Beware of Saddam's recession. As world stock markets shudder, we need to keep our perspective. One of the worst things we could do to ourselves is to use the Persian Gulf crisis -- and its threat to the economy -- as an excuse to relax our anti-inflationary policies prematurely. There are two myths to avoid. The first is that higher oil prices are the main causes of severe recessions. And the second is that a recession now would automatically be a catastrophe.
It's true that the recessions of 1974-75 and 1981-82 -- the worst since World War II -- were both preceded by big jumps in oil prices. What's not true is that the higher oil prices created the recessions. Strip away energy prices, and you discover that general inflation had already risen sharply. Between 1972 and 1974, nonenergy inflation jumped from 3.3 to 9.8 percent; between 1976 and 1980, it increased from 5.6 to 11.6 percent. Higher overall inflation was the basic reason why these recessions were so harsh.
If we lived in a utopia, there would be no recessions. In our real world, however, we need to acknowledge that recessions are often necessary evils. They dampen inflation and force companies to be more efficient. The good effects linger while the bad effects (higher unemployment, less output and lower profits) eventually disappear. Sometimes we have to accept a recession to quell inflation before it begins to hurt consumers and disrupt businesses.
You cannot easily glean this from popular commentary. Our journalistic and political language emphasizes extremes. There are triumphs and tragedies, heroes and villains. Ambiguities are few. In this language, "recession" is a term of disaster. It is pronounced with an air of foreboding. The ominous overtones already pervade all the news reports speculating about a recession. We need to move beyond this melodrama.
"Recession" is a term of art as much as a precise description. It can cover a lot of ground. Typically, the economy is described as being in a recession when gross national product (total output) declines for half a year or more. Since World War II, there have been eight recessions. But only four of these -- the two mentioned above and the recessions of 1948-49 and 1957-58 -- were severe. The others amounted to modest pauses in economic growth that barely affected most Americans' jobs or living standards. In these recessions, the peak monthly unemployment rate averaged 6.6 percent. They were more statistical events than societal trauma.
Higher oil prices increase the risk of recession by cutting consumer purchasing power and (based on what's happened so far) raising inflation slightly. But if a recession materializes, oil prices will be only a contributing cause. Even before Saddam Hussein seized Kuwait, the economy was weak. The auto, housing and airline industries have been in slumps for months. A survey in July by the National Federation of Independent Business found that optimism among small companies is at its lowest since 1982.
You will hear a lot of scare talk about how a recession will feed on itself, becoming progressively worse and causing many secondary problems. The federal government won't rescue the economy with tax cuts or spending increases because the budget deficit is already so huge. Overloaded with debt, consumers and companies will trim spending further. More savings associations and banks will go bust. Foreign economies will weaken. These arguments are all plausible.
But doomsday forecasts routinely underrate the economy's resilience. There are equally plausible reasons for thinking a recession would be relatively mild. Consider:
1. Inflation is lower now than in the early 1980s. The Federal Reserve kept interest rates high during the 1981-82 recession to bludgeon down double-digit increases in prices and labor costs. With less inflation today, the Fed has more flexibility to cut interest rates in a recession.
2. Manufacturers are more efficient than a decade ago. One reason that the 1981-82 recession was so severe is that a lot of poorly run or old plants (which had survived during the inflationary 1970s) were forced out of business. This shakeout has left a stronger industrial sector. Indeed, manufacturing productivity (output per hour worked) rose at an average annual rate of 3.2 percent in the 1980s.
3. Exports will grow. The U.S. economy is now in the midst of a long-term shift toward more exports and fewer imports. Between 1985 and 1989, exports grew 66 percent. The continuing rise of exports (though probably at a slower pace) and substitution of domestic production for imports should boost employment and business investment.
4. Inventories are controlled more tightly. In a recession, companies typically cut back production and employment because their inventories -- that is, stocks of goods on hand -- are too high in relation to final sales. But computers now enable manufacturers to keep smaller inventories. In the 1970s, inventories amounted to almost 80 percent more than monthly sales; now that's 60 percent.
The question now is whether the Bush administration -- or the public mood in general -- will pressure the Federal Reserve to cut interest rates too rapidly. Even before Saddam's invasion, Treasury Secretary Nicholas Brady implored the Fed to lower rates. He argued that the economy is weak and that any package to reduce the budget deficit might further weaken it. Therefore, the Fed should spur the economy. Higher oil prices reinforce these arguments. They should be treated skeptically.
Just look at Britain, where interest rates were cut in 1986. The circumstances seemed favorable. Unemployment was high (11.8 percent). Oil prices were actually falling, and so was the government's budget deficit. But as economist John Makin of the American Enterprise Institute points out, the stimulus was overdone. Inflation shot up from 3.4 percent in 1986 to 7.8 percent in 1989, and now interest rates have had to be raised sharply.
This is a time for patience, not panic. Long economic expansions (this one began in late 1982) tend to raise inflation and foster business inefficiency. A recession is often the only antidote for these slow economic poisons. Let's blame Saddam if we must for any recession. But let's not compound the damage by inflicting higher inflation on ourselves.