While the headlines fixate on George Bush's launch as a "kinder, gentler" president, a potentially more momentous transition has occurred over at the Federal Reserve, the independent central bank that regulates money and interest rates. Without much fanfare in the press, the Fed has, so to speak, flicked on the yellow warning light for the American economy. If the light stays on long enough, this new president will find himself staring at a recession, as well as swelling federal deficits.
The ominous signal is reflected in what the governors of money have done to interest rates. For the last eleven months the Fed has been gradually tightening the money supply, pushing short-term interest rates higher, a notch at a time. Fed chairman Alan Greenspan's purpose was to slow things down gently and avert what financial markets feared might be a new breakout of inflation. The economy seemed to plow ahead regardless, and most forecasters remain optimistic about 1989.
But in the final weeks of 1988, the Fed's campaign took a portentous turn — producing a rare, abnormal condition in credit markets that ought to alarm our political leaders. Thanks to the Fed's tightening, the interest rates paid on short-term investments, such as one-year treasury bills, have now risen above the rates paid on long-term investments, such as thirty-year government bonds. That's illogical on its face, since investors normally earn more on long-term lending, because it is more risky.
In financial markets this upside-down condition is known as an inverted yield curve, which occurs only when the central bank is putting extraordinary pressure on the supply of money that circulates through the vast labyrinth of American commerce and credit. It means money is extremely tight. It also usually means a recession is coming.
The last time we had an inverted yield curve was in the early 1980s, just as Ronald Reagan was taking his oath of office. Six months later the economy sank into a long and bloody recession, which simply means that the gross national product — production, sales, jobs — declines. Democrats and other Americans blamed Reagan and his supply-side economics, but their anger should have been directed at the Fed. The central bank has the unique power to go its own way — even when it means opposing the president.
If history is any guide, George Bush's presidency is already at risk. The rules of modern economics are regularly refuted by real events, but this is one rule that has held up remarkably well over the years. Since 1950 there have been nine occasions when short-term rates were pushed above long-term rates and held at that level for many months. Seven times a recession followed. The two exceptions, when the inverted yield curve did not lead to a full-blown contraction, occurred between 1966 and 1968 when the Fed backed off in time and eased credit. The economy was also stimulated then by vast spending for the war in Vietnam. Even so, those episodes produced a dramatic slowdown that economists remember as a "minirecession."
There's nothing especially mysterious about why abnormally high interest rates put the economy in the tank. The cost of credit is embedded one way or another in most transactions. Higher borrowing rates drive away home buyers and keep customers out of auto showrooms. Businesses that must borrow to maintain their inventories begin cutting back their orders for new goods when their sales decline. Pretty soon the factories are cutting back production and sending the workers home. If this process gains enough momentum, the overall economy stops growing and begins to contract. Borrowers begin to default on their debts — both unemployed workers who can't keep up with their mortgage payments and businesses suffering from lost sales.
The smart people in financial markets know this history and understand its implications for today. This early in the Bush era, they are not yet predicting that a recession is inevitable, but they are issuing sober warnings. Barclays Bank of London recently told bond buyers that U.S. money policy is "now tight enough to risk a harder landing for the real economy than markets have discounted." Edward Yardeni, chief economist at Prudential-Bache, has complained for months about what he calls "the Greenspan error" — the danger that the Fed will hold too tight and inadvertently sink the economy. "It's nice to prove you're macho about fighting inflation," says Yardeni, "but if you overdo it, what's the point?"
So is the Fed going to rain on George Bush's parade? Certainly a recession is not what voters thought they were buying when they opted for another four years of Republican "Don't Worry, Be Happy" prosperity. Nor do I think this is the result Bush and his advisers have in mind. Yet so far nobody in the administration has complained about the Fed's policies.
There is impressive historical evidence pointing to the possibility of a Bush recession. Every Republican president since Herbert Hoover, including Eisenhower, Nixon, Ford and Reagan, presided early in his first term over an economic recession (or worse). Because the GOP represents the people of wealth, who tend to enjoy higher returns on their money, it has always been more tolerant than the Democratic party of high interest rates and more willing to risk the consequences. The Fed, a most conservative institution itself, apparently feels more freedom to administer the harsh medicine of rising unemployment and shrinking incomes when the party of money is in the White House.
Whatever happens, Federal Reserve policy ought to be the subject of intense political debate right now. Yet there is no public discussion of the Fed's decisions. Financial experts are aware of the risks, but the public at large, and most politicians too, are ignorant of the effects of the Fed's actions. And the press does a lousy job of explaining things for them. Most people simply don't see the yellow light flashing.
It's always hard to know exactly what the Fed intends by what it does, because it is such a secretive institution. When the Fed put the economy at risk in the past, it never gave fair warning that hard times were coming and, in fact, often uttered deceptive assurances. As a result, many innocent players — from home buyers to farmers — were blind-sided by events. They went forward with ventures and borrowed, believing the Washington rhetoric about a healthy economy, then found themselves ruined a few months later in an economic contraction.
Several of the central bank's top policy makers assured me that the Fed is not setting out to induce a recession now. If anything, they say, they are still worried that the economy is too healthy, expanding at a clip that produces anxieties about inflation among investors. They do not imagine that it will sink into recession any time soon. All they intend, they insist, is to slow things down a bit. Still, they acknowledge the historic lessons of the inverted yield curve.
If the Federal Reserve succeeds in its goal, Bush will likely fail in his — reducing the deficit without raising taxes. "A modest slowdown in the economy would not be a make-or-break situation," says Manuel H. Johnson, vice-chairman of the Federal Reserve Board of Governors. "A more dramatic slowdown would be a problem. That's not our objective — I guarantee."
Johnson is among those who believe that if signs of a recessionary slowdown threaten in the coming months, the Fed could swiftly reverse things by lowering interest rates and restimulating the economy. "The yield curve forecasts recessions pretty well, but with a long lead time — probably a year or so," he says. "I don't see any strong evidence that the real economy is in any danger. I believe we would be able to move fast enough if we had to."
Johnson, however, is only one vote at the Fed's board-room table — where six other governors and the twelve presidents of the regional Federal Reserve banks also have a voice. For months a polite debate has been under way between progrowth governors like Johnson and "hawks" like Lee Hoskins, president of the Cleveland Federal Reserve Bank, who favors the Fed's keeping a tight rein on the economy. "Nobody ever wants a recession, because recessions are costly," Hoskins says. "But we will pay an even higher price if we don't curb inflation, and that's the most important thing now."
From Hoskins's perspective, the Fed should hang tough until the inflation rate subsides substantially below its present level — about four percent. That's always what stirs conflict at the Fed — the trade-off between economic growth and stable prices. While everybody at the central bank fears inflation, there is considerable dispute about how much economic pain should be induced to produce stable prices.
The danger now, it seems to me, is that institutional pride and internal arguments might prevent the Fed from backing off at the right time. Certainly there is a pattern of those errors in the past. Once the Fed finds the nerve to push interest rates up, it often holds tight too long, until it is sure that the job is done. The problem is that by the time the effects of a slowing economy are clear, it is sometimes too late to reverse the contraction.
The plain fact is nobody at the Fed is infallible when it comes to executing this sort of fine-tuning. Even the experts frequently get things wrong. For instance, policy makers like Hoskins, backed by a conservative chorus drawn from financial markets and the press, have been warning of inflation for nearly a year. So far, at least, they have been wrong. The inflation rate in 1988 was virtually identical to the inflation rate in 1987. Now the only difference is, thanks to the exaggerated fears driving the Fed, borrowers are forced to pay about twenty-five percent more for nearly every kind of loan. Sooner or later, that added toll will reduce economic prospects.
The usual risks are further compounded because, as everyone knows, the national economy is mired in unprecedented debt — not just the federal government but also consumers and corporations. Less well understood is that debtors in the 1980s are effectively paying the highest interest rates of this century. Even Fed chairman Greenspan acknowledged this when the Senate Banking Committee inquired about the extraordinary level of real interest rates, the nominal interest rates discounted for inflation. Greenspan testified that the average real interest rate on short-term government borrowing was 4.4 percent during this decade — compared with minus 0.8 percent in the 1970s or 1.7 percent in the 1960s or 0.1 percent in the 1950s. Since Greenspan's testimony last summer, the Fed has pushed rates up about 2 percent — aggravating the pain further.
How much pain can debtors take before widespread defaults occur? Nobody knows. Fed officials take comfort from the fact that the economy has grown steadily through this decade despite the huge costs of real interest rates. They have convinced themselves that the old assumptions about debt and interest rates may no longer apply. But the historical precedents are ominous. The only other decade in this century that approached the Eighties in its level of interest rates was the 1920s — when real rates averaged 3.5 percent. That decade ended with a stock-market crash, followed by a general default of debtors — a catastrophe better known today as the Great Depression.
While everyone pounds on George Bush to do something about the deficits, the president's chance of accomplishing much is directly undermined by the Federal Reserve's stringent money policy. The Bush administration bases its own budget plans on the assumption that the economy will grow at 3.5 percent and that interest rates will decline to about 6 percent. This is pure fantasy, given what the Fed is now doing — holding interest rates around 9 percent and trying to force the economy down to a growth rate of 2.5 percent or less. The deficits will be larger as a result, both because the government must pay billions more in interest on its own borrowing and because it collects less tax revenue from a weakened economy. If the Fed succeeds in its objective, Bush will likely fail in his — reducing the deficit without raising taxes.
Some cynical Democrats are convinced that Bush and his deputies are not really upset by the Fed's campaign. After all, Greenspan and the other six governors are all Reagan appointees and are quite compatible with the new regime. Furthermore, there is a distinct political cycle to the way things usually unfold under GOP presidents — the economic pain is imposed by the Fed at the outset so that the economy will be recovering, with rising incomes and employment, by the time the next election rolls around. Reagan rode that cycle with marvelous skill — or good luck. His first term began with the deepest recession since the 1930s, but by 1984 voters were feeling good again and had mostly forgotten the castor oil. He won reelection by a landslide.
My own hunch is that neither Bush nor his top lieutenants are nervy enough to play this game again — partly because the risks are now much greater. The financial system is already frayed by the crisis of failing debtors — forcing the government to bail out the savings-and-loan industry as well as some large commercial banks. Major corporations are leveraged in debt at dangerous levels. The wishful scenario in Washington is that sometime in late spring Bush and the Democrats will announce a grand compromise on the budget deficits and will thus give the Fed a pretext for lowering interest rates. The trouble is, that scenario has failed many times in the past. If a recession does take hold, it could be swifter and deeper than any of the previous contractions. The federal deficit would swiftly swell to unprecedented peacetime levels. With bad luck, George Bush really could become the new Herbert Hoover.