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Before getting to the question of what must be done to reverse the slowdown, we need to examine why the economy has been so successful up to now. The U.S. is in the tenth year of an unprecedented expansion. Even if the recession did start in January, the economy will have grown a full year longer -- without respite -- than in any period since reliable statistics began to be gathered in the 1870s. The third-longest expansion (and the second-longest during peacetime) was the period that immediately preceded the brief 1990-91 recession. In other words, since July 1982, the GDP has increased consistently, with a nine-month exception. No economy in the world has seen such a boom in output and accumulation of wealth in so short a period.
Since World War II, there have been nine recessions in 56 years, but in the past 18 years there has been just one. Has the business cycle been repealed? That cycle works like this: Low unemployment and prosperity raise the demand for goods and services. This rising demand inevitably bumps up against supply, gets tangled in bottlenecks. With supply constrained, prices rise, and general inflation ensues. The Fed, whose job it is to prevent the depreciation of the dollar and to maintain financial stability, raises interest rates to whack down inflation. The economy slows and frequently goes into recession. Interest rates fall, the economy revives, and the cycle begins all over again. But in the 1980s and 1990s, this pattern did not hold. Strong growth -- at times more than twice the post-war average -- was accompanied not by rising inflation but by relatively stable prices.
The reason is that the U.S. has been undergoing what I call a "liberation of supply." When demand rose, it did not bump up against supply constraints, so prices remained tame. In a broader sense, capital and the other tools necessary for an entrepreneurial expansion were all in place, so the economy boomed. What were the factors that liberated supply? Here are the primary ones:
The spread of free trade. When bottlenecks occurred in this country, goods from other countries took up the slack. In addition, the U.S. has been helped by immigration (free trade in people, especially in high technology) so that labor shortages were milder than usual. And, at the same time, a financial revolution helped liberate capital and spread it around the world, with investors seeking the best place to deploy their funds -- often, the United States, with its relatively accommodating business environment.
Lower tax rates and new regulatory policies. Before Ronald Reagan's election in 1980, the top rate on income was 70 percent. It was cut 28 percent, but, even at today's top rate of 39.6 percent (which applies to nearly all decent-sized private proprietorships and partnerships), it is far lower than in the 1970s (though still too high). Low taxes encourage more work and investment -- that is, more supply. At the same time, the government began a series of deregulatory measures, beginning with transportation in the Carter Administration and extending to energy and telecommunications. This work is far from done, but the change helped remove supply constraints.
Better monetary policy. The Fed has learned a lot since the 1930s, when three successive chairmen presided over tight-money policies that exacerbated the Depression. Paul Volcker, with the backing of President Reagan, had the courage to ring inflation out of the economy, and Alan Greenspan has continued those policies. The next Fed chairman can be expected to do the same, keeping interest rates low and encouraging investment and the liberation of supply.
The high-tech revolution. The advent of inexpensive, powerful networked computers has boosted productivity -- the main component of economic growth. From a rate of less than 1 percent in the 1970s, productivity averaged 1.7 percent between 1982 and 1995, and a remarkable 2. 9 percent over the past five years. Very simply, productivity means more output for the same input -- that is, more supply. Why? Greenspan's own major contribution has been to recognize that information technology not only enhances the knowledge of businesses, it also reduces uncertainty -- so that companies do not have to maintain redundancies in their workforce, inventories or plant and equipment, thus reducing inputs. As he said in a speech at Boston College on March 6, 2000:
Before the quantum jump in information availability, most business decisions were hampered by a fog of uncertainty. Businesses had limited and lagging knowledge of customers' needs and of the location of inventories and materials flowing through complex production systems. In that environment, doubling up on materials and people was essential as a backup to the inevitable misjudgments of the real-time state of play in a company.... [Now,] fewer goods and worker hours are involved in activities that, although perceived as necessary insurance to sustain valued output, in the end produced nothing of value.
What Is to Be Done?
Tax Cuts and Rate Cuts
But lately, the liberation of supply has stalled. New bottlenecks and shortages have developed that threaten not simply to reduce growth but to raise prices as well, raising the specter of stagflation for the first time since the 1970s.
Two obvious steps are now being taken.
First, the Federal Reserve's Open Market Committee has reduced its target for the fed funds rate -- from 6.5 percent to 5 percent. The Fed is likely to continue cutting through the spring and early summer, and a typical easing cycle would bring the rate to 3.5 percent, which should be enough to revive the economy eventually -- though, as Milton Friedman long ago recognized, it takes six to nine months for rate changes, in either direction, to flow through the economy. It was not until last fall that we began to feel the impact of the rate hikes that started in 1999.
Second, Congress has begun action on President Bush's plan to cut taxes a total of $1.6 trillion over ten years. While this hearing is titled, "Beyond the Tax Cut: Unleashing the Economy," I want to emphasize the importance of significant tax relief. A short-term cut of $60 billion, as was recently proposed by some Senators, will give the economy little stimulus. Current GDP is $10 trillion. If half of the one-time tax rebate is consumed and the rest saved (a decent assumption), then increased consumption will represent just 0.3 percent of GDP. Or think of it this way: The CBO expects that tax revenues in fiscal 2001 will total $2.2 trillion. A rebate of $60 billion amounts to less than 3 percent of that figure. Even after such a rebate, tax revenues will still rise -- assuming that the relief occurs wholly within the fiscal year -- by some $41 billion for 2001, applying more drag to a declining economy.