Belt Tightening Would Do More Harm Than Good

Even a short and successful war can be expensive. Given our current conflict in the Persian Gulf, the American economy should not be further impoverished by misguided policies.

Oil prices are now sharply lower. Continued allied air dominance in the Gulf and the judicious use of strategic petroleum reserves should keep them that way. With oil prices down, recession, not inflation, is the economy’s major enemy. Expansionary fiscal and monetary policies are proven weapons against this enemy.

As the economy weakens, the fiscal weapon is operating automatically, as tax revenues decline and counter-cyclical expenditures (such as unemployment compensation) increase.

Therefore, despite the October budget accord, which slashes the deficit by more than $500 billion during the next five years, the 1991 deficit will hit a record high as a result of the economy’s decline and the costs of the Gulf War. The budget accord succeeded in reversing the trend of ever-increasing deficits when the economy is strong, but it is inadequate to stem the deficit when the economy is weak.

Does this mean that we should compensate with greater budgetary austerity? The answer is a resounding no. A war tax or any other measure to cut the deficit would constitute a self-inflicted wound. In addition to the costs of the war, the American population would be forced to pay the unnecessary costs of further reductions in output and employment. It is a foolish policy to make ourselves poorer to balance the budget.

Nor need we. Balancing the budget is not an end in itself. When the economy is strong, a large deficit keeps interest rates up as the government competes for funds with the private sector. Government borrowing crowds out private economic activity. Balancing the budget under these circumstances is the means to achieving the desired ends of lower interest rates and stronger private spending.

In contrast, when the economy is weak, pessimistic expectations depress private borrowing. Government borrowing under these circumstances does not necessitate higher interest rates. Through its stimulating effects on real economic activity, deficit spending may actually generate private spending by countering recessionary expectations.

Given current financial conditions in the United States and around the world, there is no reason why the government cannot and should not borrow to finance its growing deficit. Abroad, recessionary forces are strengthening. The much anticipated shortage in world capital markets has yet to materialize.

At home, a credit crunch--mild as yet, but potentially ominous--is under way. Banks, concerned over the credit worthiness of their private borrowers, are increasingly reluctant to lend. And households and companies, already burdened by heavy debt and frightened by the unanticipated severity of the economy’s downturn, are reluctant to borrow.

Under these circumstances, there is little danger that deficit spending will crowd out private spending. But there is a real danger that unnecessary fiscal austerity, combined with excessive caution on the part of the Federal Reserve, will further depress the economy and aggravate the credit crunch. Under these conditions, a full-scale financial crisis cannot be discounted.

To avoid such a crisis, the Fed, like the fiscal authorities, must recognize that the real enemy is recession. During the fall, the Fed cut its benchmark interest rate four times, and more boldly, reduced the amount of reserves that banks are obliged to hold against their customers’ deposits.

Still, the Fed’s moves have been more reactive, responding to the weakness of the economy, than proactive, trying to head off further declines. As Greenspan conceded in his recent comments before the House Budget Committee, the Fed’s actions have so far failed to increase the money supply, which remained flat throughout the fall.

The Fed should act to lower interest rates still further. And at the first signs that the credit crunch is worsening, the Fed should purchase government bonds, if necessary in large amounts, to keep interest rates low and to maintain liquidity in the domestic banking system.

Recessionary economic conditions warrant expansionary fiscal and monetary policies to finance them. Yet the economic uncertainty created by the war doesn’t suggest a strategy of caution. In particular, Congress should not respond to two quarters of negative growth by sacrificing the hard-won spending cuts and tax increases mandated by the October budget accord. Rather, if more stimulus is needed, monetary policy should call the shots.

If, as a result of unanticipated developments in the Gulf, oil prices rise sharply, then temporary price controls and mandatory rationing must be considered. In the absence of such controls, the threat of inflation will dictate a more restrictive monetary policy that in turn will aggravate the economic downturn and increase the chances of widespread financial collapse.

In general, price controls and rationing do more harm than good, but during this particular war and in these particular economic circumstances, they may become unfortunate necessities.

Even now the President should be calling for voluntary efforts to reduce energy consumption. Each of us can take action to reduce the nation’s dependence on Gulf oil. Yet as long as energy prices remain low, we do nothing. We are selfishly overlooking the opportunity to send a powerful message of support to our troops and a powerful message of resistance to Saddam Hussein.

How best to finance the peace, as how best to finance the war, depends on prevailing economic conditions. A successful resolution of the Gulf crisis is likely to provide a boost to private economic activity through improved expectations and further reductions in oil prices. The delayed effects of lower interest rates and a lower value for the dollar will also encourage economic expansion.

To avoid renewed inflationary pressure as the economy expands, the deficit must be reduced. To some extent this will occur automatically through the counter-cyclical stabilizers in place.

In addition, the gradual spending cutbacks mandated by the October budget accord will help stem the flood of red ink. But if--as seems inevitable--the intervening war effort and the recession necessitate much bigger deficits in fiscal 1991 and 1992 than originally anticipated, further deficit-reduction measures will be required. The additional budgetary costs of the war effort cannot be avoided; deficit spending simply postpones them, to a time when a more robust economy will be better able to absorb them.

How we chose to defray these costs will have a critical influence on our economic well-being for the rest of the decade.

Regardless of the outcome in the Gulf, we must shift our spending priorities away from the military. We desperately need to increase federal spending on child care, education, infrastructure, scientific research and support for state and local social programs to fight poverty, crime, homelessness, AIDS and other social problems. If we fail to meet these needs, we may win the war in the Gulf but lose the war against declining living standards and social decay at home. Our military victory will come at the expense of our further decline as a global economic power and ultimately as a military power as well.

How shall we finance our peacetime needs and still pay the costs of the war? One possibility is a real peace dividend--a cut in military spending by 25% to 50% a year over several years, as was contemplated by many before the war began.

Another is a serious increase in energy taxes. Without even approaching levels of such taxes in Europe and Japan, we could easily raise $30 billion to $40 billion a year and significantly reduce our energy dependence at the same time. A third possibility is an income surtax or a national consumption tax, either of which could raise substantial new revenue.

Depending on the war’s ultimate cost, some combination of all three of these options may be required.

Like the allied command, U.S. economic policy-makers must correctly identify the enemy and take bold, coordinated actions to defeat it.

For now, the enemy is recession and the appropriate weapons are deficit spending and easier monetary policy. As the economy recovers, however, the enemy will be our own unwillingness to pay the costs of war and the costs of meeting our pressing economic and social needs. This enemy is a subtler but no less formidable one than Saddam Hussein.