 1990 “victory” of the environmental activists is whetting their appetite for repeating the performance in 1991 with other social regulatory statutes, notably the Clean Water Act and the Resource Conservation and Recovery Act.

In the personnel area, the Americans With Disabilities Act of 1990 is another law whose title made it hard to oppose. Yet many of the detailed provisions of this new statute are likely to be economically burdensome and especially prone to the generation of lengthy legal proceedings. Yet anyone raising questions of cost and effectiveness during the lengthy debate was quickly labeled a Neanderthal.

When we add up the strong, albeit unintended, adverse economic effects of current fiscal, monetary and regulatory policies, the odds of a longer recession than is generally anticipated would seem to be increasing. Elected officials love to sympathize with voters hit by recession, while simultaneously taking actions that exacerbate the problem. It is high time that government policy-makers take off their economic blinders.