A Double Whammy Has The Economy Reelingby
War abroad and recession at home: It's a combination that the U. S. has never experienced. Economists are still grappling with how it is likely to play out. Clearly, the August oil shock contributed to the severity of the downturn. But because the economy's problems go far beyond the price of oil, even a quick victory over Iraq isn't likely to lift the economy out of recession.
So far, the biggest surprise of the war is that the feared spike in oil prices lasted only a few hours instead of a few weeks. By Jan. 18, barely two days into the war, prices of Arabian light crude had plunged below $20 a barrel (chart). That's about where they were just before Iraq's invasion of Kuwait on Aug. 2.
There is no question that lower oil prices are a plus for the economy. They will mean lower inflation and lower long-term interest rates, which will help the economy where it needs help most--in the consumer sector. Lower inflation and rates will boost consumers' purchasing power, shore up confidence, and lift demand for big-ticket items such as houses and cars.
But lower oil prices alone will not end the recession. First of all, it's not yet clear that crude prices will stay down. As it becomes increasingly apparent that the war will not be over quickly, fear and uncertainty are starting to creep back into the oil markets. By Jan. 22, prices had drifted back up to more than $24. As long as the Saudi facilities are not damaged, prices aren't likely to spike sharply higher. But the longer the war, the greater the risk that anything could happen.
In addition, the economy faces other deep-seated problems. The most important is the overhang of debt in the consumer and business sectors. These troubles are so pervasive that they will continue to exert a downdraft on economic activity well after the war is over.
WALKING AWAY FROM IT ALL From the end of World War II until the early 1980s, the economy carried debt in the consumer, business, and government sectors that ranged from 1.3 to 1.4 times the dross national product--a manageable amount, as history has shown. But by the end of 1990, that ratio had soared to nearly 1.9 times GNP, the largest since the 1930s. Such a burden will not be shed quickly.
In fact, many households and businesses are just throwing it off and walking away. Personal bankruptcies were up 15% last year, according to the American Financial Services Assn. And in early January, large business failures, those involving liabilities greater than $100,000, were up more than 40% from a year ago. Financial stress will continue to depress demand and keep the recovery at bay.
Making matters worse, the government is simply shoveling its debt onto the private sector. Higher federal taxes in 1991, combined with tax hikes and spending cuts in many states, will eat into consumers' purchasing power, offsetting some of the benefits of lower oil prices.
For this fiscal year, which started in October, 1990, the federal deficit is likely to top $300 billion, way above the previous record of $221.2 billion in 1986. In December, the U. S. government posted a $7.4 billion deficit, bringing the first-quarter total to $86.9 billion.
According to estimates by the Congressional Budget Office, a short war without replacement of military hardware will cost $17 billion, but that figure could multiply 4 to 5 times in a long war that required new materiel. The war, the recession, and the cost of the S&L bailout will all take their toll on the budget.
Federal red ink is nothing new, but it isn't only Washington that's in financial trouble. State and city governments are also racing to balance their budgets--a task usually mandated by state constitutions. Already, 28 states are cutting outlays or raising taxes. The reason: Heading into last year's fourth quarter, state operating budgets were in deficit by a record amount, and the recession's blow hadn't even hit.
Cheaper oil and lower interest rates may take some pressure off state budgets, but not nearly enough to offset the loss of tax receipts because of the recession. In addition, demand for services from the states will increase as the downturn continues.
THE FED COULD GAIN A LITTLE LEEWAY For the economy, the most important by-product of a quick victory in the gulf would be the maneuvering room that the Federal Reserve Board would gain in the battle against recession here at home. Interest rates have fallen, but they will have to decline further (chart).
In congressional testimony on Jan. 22, Fed Chairman Alan Greenspan said that while the length of the war in the gulf will play a role in determining the length of the recession, "there are other key elements involved, mainly in the financial area."
Those concerns will keep the Fed biased toward further easing of monetary policy. And lower inflation and lower long-term interest rates will give the Fed more freedom to push down short-term rates even further. That will help correct the banking system's liquidity problems. Eventually, rates will drop low enough to get banks back in the business of making loans and borrowers back in the banks looking for them.
BUILDERS FACE WEAK DEMAND A big beneficiary of lower rates should be the beleaguered housing industry. But like the economy's other problems, the slump in housing started long before the gulf crisis. Housing starts have fallen in each of the last four years. A big reason is demographics. New households aren't forming as rapidly as they did in the 1970s or early 1980s, when most baby boomers became adults.
The recession just accelerated what was already a pretty rapid decline. In December, housing starts dropped 12%, to an annual rate of just 987,000 starts--the lowest since the last recession (chart).
A quick war would lift some uncertainty from the outlook and allow homebuilding to stage a small rebound in the months ahead. Home sales will also get some help from falling mortgage rates.
But housing is unlikely to offer the economy any robust growth. Banks' lending requirements for both home buyers and homebuilders remain unusually tight. The weakness in the resale market, which has brought about declines in home prices, means that some people are unable to sell their existing homes to buy new ones. And in some regions there is still a large overhang of vacant apartments, which will prevent any recovery in the multifamily sector. All these troubles will not disappear because of lower oil prices.
CHEAPER OIL ALONE WON'T CUT IMPORTS Of course, cheaper oil will help our trade deficit. But even here the benefits may not be all that great. Despite the dollar's decline during the past year, and despite the recession, other imports remain stubbornly high. In addition, exports are growing more slowly.
The merchandise trade deficit narrowed in November to $9.7 billion, from $11 billion in October, mainly because November imports fell by 5.8%, to $43.3 billion. However, that drop was from a record level in October, and foreign oil shipments caused some of the decline as a drop in volume offset a small uptick in oil prices.
But the growth of nonoil imports hasn't slowed much. In November, nonpetroleum imports were up 8.2% from a year earlier, not much different from their 9% pace over the previous 12 months.
Foreign producers still hold a large share of American markets. Imported cars, for example, account for a hefty 26% of all new autos sold here. U. S. demand may have to sink even lower in order to stem the flow of imports.
U. S. exports are offering some support during the recession, but with world growth slowing, exports aren't rising nearly as fast as they were a year ago. In November, they fell 4%, to $33.6 billion, after peaking in October. Exports of capital goods, consumer products, and cars all declined in November.
The data on trade and other sectors are saying that, like Iraq, the recession will not be an easy foe to conquer. Right now, the war is playing well as a TV miniseries, but if it continues as regular programming into the spring, both oil prices and interest rates could end up higher--and that could lengthen the recession.