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Recessionary Signs Were Evident Even Before Oil Crisis

IT is easy, perhaps too easy, to blame the looming recession in the American economy on the sharp run-up in oil prices brought about by the Iraqi invasion of Kuwait. True, the rise in oil prices from $18 a barrel to about $40 is the equivalent of a large OPEC tax on the American economy. That is so since we now import about half of our oil. This ``tax increase'' is clearly an economic depressant, pulling billions of dollars of purchasing power out of the national economy. But it could only tip us over into recession because we were so close to that condition just before the invasion of Kuwait in early August.

Recall the business outlook during late July 1990. The longest peacetime expansion in United States history was fast losing steam. Three major capital-intensive sectors - autos, construction, and defense - were turning down simultaneously. Large inventories of unsold cars had led to production cutbacks in in the bellwether motor vehicle industry.

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The delayed impact of tighter monetary policy in 1989 and early 1990 reinforced the lingering effects of the 1986 tax reforms that reduced or eliminated many special incentives or ``shelters'' to real estate investment. The result was to bring down housing and office construction to very low levels. Housing starts in July fell for the sixth consecutive month.

On top of the declines in these two key civilian industries, defense contractors had begun to lay off substantial numbers of employees in response to congressional reductions in the military budget. Many of the large and medium firms in this market were also announcing future work force reductions.

Thus, forecasters in July were reevaluating their projections. Several veterans had already concluded that the recovery phase of the business cycle was drawing to a close.

The uncertainties in the Middle East, generally, and in the world oil market, specifically, reinforced the negative outlook in the domestic economy following the invasion of Kuwait. The University of Michigan's index of consumer expectations fell from 77 in July to 63 in August.

In other times, we might have expected the Federal Reserve to offset the negative developments in the economy by shifting to an easier monetary policy. However, the large increases in oil prices had a double effect on the US economy, simultaneously depressing demand and raising costs. While these price increases work their way through the industrial system, Alan Greenspan and his colleagues at the Fed are understandably reluctant to expand the money supply significantly.

The sharp upward spurt in the estimated federal budget deficit for the next several years, brought about in part by the ever-more-costly savings and loan bailout, immobilizes fiscal policy as a potential source of additional stimulus. Thus, recessionary forces have been allowed to build.

The Federal Reserve can follow its current course of action (some call it inaction) because it is unlikely the recession would last much beyond a limited period of 6 to 9 months. Unlike the escalating double digit inflation of the early 1980s, the prospect that aggregate price rises (including oil) will remain in the 4 to 5 percent price range gives monetary authorities confidence that they could responsibly expand money supply should the economy weaken more than is now expected.

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Should the embargo of Iraq continue without war, the pace of inflation in the US likely would decline after the initial run-up in oil prices was fully reflected in the chain of production. If Iraq abandons its capture of Kuwait (with or without external military intervention), the change will be more dramatic.

Either way, the Fed could take a more expansive tack and the basis for the next upturn in the US economy would be in place. If the embargo continues, the upturn likely will be moderate. In contrast, a successful end to the crisis would bolster business and consumer confidence and thus aid a stronger economic expansion. An extended shooting war would force forecasters (including this intrepid economist) back to the drawing board!