To End Slump, Profits - Not Just Confidence - Must Rise
FEDERAL Reserve Chairman Alan Greenspan assured Congress last week that the recession would be short and mild. ``The odds favor a moderate upturn,'' he said. The most likely forecast, he added, ``would be one in which the economy bottoms out and starts up reasonably soon.'' Mr. Greenspan's views were in line with the consensus - in the White House and on Wall Street - that the economy will rebound as soon as the Gulf war ends. Consumers, buoyed by a surge of jingoistic pride, will rush back to the stores and start spending.
Real life is more complex. Consumers are not buying because they are out of work and their incomes are down. In turn, companies are not hiring new workers because they have been losing money with the employees they already have. Improved prospects for profit, rather than a swing in the latest Gallup poll, will signal the end of the recession. Greenspan's forecast for 1991 is not likely to prove any better than his prediction a year earlier that the risk of recession in 1990 was only one in f ive.
While his statement was doubtless designed to defuse congressional anger at the Fed for starting the recession, it also had a clear message for the capital markets. For the time being, the central bank is not willing to allow further declines in short-term interest rates. As if to underscore these remarks, the Federal funds rate hit 20 percent the day before Greenspan testified, and 10 percent while he was speaking.
This means that economic activity still has a way to go before it hits bottom. As sales fall and unemployment rises, the Fed will eventually be forced to allow rates to decline further. Sadly, these actions will be too little and too late. The 1990-91 recession will be longer and deeper than need be.
True, large amounts of apparently surplus reserve funds have suddenly appeared in the banks. Nevertheless, this was not a signal of easy money. The Fed is not pumping out money that banks are unwilling or unable to use. Rather, these ``excess'' reserves can be traced to technical problems that followed action by the Federal Reserve last December. At that time, the Fed cut by $12 billion the amount that banks are required to hold as ``reserves'' against deposits.
In theory, the cut was designed to help the banks to lend or invest funds which otherwise would be held in nonearning accounts at the Fed. In practice, the $12 billion the Fed released was sopped up by the central bank in routine operations. This was part of a long-term pattern. Fed actions have resulted in a prolonged drop in monetary growth. Total reserves held by US banks rose at an annual rate of less than 1 percent over the past four years. This was an unusually long period for such ``high-powered'' money to be frozen.
Because the Fed sterilized its own action, the cut in reserve requirements had little monetary impact. As a result, the process of paying off debt and rebuilding liquid assets - an essential part of every economic recovery - has barely begun.
Last week, Greenspan was careful to blame the recession on Saddam Hussein (who else?) and the so-called credit crunch. The reluctance of bankers to lend, he claimed, ``was having a damping effect on spending.''
In fact, the Federal Reserve itself was responsible for the downturn. Antecedents of the recession are clear. Consumer spending began to retreat more than two years ago under pressure from the Fed. Nonetheless, business people kept on hiring, especially in services, which account for three out of four private jobs.
However, the more people companies hired, the more profit margins went down. Payrolls were padded with workers who were producing losses. Obviously, this process could not continue, and it did not. Total employment has dropped by more than 1.3 million. This decline, incidentally, started before Iraq invaded Kuwait on Aug. 2.
The drop in employment sent shock waves through the economy. There have been parallel declines in income, spending, and industrial output. Meanwhile, corporate cash flow - which finances the bulk of investment in new plant and equipment - is also sliding. This suggests that business capital spending may now be poised for a typical cyclical slump.
Bottom line: Interest rates have a long way to drop before they hit bottom for the 1990-91 recession.