Why the U.S. economy is still in the doldrums

Robert Kuttner

August 27, 1993|By Robert Kuttner

INTEREST RATES are continuing to fall faster than almost anyone dared hope. Mortgage rates are now below 7 percent. Home owners who were thrilled to refinance their loans at a bargain 8.5 percent are now refinancing again.

The five-year Treasury bond is now yielding below 5 percent, its lowest rate ever. The official Federal Reserve policy is to tighten money if inflation threatens, but the inflation rate is comfortably below 3 percent and the Fed is letting rates continue to slide.

And yet the economy is still stuck in the doldrums. Though consumers have more money in their pockets thanks to refinanced mortgages and though businesses face declining interest costs, there is neither a consumer boom nor an industry investment boom.

This sluggishness is persisting, even though the recently enacted tax hikes and spending cuts have not yet taken effect. When the cuts begin reducing purchasing power, the economy will only slow further.

It now seems likely that the contracting effect of the deficit-reduction budget will more than offset the benefits of lower interest rates. Last spring, Treasury Secretary Lloyd Bentsen was quoting a Federal Reserve projection claiming that every one-point drop in interest rates would produce a stimulus equal to $100 billion of government spending. But lately, the administration's own economists have concluded that the tonic effect of lower rates will be half that, at best.

Other studies conclude that the "fiscal drag" of $496 billion in deficit reduction over five years will overwhelm the beneficial effects of lower rates. Economist Dean Baker of the Economic Policy Institute calculates that the five-year, combined effect of a smaller deficit and lower rates will be a $394 billion drop in gross national product.

The reasons why this economy doesn't rise to the bait of cheaper interest rates have to do with both demand and supply.

Stagnant incomes. On the demand side, average take-home pay has been lagging behind inflation since 1990. Some consumers have more money in their pockets thanks to lower interest rates, but studies show that a surprising number are using this windfall to pay down debt, not on a spending spree.

Joblessness. With unemployment stubbornly high and industry

relentlessly downsizing, even the employed live in fear of losing their jobs. These fears are hardly conducive to a consumer spending boom.

Depressed interest income. For every dollar that borrowers save in interest costs, investors lose virtually a dollar of interest and dividend income. Retired people, in particular, have had to tighten their belts as higher-paying bonds and certificates of deposits mature and are replaced with much lower-yielding investments.

Weak global demand. The administration has been counting on an export boom to energize the U.S. economy. Cheaper interest rates and a cheaper dollar can help stimulate exports. But the economies of our potential customers continue to be even weaker than our own. In July, the trade deficit soared.

Weak investment. If lower rates have not done much to boost demand, their supply-side (investment) effects are equally disappointing. In principle, lower interest costs should encourage capital spending by industry. But in the face of the softness on the demand side, industry hesitates to invest just as consumers hesitate to spend.

High "real" interest rates. With inflation falling almost as fast as interest rates, the "real" interest ratethe spread between the nominal interest rate and the inflation ratehas left industry with real capital costs that are still relatively high by historic standards.

Glut. The big real estate overhang (or should we say hangover) from the 1980s boom continues to plague most big cities. Vacancy rates of commercial properties are down only slightly from their peak. Housing starts, though a bit better, are still sluggish. In this context, there will be no construction boom despite cheaper money.

Administration economists should not profess surprise at this disappointing turn of events. During the mid- and late-1930s, real interest rates were about zero, but no boom materialized because there was a glut of industrial capacity relative to the demand for products, as wages and consumer buying power continued to be depressed.

Economists of that era termed the effort to coax a recovery with low rates alone "pushing on a string."

Ironically, Candidate Clinton seemed to have a better grasp of these issues than President Clinton. He proposed a big investment package to offset the contraction of deficit-reduction, which he knew would not be rectified purely with cheap money. But Republican opposition killed it.

The next six months will test the proposition that low interest rates alone can produce a recovery. If the present sluggishness continues the administration should be ready with a different strategy, namely, a new investment package for 1994. If Clinton can't sell this approach to the Congress and the country, he and the economy will continue to sag.

Robert Kuttner writes a regular column on economic affairs.

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