Length of Recession Pivots on Consumer Confidence

Wars are usually associated with rising output, low unemployment and high rates of capacity utilization, as military demands add to normal economic activity. This time, for the first time, war and recession have come together. Recessions are usually caused by rising interest rates, brought about by the Federal Reserve to curb inflation. This time the Fed’s short-term interest rates had been steady or declining for more than a year before the economy turned down. What do these unusual circumstances tell us about the recession and where it will probably go from here?

As soon as Iraq invaded Kuwait, oil prices shot up, suggesting a parallel between the present situation and the recessions of 1973-74 and 1980-82 that were brought on by the price hikes of OPEC-1 and OPEC-2. The OPEC price shocks depressed the economy through two channels. First, the higher oil prices acted much the same as a new excise tax in depressing real incomes and raising production costs. Second, by adding immediately to inflation and to the expectation that the wage-price spiral might accelerate further, the oil price increases led the Federal Reserve to tighten monetary policy severely.

This time, the effect of higher oil prices has been much smaller. As of the fourth quarter of 1990, the “oil tax,” calculated as the increase in the amount spent on oil because of higher prices, was about 1.5% of GNP. It was more than twice that large in OPEC-1 and in OPEC-2. What is more, oil prices were already declining by this winter, so little oil tax effect remains.

Between June and December, the overall consumer price index rose at an annual rate of 6.4%, while the index, excluding energy prices, rose at a 4.7% rate. Thus the inflation effect of higher oil prices has been noticeable but not so great as to push the Fed to tighten policy. On balance, there was some negative effect on the economy from higher oil prices, but it has been modest--not decisive, as it was in causing the previous two recessions.

What seems to have mattered the most this time is the effect of the Gulf crisis on consumer attitudes and spending. There are two main surveys of consumer attitudes: the consumer confidence index of the Conference Board and the index of consumer sentiment of the Survey Research Center at the University of Michigan. During the second half of last year, the confidence index declined by 40%, from 106 to 62, then fell to 54 in January. Between the second and fourth quarters last year, the less volatile sentiment index fell nearly 30%.

Consumer attitudes always turn down in a recession out of fear of job loss.

Indeed, because consumption represents some two-thirds of total demand, it would be hard to imagine a sustained decline in total gross national product alongside rising spending for consumption goods.

However, this time the attitude change appears to be larger than usual and to have been moved by the Gulf crisis as well as by conventional recession fears or simply higher oil prices. Attitudes started down sharply from the start of the crisis and have continued falling this winter despite the retreat in oil prices.

In contrast with these strong depressing effects from consumer attitudes, the traditional stimulus that war provides to an economy will be muted this time. The war is being fought out of the inventory of planes, tanks, guns and missiles that had been built up during the Cold War with the Soviet Union. And while the costs associated with personnel, troop movements and construction in Saudi Arabia add to the budget totals, they add only moderately to demand for current domestic production. Some of the weapons inventory will be replenished, adding to orders of defense contractors and to economic activity through that route. But that effect has been small thus far and will be superimposed on a defense budget that would otherwise be declining.

Because the effects of the war on the expectations and attitudes of the private sector can affect spending so promptly and sharply, a quick and successful end to the war could, by itself, provide enough lift to consumer spending to stop the recession. Except for construction, where overbuilding will force reduced activity for several quarters, other sources of demand could easily revive, particularly if consumer spending leads the way.

But there is also a downside risk to this apparent sensitivity to news from the Gulf. If the war drags on and the news worsens, still more negative consumer attitudes may depress consumer spending for some time to come. In turn, this may cause businesses to curtail investment plans, further deepening the overall recession.

Conventional economic remedies are still useful in this unconventional environment. The Fed has driven down interest rates aggressively as it has become more convinced of economic weakness. With a quick and successful conclusion to the war, its actions to date may be enough. If we get prolonged bad news from the war front, it may have to do much more.