Economists' debate: Will cutting deficit choke or spur growth?
Boston — Popular economic views aren't always consistent. Last year, for example, many economists, politicians, and others were contending that Congress must reduce the federal deficit to keep the recovery going. The theory held that financing of the massive deficit was propping up interest rates and that these high rates would eventually squelch activity.
The recession didn't happen.
With the prospects for deficit reduction raised somewhat, whether or not the Gramm-Rudman-Hollings provision survives its challenge in the Supreme Court, some are now concerned that a drop in the deficit will prompt an economic slowdown.
Contrariwise, Beryl W. Sprinkel, the top White House economic adviser, says money has been too loose and should be tightened.
This difference is one issue the Federal Reserve System's monetary policymaking body must iron out at its meeting this week, ending today.
Preston Martin, vice-chairman of the Fed, has been calling for easier monetary policy to offset an expected decline in the deficit. So have some congressmen.
These officials appear to be accepting the doctrine of British economist John Maynard Keynes that changes in fiscal policy (tax or spending policies) affect business activity.
That economic opinion lost much of its popularity in the United States in the 1960s and '70s, when changes in monetary policy overrode opposite fiscal policy moves in their impact on the economy.
Jerry L. Jordan, an economist with First Interstate Corporation, Los Angeles, says his research at the Federal Reserve Bank of St. Louis some years ago found that a spending cut might stimulate the economy and a spending boost depress it. A quarter or two later, however, theorists say these modest effects would be reversed. Further, monetary policy has a more powerful effect on the business cycle.
In other words, Dr. Jordan has little fear that a decline in the deficit by itself will shove the nation into recession. If Washington cuts back on its outlays, the money saved will not be borrowed by the government on the capital markets and will instead be spent by private business or individuals.
Nonetheless, Fed chairman Paul A. Volcker, testifying at a House banking subcommittee hearing last month, thought it necessary to assure an inquiring congressman that the government's fiscal policy would be one of the factors the Fed would take into account in setting monetary policy this year.
Mr. Volcker used vague language. ``Taking into account'' does not necessarily mean the Fed will ease its monetary policy.
In fact, Jordan believes it more likely that the Fed will have to tighten credit. In the last 12 months, money (M-1 -- checkable deposits plus currency) has grown 11.6 percent, a record rate. His forecast of a handsome 4.5 percent growth in real gross national product this year counts on money growing at a reduced 8 percent.
Historically there has been a close link between growth in the money supply and economic growth, and, with a longer time lag, inflation. But that link did not work last year. Despite the rapid money growth, the economy grew only 2.3 percent last year. And inflation remained modest. The consumer price index was up only 3.8 percent last year.
``Maybe we do have a new era,'' says Michael J. Hamburger, an economist affiliated with Keane Securities in New York.
Many monetarist economists, members of the economics school that believe changes in monetary policy work fairly quickly on the economy, found their forecasts of gross national product (GNP) and inflation far too high for 1985. These economists have had some explaining to do.
Citibank economists, monetarist in inclination, devote a page of a weekly report to why money ``whispered'' last year. Jordan, also a monetarist, has some explanations, too.
Both Mr. Hamburger and Jordan now believe last year's large addition of new money will have more impact this year. ``It's a bit too soon to write off M-1 or the impact of monetary policy,'' writes Citibank economist Charles E. Wainhouse.
In economics, the basic money equation is MV = PT. That means that the amount of money times velocity (how many times money turns over) equals prices times transactions.
``PT ''is usually defined as nominal GNP reflecting the effect of price increases on actual output of goods and services.
Monetarists figure one problem last year arose from the usual definition of ``transactions'' as GNP. In 1985 the rise in GNP was dampened by an extraordinary inflow of imports that depressed GNP.
Demand from consumers and businesses grew strongly, but their money was spent increasingly on imports rather than domestic suppliers. Also, inventories did not grow, as expected. They declined.
On the other side of the equation, these factors show up partly as a decline in velocity. This has surprised nearly all economists, monetarist or not. Velocity of M-1 grew at an average annual rate of nearly 3 percent from 1959 through the end of 1985.
Contrariwise, it dropped at an annual rate of 4.8 percent in the first quarter of 1985 and 6.1 percent in the second three months.
``People decided us crazy monetarists were not right,'' says Hamburger, who now deviates from standard monetarism. He explains the decline in velocity as related to the drop in interest rates. Since money cost less to hold, consumers and people did not spend it so fast.
Monetarists also reckon that with changes in the financial institutions, M-1 now includes some elements of savings, and thus M-1 is not spent so fast as before.
John M. Godfrey, chief economist of Barnett Bank, Jacksonville, Fla., says M-1 would have grown only 8.4 percent last year if the savings element had been removed.
Whatever, Hamburger expects another good year, with real GNP up 3.5 or 4 percent, inflation in check, and interest rates down further.
Other monetarists are counting on that money going to work even faster in the domestic economy as imports grow more slowly and business rebuilds its inventories. ``We are going to get more inflationary pressure and higher interest rates,'' adds Dr. Jordan.
If such monetarists as Jordan are wrong again this year, they will have to offer some good excuses to save their economic theory from disrespect.
Thus they are breathing easier with each new sign of economic revival in the United States.
These economic uncertainties make the Fed's monetary policymaking function a difficult task.