A steeper-than-expected recession could complicate the achieving of several of President Bush's cherished goals. These include a huge multiyear tax cut, reduced federal spending, and partial privatization of Social Security.
Until recently, optimists forecast a shallow recession, with the boom resuming in the fall. This could have helped Bush politically, adding pressure for a front-loaded tax cut. Moreover, it wouldn't have derailed the economic assumptions of endless budget surpluses.
But now a more pessimistic picture is likely: Profits keep falling well below projections, depressing stock prices as well as capital spending. Lower demand is inducing steeper layoffs, and consumer confidence is falling fast. This mutually reinforcing tailspin adds up to a classic business-cycle recession. But this downturn could be deepened by four other factors.
First, the tech boom is clearly over--even blue-chip tech stocks such as Sun Microsystems Inc. (SUNW ) and Cisco Systems Inc. (CSCO ) are not immune, and the broader market may still have a lot of air in it, too. A further stock-market free fall would have a reverse "wealth effect," leading to a deeper contraction in consumer spending.
OLD DEVIL. Second, the trade imbalance, already high, has doubled in two years to almost 4% of gross domestic product. Foreigners have kept buying dollar investments--bonds, stocks, real estate, and companies. But a faltering economy may make foreign capital think twice, especially if the Fed needs to keep cutting interest rates--weakening the dollar. A foreign flight from dollar assets would massively worsen our recession.
Third, inflation may be breaking out. Never mind that it is being driven by sectoral factors (oil prices, medical costs) rather than macroeconomic ones. It may make the Fed think twice about cutting rates. Stagflation, anyone?
Finally, a persistent minority of economists, including Robert J. Gordon of Northwestern University, insists that the vaunted statistical increase in productivity is exaggerated. Many attribute the recent boom more to people working longer and harder rather than to better machines. Anybody who wastes hours a day on e-mail and balky software can identify with this dissent. People can only ratchet up their work intensity so far.
If the recession is deeper, the stock market weaker than anticipated, and the high growth rates of the 1990s a fluke created by a technology bubble, we are in for a bumpy ride with interesting political fallout. For starters, we can chuck the rosy budget projections that are the foundation for President Bush's $1.6 trillion tax cut. Instead, we need a smaller, more targeted, and shorter-term tax cut that gives the economy a Keynesian boost.
A recession rooted in faltering sales and profits, depressed consumer demand, layoffs, and reduced capital spending resurrects the case for counter-cyclical spending--old-fashioned pump priming. Until now, fiscal policy was pronounced dead and monetary fine-tuning the entire game. But in the face of a market unwinding and skittish consumers, the Federal Reserve's rate cuts may have lost their magic. They would be "pushing on a string." Suffering businesses and consumers would still not borrow and the economy would continue to drop. Rate cuts are necessary but not sufficient.
It may also be that several years of contractionary fiscal policy are finally taking their toll. It's one thing to run deliberate surpluses when the economy is overheating and quite another in a recession. Temporary deficits could even become respectable again.
We can debate the relative virtues of tax cuts vs. spending--the old argument between John Kenneth Galbraith and Walter Heller about the form of President John F. Kennedy's tax cut. Galbraith made an impassioned case about impoverished public needs amid private affluence, but Kennedy sided with Heller and tax cuts.
GIDDY ACTION. However, with the safety net in shreds, Galbraith's case surely resonates today. A real recession would revive government's necessary role as shock absorber. Unemployment insurance coverage, both as a fraction of the labor force and as a proportion of pay checks, has been dropping for 20 years. Welfare reform has pushed millions of the dependent poor into the low end of the labor force. But they will be the first ones fired in a recession, and welfare now has time limits.
Tax and budget politics look very different with unemployment at 7% than they do at 4%. Some states, notably Texas, which giddily cut their tax bases during the boom, are already facing budget shortfalls. One other casualty of Bush's program may be partial privatization of Social Security. It looked great to younger voters when the market was soaring. But now?
If recession is deep or prolonged, President Bush will pay the political price in two respects. His Administration, fairly or not, will reap the blame and his program will be overtaken by events. When the economy turns, politics follow.
By Robert Kuttner