The Economy -- Mischief Ahead?

Dec. 21, 2004
Political maneuvering could worsen the effects of a slowdown.

Next year, for the first time in almost a decade, real growth will fall below its long-term equilibrium rate, and the unemployment rate will rise. Is that good news or bad? At first it might seem obvious that some respite is needed. It is almost a given that the economy cannot grow faster than equilibrium indefinitely. The last two years have featured severe labor shortages in many industries and regions. A modest gain in the unemployment rate to 4 1/2% should remove the worst of these pressures while still keeping the economy essentially at full employment. The equilibrium growth rate of the U.S. economy is now about 3 3/4% per year, equal to a 1 1/4% annual growth in the labor force and a 2 1/2% annual gain in productivity. At that growth rate, the unemployment rate would remain constant. However, if it were to rise to 4 1/2% or even 5%, the chances of another wage/price spiral would be much smaller than if it remained at 4% or fell to 3 1/2%. From a long-term perspective, the U.S. economy would probably perform better if the unemployment rate were slightly above 4% than if it were slightly below 4%. Maybe Fed Chairman Alan Greenspan and his colleagues on the Federal Open Market Committee (FOMC), as well as the various leaders of Congress, all agree with this sentiment, in which case there is no reason to become concerned about a slowdown in real growth to 2 1/2% next year. The risk is that even this slight upward blip in unemployment could cause mischief in monetary and fiscal policy that eventually would reduce the long-term growth rate in productivity. It is likely that when the economy softens the Democratic heavy hitters in Congress will start demanding that something be done. That "something" could either take the form of terrorizing the Fed or opting for big increases in spending packages. Right now, Greenspan is considered not only the second most powerful man in Washington but the most admired as well. Nonetheless, it would be a serious mistake to suppose that if the unemployment rate starts to rise but the FOMC holds the funds rate constant, the notables on the Democratic side of the aisle would remain silent. Greenspan is hardly impervious to political pressure. In 1993 the federal funds rate fell all the way to 3% and stayed there all year. That rate, which was at least two and possibly as much as three percentage points below equilibrium, sharply boosted inflationary fears. As it turns out, the economy was still far away from full employment (the unemployment rate averaged 6.9% that year) so Greenspan was able to slam on the brakes and boost the funds rate to 6% the following year before any damage occurred. However, the Fed clearly does not have that much leeway this time. The other possibility for mischief is that the Democrats in Congress (who could gain control of the Senate before the 2002 Congressional election) will take dead aim at the burgeoning surplus, now estimated at $300 billion for FY2001. They could introduce massive spending bills and then invite Bush to veto them so they could paint him as just another heartless conservative who cares not a whit for the poor, the aged, and the sick. The historical example for this occurred in the Eisenhower Administration, when the Democrats regained control of the Senate and Lyndon Johnson pushed through the massive expansion of Social Security that later came back to haunt the balanced-budget folks. Some may point out that Democrats also controlled the House at that point, but the key chairs were held by Southern conservatives. The push for greater spending emanated entirely from Johnson. Ike could have vetoed these bills but did not exercise that choice. If Bush does indeed move into the Oval Office, the Democrats will go out of their way to cause problems for him. And if Greenspan doesn't go along, they could threaten to curb the independence of the Fed further, just as happened in 1975. It doesn't have to turn out this way, of course, but that's why the combination of slower growth next year and increased Democratic power in Congress could have a bigger negative effect than would ordinarily be the case from another soft landing. Michael K. Evans is president of the Evans Group and professor of economics at the Kellogg School of Business, Northwestern University, Evanston, Ill.

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