176. "'Preventive Recession' Won't Help the Country" The Boston Globe, (June 28, 1988).


Under the guidance of mainstream economists, the country is considering a highly dubious policy. Experts, public leaders and large segments of the public are forming a consensus that after the election the next president ought to cut the budget and foreign trade deficits drastically. This is what a bipartisan National Commission on Economics is expected to recommend, a policy that has already been favored by 54 other study groups and public interest lobbies, according to one list.

Specific plans for 1989 economic policy vary, but a typical scenario calls for reducing deficits to zero by 1991. This would require at least a $70 billion reduction in public expenditure and a similarly hefty increase in taxes. The trouble is that such a policy is likely to cause a severe recession in 1989. The recovery is already very old. There are already signs of inflation and rising interest rates, a precursor of recessions. Sharply reducing demand in 1989 may hence kick the economy on its way down: at least it will make a recession much more likely and more severe.

Mainstream economists realize that such a recession would increase the domestic deficit. They nevertheless favor administering the painful therapy in 1989 for trade-imbalance and political reasons. They seek to avoid a looming calamity. The United States is still adding $10 billion or more each month to its overseas indebtedness as it finances the excess of import over export, by owning ever more dollars to foreigners.

Signs abound that foreigners are less willing to take our dollars. Given this background they may at any moment be spooked by some unexpected piece of bad news and withdraw large parts of their funds. This would drive interest rates up sharply in this country and send the American economy into a deep recession.

In effect, economists are calling for a “preventive recession” to cut trade deficits before a panic sets in. Politically, the believe, the most opportune time for such bitter medicine is shortly after the elections.

First, the economies of other countries are likely to slow down, if not fall into recession, once the United States suddenly reduces its imports (their exports). West Germany and Japan have already shown a great reluctance to stimulate their economies. Also, a major American recession may be the event that spooks foreign investors, rather than preventing a major socio-economic point that is quite well-known, but whose relevance to the issue has been largely ignored: stickiness.

Stickiness refers to the well-established fact that consumers, investors and business executives are slow to adjust to signals included in changes in prices and public policies. It took years for most people to open IRAs, despite the fact IRAs were clearly in their interest and widely advertised. It took years for the deficits that President Johnson created to finance the Vietnam War to produce the expected inflation. And it is taking much longer than many economists expected for the decline in the value of the dollar to have the expected effects.

Significant changes in the level of investments and of experts have a singularly slow place. While consumption can be cut quickly in 1989 by gutting public expenditures and raising taxes, it will take years before exports will be expanded significantly, sufficiently to offset the domestic loss in demand.

It takes years for a corporation to learn to adapt its products to overseas markets, to modify its advertising, to develop local distribution networks. And investment plans to expand capacity will likely be curtailed in a recession, at best to grow slowly. Also, executives have learned to expect frequent changes in government policies and do not rush to change their investment plans. Anyway, it takes years to plan, build and equip a new plant.

Many economists talk about the two policies as if they were dials one could readily reset: turn consumption down, investment and exports up. While one is like a dial, the other is more like rebuilding the whole machinery. The likely result of the considerable mismatch in the pace of constricting and constructive policies would be painful and costly recession and little lasting cure on the export and investment fronts.

We need, instead, to introduce a policy that encourages investment, one that reduces the deficits only slowly, as capacity to produce and to export expands. Such a policy might include new incentives for saving, for example, doubling the amounts one may deposit in one’s IRS and allowing individuals to contribute to a new IRA dedicated to investment in human capital. It would encourage investment by taxing speculation and by increasing the tax on short-term capital gains while reducing it on long-run investment. It would segregate Social Security from the budget and use its surplus for long-term investment in a portfolio of corporate and government bonds. Tax credit for investment might be reinstated.

Other policies can be surely devised once expanding capacity and increasing productivity become our main goal - not merely depressing domestic consumption. To buy time and credibility, to reassure the foreigners, we may follow Martin Feldstein’s idea of introducing an ironclad, multi-year commitment to reduce the budgetary deficit. This would also help reduce interest rates, which we need to reduce the costs of capital and investment.

It is time to take our head out of the sands of ostrich economics, but not to be mired in the negativism of cutting programs, raising taxes, massive unemployment and the various corollary social ills.. We need a constructive program of rebuilding, expanding capacity, one that will lead us to restore our ability to pay for our standard-of-living, defense and a more just society.

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