Even if the crisis in the Persian Gulf had not erupted, the U.S. economy would probably have entered a recession in 1990 anyway. And even if the debacle in Washington over the budget deficit had not shaken consumer confidence, it was probably too late by then to avert a downturn caused by an overly tight monetary policy.
But the additional shocks from the oil-price increase and from the expected tax increases all but guaranteed that the insufficient growth of money and credit since early spring would precipitate the recession. And they will require strong steps by the Fed to get the economy back onto a path of stable growth.
Ultimately the Federal Reserve has the responsibility for maintaining non-inflationary growth through its control over the amount of money and credit available. When the Fed allows money and credit to grow too quickly, inflationary pressures build up. Conversely, when there is too little money and credit available, the economy slows down or even declines.
It should now be clear that the Fed was too restrictive in its monetary policy last year. Its original goal of 5% growth in money and credit (as measured by the growth of M2, which includes bank deposits, money-market mutual funds and other liquid assets) would have been adequate to ensure real growth in gross national product in the absence of other negative factors. But, in fact, the Fed did not come close to meeting its 5% goal. Money and credit grew by just 3% from December, 1989, to December, 1990. In the second half of the year, M2 grew at an annual rate of only 2.5%. Such low rates of money expansion provide no room for real GNP growth after allowing for inflation.
We are not forgetting that the Fed has taken several notable steps to lower interest rates since July. But the statistics on money growth indicate that the Fed’s action was too little, too late.
The original Fed goal of 5% money and credit growth was long before the Iraqi invasion of Kuwait and the disruption in oil supplies. Even if the Fed had met its original goal, the jump in oil prices could well have been sufficient to push the economy into a temporary recession. Higher oil prices have helped to push inflation close to 6%. The resulting reduction in real incomes could have dampened demand enough to cause a temporary decline in GNP even if the Fed had permitted money to grow at 5%.
Although the gulf crisis needn’t have interfered with the Fed’s ability to maintain its original plan, its continuing tight monetary policy since August may have been due in part to a desire to dampen the temporary rise in inflation as oil prices rose.
The collapse of consumer confidence in October was the third factor, along with insufficient monetary growth and the oil demi-shock, responsible for the current recession. The index of consumer confidence registered its largest drop ever between September and October. Worried consumers stopped buying homes and big-ticket consumer durables and looked for ways to save money on even everyday purchases.
The gulf crisis is only a partial explanation for the loss of consumer confidence. The seemingly endless debate between the Administration and Congress over the budget undoubtedly contributed to growing pessimism. But in the final analysis, consumers were most likely reacting to the expected loss of real income from the tax increases now in place.
How does the economy bounce back from the triple whammy we have just described? It is possible that much of the dampening effect of tax increases may be over by the end of the current quarter. The oil-price hike is unlikely to worsen. The decline of the dollar during the past year should give exports a helpful boost and reduce Americans’ appetite for imported goods. But these positive factors must be weighed against such things as the general tightness of credit in the financial sector and the danger that the debt overhang of the corporate sector will worsen as the downturn squeezes profits.
Federal Reserve policy, as always, is the key to recovery and, under current conditions, should be enough to ensure that recovery. But the Fed should make certain that money and credit expand fast enough in the months ahead to support a positive growth of real income even if that means a faster decline in interest rates and in the dollar than it has recently been willing to accept.