U.S. Has Plenty of Room to Maneuver
The Federal Reserve’s Open Market Committee, which meets Tuesday, has given strong indications that U.S. interest rates may rise. While many are nervous about this, it also underlines one of the most powerful facts about the U.S. economy, its enviable position compared to its trading partners in Europe and Asia. The United States, unlike other countries, has the ability, using the standard macroeconomic tools of monetary and fiscal policy, to either restrain or boost the economy as it sees fit.
Admittedly, the buzz about the new economy and the Internet makes emphasis on these textbook methods of business cycle control seem downright old-fashioned. And yet the United States stands uniquely equipped to employ either--or both--tools to offset a possible slump. That is fortunate not just for the United States but for the world economy as well. Europe and Japan, by contrast, cannot rely on either policy if their economies worsen.
Just consider the condition of U.S. fiscal policy. As recently as 1990, the thought of using fiscal policy--widening the deficit by lowering taxes or increasing spending--to offset the recession was considered heresy. No one wanted to draw the arrow of fiscal policy with the United States running up record budget deficits. Instead, pressure mounted for spending restraint, despite rising unemployment. Today, thanks to good luck and intelligent policymaking, the budget is in surplus for the first time since 1969. The U.S. fiscal position is excellent. Should the need arise, the United States can afford to run a budget deficit.
The other textbook tool of macroeconomic policy management--the ability to use the money supply and interest rates to increase growth--is readily available as well. The real Fed Funds rate now stands at the very high level of about 3%, substantially above the 1.5% average of the 1950s and 1960s, America’s previous era of low inflation. If the economy shows signs of softening, the Fed has plenty of room to maneuver aggressively by lowering interest rates. In fact, should the Fed decide to raise interest rates Tuesday, doing so would simply add to its ammunition in the event of a downturn. Higher interest rates mean more room to ease later on.
Contrast this with the situation in Europe, where using government spending to stimulate the economy is out of the question. To qualify for the common currency, the Euro countries underwent painful fiscal retrenchment. Now, some Euroland countries are contending with the budget tricks they used to get into the monetary union. As a result, further fiscal retrenchment is required. In addition, the European Commission and the new European Central Bank need to establish their credibility, so they keep close watch on members’ fiscal plans. Thus, the ECB and the commission, despite relenting on Italy’s entreaties for a waiver, continue prodding countries to keep their deficit levels well below 2% of GDP. In Europe, fiscal policy is out as a possible weapon against a softening economy.
Perhaps the ECB could shoot an interest rate arrow or two, but it will be reluctant to do so. The ECB wants a reputation for fighting inflation, not easing monetary conditions. It therefore prefers erring on the side of tight money.
Japan faces worse problems. Its policymakers have used fiscal policy in the form of massive public spending in a desperate 10-year attempt to stave off recession. By now, Japan’s public sector deficit is almost 8% of gross domestic product, much higher than the out-of-control U.S. deficits of the 1980s. Fiscal policy has clearly failed. With its government debt projected to rise to 125% of GDP in 2000, Japan has few options. Even worse, Japan’s aging population needs to save more, not less. Piling on debt before the number of retirements picks up is counter to good financial sense. Worse, anticipated increases in private savings could offset activist fiscal policy, compromising its ability to actually affect the level of economic activity.
As if that were not enough, monetary policy is worse off. Japanese short-term interest rates are near zero. And yet, the perilous state of Japanese banking prevents a corresponding surge of credit to businesses and consumers that could revive the economy. The main result of a decade of Japanese monetary policy may have been to transport the dreaded “liquidity trap”--in which interest rate changes have no impact on spending--from the dusty pages of the textbook into actual experience.
While every country worries about a recession, Americans have by far the least reason to worry. The U.S. economy’s strength means that, much like a battery charging, policymakers are accumulating room to react to, and blunt, future economic shocks. Not so in Europe and Japan, where policymakers face an uncertain future with little ammunition, and therefore depend, more than they wish to acknowledge, on the United States.
