I want to thank the Committee for the opportunity to testify today on the economic outlook. This initial statement will be short and pointed, because I believe that a lively discussion will get us closer to where you want to go.
The current economic situation is a living example of the reason why most economists think of monetary policy as the tool of choice for short-run economic stabilization purposes. We have been told by the National Bureau of Economic Research that a recession began exactly a year ago. The Council of Economic Advisers, in its Annual Report, seems to think that the recession began on September 12th. But then, to everyone's surprise, including mine, the first revision of data for the 4th quarter of 2001 showed that real aggregate output actually rose non-trivially, and gained back everything it had lost in the third quarter. The preliminary tea leaves suggest that the current quarter will show a further gain in real GDP, probably faster than the quarter before.
So, with maybe only one down quarter, was it worth calling this a recession? Perhaps more to the point: is that really the right question to ask? I think the answer is No, and focusing on that questions leads to unnecessary confusion. There are some good reasons to fear that the current upswing will be weak, at least for a while. Corporate profits and business fixed investment are still falling. Unemployment will continue to rise for a while. Much of the strength in the 4th quarter came from consumption spending, but more than half of that was on automobiles, and thus very likely borrowed from later quarters, enticed by temporary incentives. Europe and Japan have been stagnant or worse, and do not seem to be turning around as rapidly as the U.S. They will not be good markets for American producers; on the contrary, they will be trying very hard to sell in the U.S. All in all, I was going to conclude that only God knows how the next few quarters will turn out; but it may be that God has not yet decided.
In this kind of environment, it is hard to know what to do now. The Federal Reserve doesn't know any better than you or we do. The fundamental difference is that the Fed can act quickly and then, if it soon changes its mind, it can reverse itself quickly. It would be helpful if fiscal policy could be mobilized in tandem with monetary policy, but you can not reverse yourself.
This lack of maneuverability in fiscal policy explains why the so-called "automatic stabilizers" are so valuable; they do adapt to events, without requiring you, or anyone, to take action. But they have been allowed to get weaker, for various special reasons. They are not likely to be revitalized. Maybe it would be useful if you could enact a "standard stimulus package" (which, worked in the other direction, could serve as a standard cooling-off package). It could be triggered automatically by events - - at one of several levels - - or even proposed by the President, and subject to a straight up-or-down vote. I realize that no such thing is likely to happen; maybe you have a better idea.
There ought to be a more appropriate basis for making stabilization decisions than wondering if there is or isn't a recession, and when it will end. In fact I think it would still be a good idea to pass a stimulus package in spite of the current lack of clarity about which way the economy is headed. I will explain why, briefly, because that may help untangle fiscal policy from the inevitable uncertainties of forecasting that Congress is too ponderous to deal with, unlike the Fed.
Real GDP in the 4th quarter of 2001 was only about one percent higher than it was in the 2nd quarter of 2000 when the clearly visible slowdown began. Two years ago the unemployment rate was about 4 percent, compared with 5.8 percent now. Capacity utilization in industry was then measured at 83-84 percent, compared with 74-75 percent now. Suppose that early 2000 was a desirable state of the national economy. (Some thought it was a little too prosperous for peace of mind about inflation; but that would require only a small change in what I am about to say.)
We have to presume that the economy's aggregative productive potential has been increasing fairly smoothly since then, because that is how it usually behaves. The Council of Economic Advisers estimates that the rate of increase of productive potential is a hair over 3 percent a year. In that case, full utilization of our economy's potential this spring would entail a real GDP about 6 percent higher than current output. By this time next year, even if the economy grows by 3 percent this year (which is slightly faster than the Council's forecast in the Economic Report), there will still be a 6 percent gap of unused economic potential. The gap will be larger if the economy grows more slowly, and smaller in the opposite case.
That gap can not be safely closed in a single year. The Fed would certainly fear that an upswing fast enough to do that is fast enough to exceed the inflation-safe speed limit, and would choke it off. But it would certainly be safe to grow fast enough to close some of that gap. That is why I think there is still room for a modest stimulus package, if you are capable of enacting a sensible one. By sensible I mean effective, temporary, and free of partisan sacred cows. The House bill started off as a ghastly mockery. It has got better, just not enough better to be acceptable. Accelerated depreciation is not the best way to promote capital spending, and it fails the test of being temporary.
I mention all this for a broader reason. All this talk about whether there is or isn't a recession, when did it begin and when will it end, leads to confusion because nobody knows. Anyway, it concentrates on the wrong thing. The CEA can make approximate calculations of economic potential; in effect it already does so. The Congressional Budget Office does something similar. Focusing on that would force debate on the right issue, which is where we stand relative to potential, and would provide a better guide to policy.
I should say that I am one of those who thinks the Economic Growth and Tax Reduction Reconciliation Act of 2001 was a big mistake. Part of the "surplus" it gave away has already evaporated, as we knew it would as soon as the economy weakened. And we have converted the rest mostly into future consumption instead of the future saving and investment that the country urgently needs as it looks ahead to an aging population. You should resist any suggestion that stimulus should take the form of advancing the date at which an ill-advised decision comes into effect.
Like most observers, I think that monetary policy has done very well in coping with the past five quarters. Long-term interest rates have not fallen very much. Nevertheless, if the Fed had behaved more traditionally the housing sector would not have held up as well as it has, the auto industry would have had a harder time providing those successful incentives, and business investment might have fallen even faster.
Some people complain that the Fed stuck with its contractionary stance a bit too long in 2000. Maybe it did; hindsight is usually 20-20. But perfection is the wrong benchmark against which to judge Alan Greenspan and the Federal Open Market Committee. They are not omniscient; I have already said that they are, like the rest of us, uncertain about what will happen next month. What distinguishes the Fed is the flexibility with which it handled the boom of the late 1990s. If you want to see how well they have performed, take a look at the record of the much more doctrinaire central banks of Japan, the U.K., and Europe.
What we have a right to hope for is that the Fed will exercise the same kind of informed flexibility in the course of the coming upswing, whatever shape it takes. If the recovery is indeed anemic, then the gap between current and potential output, which is already ample, will be widening; there will be no need to move short-term interest rates higher. Anecdote is piling up that lenders are being extra-cautious, as a reaction to the Enron swindle. Suspicion falls especially on smaller, less well-known companies without much of a track record, and they find it hard to get credit. Other things equal, this state of affairs should incline the Fed toward maintaining liquidity and credit ease. (It is this kind of circumstance that makes me suspicious of even a reasonable formula like the so-called Taylor rule: why should the central bank ignore this kind of market fact?) But if the economy picks up enough speed, the margin of slack will narrow. In that case, we have to expect the Fed to begin positioning itself for the inevitable palaver about soft and hard landings, and interest rates will rise pretty quickly. Having a flexible monetary policy means learning to live with a certain number of tentative and even reversible steps. Right now I imagine wait-and-see is the right attitude.
All the above was written before I saw Alan Greenspan's statement to this Committee last week. It contained no surprises, unless you count his strengthened conviction that the third quarter of last year would be the only down quarter. At this late date, I would not count it as a surprise.
There is only one point I would like to call to your attention. Mr. Greenspan agrees that the upswing now launched is likely to be "subdued," and he gives the standard reasons for suspecting a slow increase. He waffles a bit, but a little of waffle is justifiable. He reports that the FOMC forecast is for real output to increase by 2.5 to 3 percent during the four quarters of 2002. That forecast is six weeks old, and thus possibly already out of date. Anyway this pace is just a bit slower than the estimate I quoted from the Economic Report that potential output is growing at about 3.1 percent a year. The last decimal place in such estimates is not to be taken as doctrine, of course. The underlying point is that in this scheme of things, the gap between actual and potential output will not narrow during the rest of this year. That is what matters, not just whether the movement is up or down. The implication is that a somewhat faster path for the economy would be desirable; a slower path definitely would not.
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