THE HOUR IS LATE, the situation is critical. The president, the Congress, and the Federal Reserve Board can no longer postpone a basic reappraisal of their economic policies.
The summer's dismal business news makes it vividly clear that under current policies, significant and sustained economic recovery in 1982 and 1983 is improbable. Maybe the recession trough has been reached, maybe not. But a second dip is quite possible, or stagnation with minor wiggles, or at best a limping and fragile expansion. Responsible policymakers and rational politicians cannot afford to remain complacent.
As the prevalent gloom of business managers is confirmed by events, their pessimistic expectations reinforce high interest rates and other obstacles to recovery. Plant and equipment investment, whose stimulus was the principal objective of the "economic recovery" tax act of 1981, is a disaster; even projects already scheduled and budgeted are being cut back.
The seven previous post-war recessions were pretty short, averaging 10 months. They were reversed when inventory liquidation ran its course. Federal monetary and fiscal policies helped turn the tide. Widespread belief that recessions were only brief interruptions of normal growth sustained investment, home building, and consumer spending.
The current recession has severely shaken that faith, coming only 12 months after the previous trough in July 1980. And the significance of such faith should not be underestimated. When faith in recovery was destroyed in 1931, recession turned into depression.
Nevertheless, powerful voices within the administration and the Federal Reserve Board and on the outside oppose any significant change of policy.
Doctrinaire monetarists still contend that the way to pilot the U.S. economy is to hold the helm and engine revolutions steady, ignoring the actual course and speed. Anti-inflation hawks are not terribly dissatisfied with the economy's path anyway. Their overriding goal is conquest of inflation, which has indeed been reduced somewhat. Several years of economic distress, perhaps even a full presidential term, are just the regrettable but inescapable cost of beating inflation, they reckon. Under the redoubtable Margaret Thatcher Britain has been paying the cost for three years; the promised benefits have yet to materialize.
Thatcherism may be American policy, too, but its author is not Ronald Reagan. It is Fed Chairman Paul Volcker. The president has never told the American people that recovery and prosperity must wait until inflation is expunged. Nor has the Congress, for sure. Maybe president and Congress didn't understand the consequences when they blithely assigned the task of disinflation wholly to the Fed and went off on their "supply-side" spree. Now the consequences are clear for all to see, and elected officials cannot responsibly leave to the Federal Reserve alone policy choices so crucial to the economic health of the country and the world for years to come.
The Federal Reserve holds the key to recovery. High interest rates, above the inflation rate by unprecedented margins, are the source of the recession and remain the insurmountable barrier to recovery and prosperity. They are not an act of God. They are not the natural equilibrium of investment opportunities and saving propensities in America today -- if they were, investment and economic activity would not be so depressed.
The Fed's money supply targets are just too stingy to finance a growing, prosperous economy. Bank deposits are the major constituent of "money." Banks, and now other depository institutions, are required to hold, in currency or on deposit in Federal Reserve Banks, reserves proportional to their own deposit liabilities. The Fed controls the aggregate supply of such reserves. The Fed keeps reserves in scarce supply, and banks pay high rates to obtain or borrow reserves. Consequently they charge high rates on business loans, consumer credit, and mortgages.
It really is that simple. And so is the antidote. The Fed can bring interest rates down by providing more reserves, letting bank credit and money supply expand faster than its present targets allow. Otherwise the prospects for recovery will remain dismal.
Yet a potent taboo inhibits adoption, indeed even consideration, of this obvious remedy. Even officials, politicians, and commentators who reject Thatcherism shy away from its antidote. They will the ends -- lower interest rates and recovery -- but not the means -- easing of monetary policy.
The governing cliche is that easier monetary policy is a recipe for high inflation. Well, prices will almost surely be higher in 1984 if the next two years bring recovery than if the economy remains depressed. Prices do move with business activity; recovery would reverse many of the declines in the prices of goods whose prices are particularly sensitive to a downturn in the economy, like foods, metals and oil. Those price reductions made for pleasant inflation statistics earlier this year, although they were produced by unpleasant developments like higher unemployment and interest rates and lower production. To say that some price increases in conjunction with a recovery are unacceptable is just to say that Volcker should continue to be cast as Thatcher, and recovery should be postponed indefinitely.
But there is no reason to expect a great new surge of inflation if we do get a real recovery. With 9.8 percent of the labor force and 30 percent of industrial capacity now idle, there is plenty of room and time for expansion without unleashing the classic inflationary pressures of excess demand -- "too much money chasing too few goods" -- throughout the economy. In circumstances like the present most new monetary spending will be absorbed in added production rather than in prices. Monetary expansion is not invariably and arithmetically inflationary.
To be sure, a change of course would involve the Fed in some awkward problems of public communication, mostly of its own making. In the Fed's more eclectic and pragmatic days, before it was so tightly locked in the monetarist vise, easing controls on the money supply in response to financial and economic crisis would not have surprised or alarmed anyone. Now the Fed has tied its own hands by committing itself to achieving specific money supply outcomes, regardless of what may happen to unemployment, production, etc.
The Fed's targets for growth in the money supply are set in terms of two basic measurements, called M-1 and M-2. M-1 measures cash in circulation, traveler's checks and all checking accounts at banks and other financial institutions. M-2 is broader. It adds to M-1 the deposits in money market funds, small-denomination time deposits and all deposits in savings accounts, and a few other categories.
The current Fed targets -- announced last fall and reaffirmed in February -- set target ranges for percentage growth in monetary aggregates for 1982 of 2.5 to 5.5 percent for M-1, 6 to 9 percent for M-2. However, in today's rapidly changing environment of financial technologies and regulations, the relation of these aggregates to national spending and income is quite variable.
This year, as the Fed itself has recognized, the spread of interest-bearing checking accounts (included in M-1 as well as M-2) and the precautionary psychology of the public have slowed the rise in turnover of M-1. That means the Fed's targets for growth in M-1 do not support as large a level in dollar spending as had been expected.
Evidently the monetary medicine has been more painful and debilitating than the Fed itself intended. Yet the targets remain sacrosanct. The only relief Volcker feels free to offer is to aim at the top of the range of targeted growth, to tolerate temporary overshoots if they are offset before year's end, and to refrain, tentatively, from setting 1983 targets below those of this year. But doctor, those are bandaids -- the patient needs a transfusion!
The Fed has also limited its own flexibility by acquiescing in the monetarist convention of describing policy always in terms of money supply growth rates. This habit of thought could lead skeptical Fed-watchers to extrapolate to the long future a one-shot corrective burst of reserves and money creation, if there were one. Growth of M-1 at, say, 8 percent a year would indeed mean permanent inflation if continued indefinitely. But over the coming 12 to 18 months it would be no more than needed to bring interest rates down and to allow total spending and income in dollars to grow at 10 to 13 percent per year.
This would permit real GNP to recover at a modest 4-6 percent annual rate, no more than reduce unemployment by 1-2 points, given ongoing inflation of 6 or 7 percent a year. Thereafter, as and when circumstances warrant, the Fed could again tighten up on money supply growth to prevent a resurgence of inflation.
The most constructive thing the Fed could do right now is to indicate its willingness and determination to support growth of GNP measured in current dollars of 10 to 13 percent per year through 1983, whatever this may imply for bank reserves, money supplies and interest rates. It is surely not beyond the wit of Paul Volcker to explain, or beyond the wit of his constituency to understand, that the Fed can rescue the economy and the financial markets now without abandoning its longer-run determination to limit monetary growth to non-inflationary rates.
It is often said that news of easier monetary policy would lead bond dealers, bond buyers, and lenders generally to raise interest rates in anticipation of higher inflation. In present circumstances this would be an irrational response to the kind of policy change envisaged.
Even if bond dealers and lenders were obtuse, they could not raise rates for long. Additional reserves supplied by the Fed would increase the lending capacities of banks and the public. They will not hold idle cash. They will find borrowers only at lower rates. Like the price of any commodity in oversupply, the cost of borrowing money would have to drop. The Catch-22 scenario by which interest rates rise whichever direction the Fed movies is a fairy tale designed to justify doing nothing.
Likewise, anyone so bewitched by primitive monetarism as to believe that new money will be wholly absorbed in higher prices and wages given the slack product and labor markets of 1982-83 would find these expectations refuted by events.
But what about those whopping budget deficits for the next several years? Isn't excessive federal borrowing the culprit for high interest rates and the obstacle to recovery?
Clarity on this question requires a moderate degree of subtlety, in particular distinction between deficits now and in 1983 and those in prospect for later and, one hopes, prosperous fiscal years.
This year's deficit is largely the >result, not the cause, of the recession and of the high interest rates that have depressed the economy.
Every extra point of unemployment raises the deficit some $30 billion, by losses of tax revenues and automatic increases of outlays. Moreover, high interest rates directly raise the deficit by adding to the cost of federal debt service about $7 billion per point.
Defense spending and the tax cuts enacted in 1981 begin to be significant sources of deficit in the coming fiscal year. But recent upward revisions of the estimated FY 1983 deficit, by the Congressional Budget Office and other forecasters, reflect mainly more pessimistic projections of economic activity and interest rates.
Deficit-reducing measures, whether tax increases or expenditure cuts, might indeed lower interest rates. But in present circumstances, with monetary policy unchanged, they would do so only by making a weak economy still weaker. >There is no way to enjoy both lower interest rates and economic recovery without an easing of monetary policy.
The large deficits in prospect for 1984, 1985 and subsequent years, even if the economy is prospering, are a different matter. Anticipation that they will crowd out private borrowere or that the Fed will be forced to monetize them may be raising longer-term interest rates today. That is why I and others urged earlier this year an "Accord of 1982," under which easing of monetary policy today and correction of future budgets would be simultaneously agreed and announced. That is still a good idea.
Can nothing be done to relieve the paralyzing fear that recovery supported by accommodative monetary policy will re-ignite inflation? As this risk inhibits policy for recovery today, so it will tomorrow and tomorrow. It will continue to do so even though inflation subsides further in a depressed and stagnant economy. Something can be done, and now is the right time.
Price and wage guideposts could assure continued disinflation even while employment and production improve. Given the dismal markets they now face, both business and labor should find a package combining guideposts with expansionary policy an attractive bargain. From 1961 to 1965, after two recessions back to back in 1957-58 and 1960, such a package brought a strong and durable recovery free of inflation. Today compliance with guideposts could be induced by tax credits for workers and employes -- so-called tax-based incomes policy, TIP. Incomes policies do entail costs, inefficiencies and inequities; but these are small compared to the massive economic damage of protracted stagnation. The first requirement of a guidepost policy is Presidential leadership in building the supportive consensus, and that of course is an unlikely departure from the Administration's ideology.
The hardships we are suffering are not inevitable. They are made in Washington. Better policies are at hand. Those who reject them should not be allowed to take refuge in the plea that they have no choice.