Full Speed Ahead to Recession

A black, billowing cloud of recession is about to engulf the U.S. economy. The only questions are how long and how severe it will be.

A recession starts when our gross domestic product begins to contract. GDP is calculated using four components--consumption, investment, government spending and net exports (exports minus imports). Three of these are entering free fall.

The problem started with the Asian crisis. Weaker Asian currencies have made U.S. exports less attractive and foreign imports more attractive, while recessions in Asia have greatly reduced the income of Asian consumers and hence their purchases of U.S. goods. The result has been a sharp decline in U.S. net exports and a soaring trade deficit.

Initially, this decline was perversely comforting because it saved us from a nasty round of interest rate hikes by the Federal Reserve aimed at cooling the economy. Now, however, with two other GDP components--consumption and investment--about to plunge, the Asian crisis has come home to roost.

It began several months ago with a slight decline in consumer confidence. Since consumption represents about 70% of the GDP, even a small change in consumer confidence can’t be taken lightly. But this small change has been magnified by the recent and jarring drop in the stock market.

When the stock market was rising, investors saw their portfolios rise dramatically. Feeling wealthier, consumers went on a binge, snatching up everything from refrigerators and cars to houses. But with the stock market in sharp decline, this “wealth effect” has reversed. Now consumers are going to be more frugal. While this is rational behavior at the individual level, the collective effect could be devastating.

Which brings us to a third GDP component about to go into free fall--investment. When stock prices plunge, corporations are loath to issue new shares at bargain basement prices to finance growth. In a bear market, businesses also are much less likely to invest for fear of being caught with high inventories.

It follows, then, that with net exports, consumption and investment all heading south, a recession is inevitable. What, if anything, can be done?

The traditional Keynesian cure for a recession is expansionary fiscal policy--increase government spending or cut taxes. With the GOP controlling Congress, we can rule out any new government spending but, as recession looms, talk has begun about a tax cut. However, such a tax cut is likely to be ineffective. Indeed, we need to look no further than the recent Japanese experience. Instead of using tax cut gains to consume their way out of recession, worried Japanese citizens increased their savings--an action credit-stretched and equally wary Americans would probably emulate.

That leaves monetary policy to ride to the rescue. However, history teaches us that monetary policy is far more effective combating inflation than curing recession. When the Federal Reserve raises interest rates to fight inflation, it is “pulling on a string” in the sense that businesses immediately respond by reducing investment. However, as we learned during the Great Depression, lower interest rates can’t “push on a string,” meaning that unless businesses are convinced that a recession can be averted, they won’t invest no matter how low interest rates go.

The bottom line: We are about to be engulfed in a recession that is largely not of our own making and that we can do little about. The important thing now is not to panic. Rather, we must batten down the hatches, ride out the storm and remember that we are, above all, a tough nation; we will not just survive the coming downturn but once again prosper.