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Does the Fed Have an Excuse for the Economic Slump?

WHEN Federal Reserve chairman Alan Greenspan testified before Congress Wednesday, he blamed the nation's continued economic stagnation on a huge overhang of consumer and business debt and a financially strained banking system.Consulting economist A. Gary Shilling agrees. He calls the nation's economic troubles "a balance-sheet recession." It isn't the result of a usual cyclical swing in the level of business inventories, he says. Rather the stubbornness of the slowdown results from the huge pileup of consumer, business, banking, and government debt in the 1970s and especially the 1980s. Slyly, Mr. Shilling characterizes Mr. Greenspan's testimony as explaining why the second dip of the recession isn't my fault. He adds: "Being politically savvy is important to survival in Washington." But Shilling argues that the Fed's ability to ease monetary policy faster in the past year or so was limited by the danger that the bond market might have reacted negatively and demanded higher long-term interest rates to offset anticipated higher inflation. Another economist, Michael Cosgrove, a professor at the University of Dallas, doesn't accept the Greenspan excuse so easily. He attributes the slack economic condition primarily to a monetary policy that "was not easy enough soon enough." In determining monetary policy, the Fed was looking at interest rates. Greenspan pointed out in his congressional testimony that since the start of the recession in July 1990, the Fed has moved 14 times to cut short-term interest rates, and is prepared to act again if t he economy remains weak. Mr. Cosgrove says the Fed should have paid more attention to growth in the money supply, which was extremely slow until recently. Another factor in the slump, says Cosgrove, was a tax increase this year of around $32 billion ($17 billion in higher federal Social Security and income taxes, $15 billion in state and local taxes). The debt problem, he says, "contributes to a sluggish rebound but does not prevent us from a recovery. [Debt] is a long-term secular issue that we have to spend most of the 1990s working out." In an economic newsletter he writes called The Econoclast, Cosgrove spells out some details of that debt buildup. In 1980, debt outstanding (the sum of corporate, noncorporate, household, government, and farm debt) was 40.3 percent of the nation's net worth (all assets minus liabilities). By 1990, that ratio had reached 67.6 percent. The good news, says Cosgrove, is that there is more than enough net worth to pay the debt. The bad news is that taxpayers are being asked to pay for bailouts of savings and loan associations, and eventually commercial banks. "Bailouts, large amounts of less than investment grade bonds, and high relative business failures all say excessive debt," he notes. Business failures, which ran at 36 per thousand enterprises in the 1970s, were occurring at a 91 per thousand annual rate in the 1980s. Shilling speaks of the massive borrowing in the 1970s to finance farm land speculation, oil investments and oil-patch real estate, and third-world deficits. In the 1980s, new debt fueled tax shelters; federal, state, and local deficits; dubious real estate loans; and consumer spending far in excess of incomes. "Most of the funds were not invested prudently, so the income streams they produce are far from adequate to service the debts," he adds. Debt owed by consumers in 1990 was 22.5 percent of their net worth, notes Cosgrove. That compares with 16 percent in 1980. The debt of nonfinancial corporations amounted to 54.7 percent of their net worth in 1990, up from 30.6 percent in 1980. Noncorporate business (partnerships and sole proprietors) had debt amounting to 63 percent of their net worth in 1990, far higher than the 36.8 percent in 1980. In other words, consumers and businesses are highly leveraged today. Efforts to reduce debt levels by trimming expenditures are reflected in business layoffs and the reluctance of consumers to make major purchases, such as those of cars, large appliances, and homes. Nonetheless, both economists expect economic activity to become more lively next year. Cosgrove guesses the first or second quarter. Shilling is more gloomy - the fourth quarter. If Shilling is right, this will be the longest recession since the Great Depression in the 1930s.

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