Today's date:
Fall 1987

When the Recession Comes

Alfred Malabre - Malabre is the Economics Editor of the Wall Street Journal and the author of Beyond Our Means. He argues that we have overspent our way into such overwhelming debt that the next inevitable downturn in the business cycle could lead to depression and massive government intervention.

In America today, our total outstanding debt amounts to roughly 170% of GNP. This extraordinarily high level of debt has climbed steeply during the Reagan years. It also cuts across all sectors of the economy - the federal government, corporations and consumers.

Such a situation is clearly not sustainable over the long term, particularly when we look at the erosion of savings and the weakening of the debt's underlying collateral. For example, roads, bridges and dams which collateralize much governmental debt are old and costly to repair.

On the consumer side, household assets to liabilities are deteriorating. Home mortgages and automobile loans are experiencing delinquency rates previously experienced only during recessions. In the last few years, American farmers have lost half of their assets in bankruptcy!

In terms of corporate liquidity, the "quick ratio" - cash plus cash-type assets divided by current liabilities due within 12 months - has declined precipitously to a post-Depression low, and the long term trend is down, down, down. For all their high-flying stock prices, corporations are basically very illiquid, and the ratio of short term to long term debt is relatively high.

The Business Cycle
All of this is cause for concern because we've now been in an expansion phase of the business cycle for 56 months, a period in which things should improve, not get worse. Since the average length of expansions since 1854 has been 33 months, by the law of averages, this upturn is living on borrowed time. What will happen with the next inevitable downturn in the business cycle?

For example, budget deficits usually shrink very sharply during the course of business expansions. But in this expansion, the deficit has increased. In the fiscal year ending September 1986, the federal budget deficit amounted to $221 billion - the highest level in our history. At the pit of the 1981-82 recession, the budget deficit was lower than in the fiscal year 1986, after four years of expansion!

Let's be optimistic and assume that Congress and the Administration will pull in their belt and the budget deficit is reduced to $150 billion within the next couple of years - a highly unlikely scenario.

Then, let's say we go into another downturn of the business cycle. Budget deficits during recessions don't just increase by factors of 20% or 30%, they double, triple and quadruple. So, if we start with a $150 billion deficit when the downturn comes, we could be looking at a $400-500 billion deficit during the next recession. Then we are really in uncharted waters.

The Legacy of Affluence
America is in debt because we have been living in a spendthrift fashion. We came out of World War 11 with a very high savings rate. Savings as a percentage of after tax income in those years approximated 25%. In April, 1987 the savings rate was below 1%.

Over the years we have become too accustomed to freebies from Uncle that are a legacy of the mentality of easy affluence. We tend not to believe in restraint or limitation, so we lack the degree of self-discipline necessary to tighten our belts when things get out of hand - whether we are talking about private consumption or Great Society programs.

What made the debt buildup even worse was the election in 1980 of an administration which has repeatedly cut the tax rate without decreasing federal spending. Supply-siders like Arthur Laffer and Jack Kemp told us that a reduction in the tax rates would generate a sharp spurt in economic activity that would in turn produce a sharp rise in profits and earnings which would flood the federal coffers with tax revenues. The deficit, like magic, would disappear.

After eight years the evidence is in. That is exactly what didn't happen. The tremendous surge in productivity never happened and the tremendous surge in revenues never happened. There's no free lunch. Instead, the economy is exceedingly brittle, and for the first time, despite expansion, living standards are declining.

Real per capita consumer spending was rising steadily until the third quarter of 1986. It has been steadily dropping ever since. If the 40 +% decline in the value of the dollar in terms of the yen and the Deutsche Mark is superimposed on top of this drop in consumer spending, there has been a very sharp erosion in the American standard of living.

The Wages of Overspending
Overspending and so much debt will make it very difficult to get out of the next recession. In such circumstances recessions become increasingly long and nasty. The reason budget deficits increase so sharply during recessions is because profits and revenues decline precipitously on the revenue side while transfer payments for welfare relief and unemployment compensation explode on the expenditure side.

What, for example, are the credit markets going to do if they see a $400 billion budget deficit staring them in the face? Such a deficit will make interest rates extremely high, stifling business activity. It will be vastly more difficult for foreigners to continue to finance our deficits because if the US goes into recession, Europe and Japan won't be far behind and they'll need their cash to cope with their own recessions.

There is also the question of monetary policy. If we get into a real slump, how fast will the Fed have to pump up the money supply? Last year, M1 was increasing at an annual rate of 12-13%, yet GNP growth has been chugging along at 2-3%. Will the Fed have to 'increase the money supply an unprecedented 50 or even 100%? If it does, would this result in a sudden burst of severe inflation that would drive interest rates through the roof?

If we are very lucky and this expansion continues for another two or three years, perhaps we can bring some balance back into the economy before a recession hits. However, I see no evidence of the will to do this.

Spending goes merrily along. The Tax Reform Act still favors borrowing over savings and consumption over investment even more than before the "reforms." The capital gains tax has been raised and depreciation guidelines have been tightened up. Individual Retirement Accounts have been removed despite evidence that IRAs were a net addition to national savings. A value-added tax that would encourage people to spend less is nowhere on the horizon.

Beyond Our Means
We are living beyond our means in a double sense. It is beyond our means to pay for our accustomed standard of living and it is beyond our means to correct that situation painlessly. The level of debt is now so great that a tax increase might even hasten a deflationary spiral.

More than at any other point in the postwar period, a depression is likely. At the bottom of the 1981-82 recession, the unemployment rate was 11%. What constitutes a depression? Fifteen percent? In the Great Depression of the 1930s, the highest rate was 25%. We were almost halfway there in the last recession!

As a result of these dilemmas, the ironic legacy of Reaganomics will be that the revolution to ''get government off our backs" will result in more government on our backs because only strong intervention - economic policy by fiat - is going to get us out of the next downturn. Just as there is no free lunch, there is no free bail out. The FDIC didn't even exist in 1929. In the next recession it is a government institution that will be greatly strengthened.

The great paradox of this decade is that the Reagan Revolution was not really a departure from the guns and butter Great Society, but a continuation of the tradition. Lyndon Johnson refused to raise taxes sufficiently to pay for both the Vietnam War and social programs. Reagan only took it a step further by repeatedly cutting taxes while continuing to spend.

At the moment, the system seems incapable of producing effective political leadership in the precious time before the next downturn because the public doesn't want it. After all, our political leaders are our elected representatives. In this sense, we have met the enemy and the enemy is us. As a nation, we seem quite willing to live beyond our means despite the certain consequences.

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