Economics 101. Final Exam
Question: President Carter has announced a major new economic program designed to reduce the rate of inflation without bringing economic growth to a halt. Economists think:
a). The economy will continue will to grow modestly.
b). The economy will slow down considerably but a recession will be avoided.
c). There will be a recession.
d). In any event, the President's program will not likely hurt economic growth.
e). All of the above.
Answer: e) All of the above.
Almost in all the fanfare surrounding the president's announcement last Tuesday of a major new government fight against rising prices was Carter's caveat that the administration's persistence in following the new anti-inflation program will depend on whether the economy continues to grow at its current, moderate pace in coming months.
Most of Carter's economic advisers think it will. And if they are right, the economy should continue to create enough jobs to keep unemployment from rising while not creating further inflationary pressures. if the economists who see a recession are right, however, the president's pledge to curb federal spending and stop further tax cuts would have to be put aside.
What President Carter would do about the voluntary wage and price guidelines - the heart of his complicated attack on inflation - remains to be seen. "The whole program is predicated on continuing moderate growth," says a top architect of the anti-inflation policy.
The inflation program itself is unlikely to have much impact on inflation right away or on economic growth at all. Whether the economy sails on serenely or sinks into recession depends on monetary policy, consumer buying and business investment. The prognosticators are divided on just where the cruise is headed.
And for good reason. The economy, in many respects, is sailing in uncharted waters. Many of the buoys that used to tell economists where reefs are hidden have been dislodged. As a result, economists seem to be making their projections as much on faith as on anything else.
Things are different than they were 10 years ago, notes one top administration policy maker. A crising in the housing industry and the savings and loan associations that make home mortgages used to be a warning that the Federal Reserve Board was clamping down on inflation hard enough. The Fed tries to fight inflation by raising interest rates, making it more expensive to borrow and, therefore, to buy.
When savings and loan associations began to run out of money (as depositors took out their funds to place them in more lucrative investments such as Treasury bills), the housing industry would slump.
"Once housing began to hurt, we knew that monetary policy was getting tight and what that would trigger. It was like a minuet. You could anticipate what would happen next," according to one top administration economic official.
But despite a surge in interest rates in the last six months, S&Ls, with the help of federal regulatory agencies, have devised ways to keep the interest rates they offer savers competitive with the interest those same savers could get in the open market.
As a result, although it is expensive to borrow money to buy a house, the funds are there for the borrowing, at least right now. And despite dire predictions four months ago, builders keep starting new houses at a brisk rate.
Does that mean rising interest rates are a long way from doing damage to housing and the rest of the economy? Or does it mean that the effects of a tight money policy, instead of giving a warning through the housing sector, will sneak up on the entire economy at once?
"I don't know," says another economic policy maker. "But if it does with anything approaching the force it used to bite housing, we're in trouble."
By the time that housing started to slump, economists could begin to detect the other imbalances in the economy that would signal a recession. Usually excess demand for goods and services in a number of sectors would cause prices to rise. Then companies that has built up inventories to take care of rising demand would detect a slowing in consumer demand and then in business demand as high interest rates began to affect other sectors of the economy.
Caught with their inventories too high, businesses would cut back. Retailers would stop buying televisions from wholesalers who in turn would cancel their orders from the television factories who then would lay off their workers. Bingo, a recession had begun.
But consumer demand has remained strong, although not strong enough to build up excess demand except in a few specific industries (such as furniture or cement that supply housing). And no industries seem to have built up excess inventories. There is no wild speculation in scarce commodities and no evidence of overbuilding.
Good news? Some economists say "yes." Some say "maybe." Others, say things aren't as they seem and answer "no."
The administration is banking that a continuation of the mild economic growth of the last nine months - at an annual rate of about 3.5 percent - will be sustained and will not generate the imbalances that normally upset the economic applecart. If that happens, they say, President Carter's anti-inflation program can begin to slow price increases if American cooperate with it.
But they are worried about the consumer. An increasing amount of the average consumer's income is going to pay off the mortgage and the installment loans. For the first time in decades, consumers' debt repayment takes up more than 20 percent of their disposable income, according to an internal Treasury study. If consumers get scared and suddenly stop buying, the economy could start to slide. Officials hope they do not.
And some economists are worrying about housing, too. The new special certificates that kept funds flowing into S&Ls since June are becoming more expensive as interest rates keep rising. What worked when Treasury bill interest rates were 7 percent or 8 percent may not work as those rates push 9 percent.
As the spread narrows between what S&Ls can get for their mortgage loans and what it costs those institutions to get deposits. S&Ls may stop making new loans, throwing the housing industry into a belated, but familiar tizzy. Already, some shrinking of the availability of mortgage funds is becoming apparent.
Administration officials hope interest rates do not rise much more, praying tht inflation has peaked and that the Fed will not find it necessary to tighten the monetary screws much further. But a continuing slide in the dollar may keep the central bank on its hawkish path as it tries to make it more attractive for foreigners to invest here as well as to fight inflation.
The problem of inflation is self-feeding, which makes it a difficult one for the Fed to combat. In large part, the dollar is declining because of domestic inflation. Raising interest rates here contributes to domestic inflation, but so does a declining dollar, because import prices rise. So, in some measure, the Fed fights inflation by feeding it, tightening monetary policy. But if the Fed tightens too much, it could stop borrowing all together and trigger a recession.
Administration officials are counting on the Fed not to miscalculate.
Others, such as former top Treasury forecaster Herman I. Liebling, see a dicier situation in which growth starts to slow around Jan. 1, unemployment starts to rise and inflation slows but only marginally.
But, Liebling said, if the Fed handles monetary policy skillfully enough, a recession can be averted. Housing will turn down, but businesses still will be able to build new plants and equipment.
Alan Greenspan, one of the nation's top economic consultants and chairman of President Ford's Council of Economic Advisers, thinks a recession is almost a foregone conclusion. And, in Greenspan's analysis, homes are the key, too.
Consumers have kept buying goods and services for 42 months in part by borrowing on the huge increases in the values of their homes, Greenspan said. It is not uncommon for a house worth $20,000 10 years ago to be worth $50,000 or more today. Consumers have been refinancing those houses and buying goods and services with the proceeds of the new mortgage loans, he said.
But now, with the availability of mortgage funds diminishing and consumers finding their repayment burden rising, they will stop borrowing on their homes, he predicted. Greenspan maintains that when that happens, a recession will not be far behind.
Many economists think Greenspan's novel analysis has merit, but question how important home refinancing has been to the 1975-78 recovery. "No one, not Alan or anyone else, has good data on that. If he's right, there'll be a recession," according to one government policy maker.
Of course, noted one congressional economist, if the "economy should go into a recession, we're likely to have more success in fighting inflation." Whether or not the president makes his anti-inflation plan work.