Prosperity May Not Have Arrived but an Economic Recovery Surely Has

When I talk to businessmen, the first question many ask these days is: When will the recession end? Often they are dissatisfied, even scornful, of my answer: The recession ended more than a year ago in spring, 1991.

Part of the problem is semantic. To an economist, the opposite of recession is recovery or expansion; to many laymen, the opposite of recession is prosperity.

We have recovery but not prosperity. The economy has been expanding, on most conventional measures, for more than a year. But the expansion is uneven and slow. Output, adjusted for inflation, rose about 6% in the first year of the average postwar recovery. This time, first year growth was about 1.5%.

The difference is important to everyone. For workers and wage earners, the slow recovery means that new jobs are created too slowly to reduce the unemployment rate. Faster economic growth would both absorb the unemployed and lower the risk of layoffs and job losses. For pensioners, the slow recovery keeps interest rates low, so it cuts the income on past savings and entices them to buy riskier assets. In these and other ways, we are all affected.

Since this is an election year, the candidates have heightened interest in how the economy develops. Officeholders offer an abundance of proposals for doing something to speed recovery. Some want faster money growth and lower interest rates. Some want to increase subsidies for home buying. Some want new programs to build highways and infrastructure. Some want an investment tax credit to increase private spending. Some want all or most of the above.

Before choosing a remedy, it is a good idea to see why this recovery is below average. Doctors usually diagnose the illness before recommending treatment. Economists and policy makers should do the same. A poorly chosen remedy can do more harm than good.

Why, then, is the recovery so sluggish? I believe there are four main reasons.

- Typically, the pace of recovery is more rapid if the previous recession has been deep. Mild recessions are usually followed by relatively slow recoveries. The 1990-91 recession was one of the mildest of the post-war period. Real output fell at an average annual rate of 3.2% for two quarters. In contrast, the 1981-82 recession was deeper and longer. Real output fell an average of 5.7% for two quarters in 1981-82, then recovered briefly for one quarter before declining again. In the 1957-58 recession, output fell at an annual rate of 7% for two quarters.

* A more important cause of the slow recovery is the cutback in defense production and procurement. Because of the war in the Persian Gulf, defense expenditure rose at an average annual rate of 14% during the recession, thereby keeping the recession relatively mild. Just as the economy began to recover, defense spending began to decline. For the four quarters ending March, 1992, defense spending fell at a 5.5% annual rate. The fall was particularly rapid (13% annual rate) in the fourth quarter of 1991, giving rise to incorrect predictions that the economy would return to recession.

Lower defense spending has been particularly important for Southern California and New England. These regions are having great difficulty replacing the jobs and income that the Defense Department once supported. Experience after the Korean War and at the end of the Vietnam War suggests that the effects of lower defense spending will continue to slow the recovery for a year or more.

* Disinflation may also contribute to the sluggishness of the recovery. One reason is that land prices are incorporated in the anticipated future rate of inflation. When people believe that inflation will rise, they bid more for land, gold, platinum and other assets that are relatively fixed in supply. Rising inflation lets those who borrow to buy land and houses gain at the expense of lenders, such as banks.

When inflation is expected to fall, the process works in reverse. Land prices adjust downward until they reflect the lower expected average rate of inflation. Borrowers lose.

Land and housing prices have fallen in many parts of the United States during the last three years. As these prices fell, homeowners’ wealth was reduced. Many try to save more to restore part of their lost wealth, so they buy fewer goods and services. Slower spending contributes to slower growth of output.

However, slower inflation also lowers interest rates. Lower interest rates allow homeowners to rewrite their mortgages, lowering the cost of owning property. Once these adjustments are completed, land and housing prices stabilize or resume their increase at a rate that reflects the economy’s lower rate of inflation.

Disinflation is not limited to the United States. In Europe, particularly Britain, inflation has fallen. Housing values in many parts of Britain are below the value of mortgages and continue to fall. Tokyo and Osaka, Sydney and Singapore have also experienced disinflation. Growth of consumer spending is slow or negative in several of these countries. They buy less from us, and we buy less from them.

Disinflation and defense cutbacks are painful, but they bring durable long-term benefits. Once the defense adjustment is completed, the economy will be able to produce more non-defense goods and services, export more, invest more in civilian research and development. People will enjoy a higher living standard. Once the disinflation is complete, the economy will be free of the uncertainty, distortions and transfers that inflation causes.

* The remaining reason for the slow recovery--slower average productivity growth--brings no long-term benefit. Productivity growth was higher in the 1980s than in the 1970s but lower than in the early post-war decades. Comparisons of the current recovery to the average post-war recovery that neglect the slower productivity growth of the last 20 years overstate the normal or expected rate of recovery by about 1%.

Add about 1% for the cut in defense spending to the 1% for slower average productivity growth, and perhaps 0.5% to 1% for the effect on spending of households’ loss of wealth from disinflation. Together these factors take at least 2.5% off the growth rate during the first year of the current recovery. Without them, the slow 1.6% growth would be about 4%.

A 4% rate of recovery would have reduced unemployment. Concerns about the near-term future, job losses and wealth losses would be smaller or nonexistent.

Although these numerical estimates cannot be precise, they make an important point. Once the adjustments to lower inflation and lower defense spending are over, the U.S. economy will expand more rapidly. The real peace dividend will be the more productive use of resources in an economy with stable prices or low inflation.