We are fast rediscovering an uncomfortable truth buried between the lines in the 384 pages of Keynes’s General Theory: Central banks cannot end recessions that they did not cause. After 450 basis points of rate cuts by the Federal Reserve so far this year, the Fed’s press release after the November 6 Open Market Committee meeting sounded almost apocalyptic: “Heightened uncertainty and concerns about a deterioration in business conditions both here and abroad are damping economic activity. For the foreseeable future . . . the risks are weighted mainly toward conditions that may generate economic weakness.”

Global Slowdown and Deflation

The Fed’s comment reflected two underlying developments of concern to central banks. First, the slowdown in the global economy is accelerating, with Japan’s virtual depression intensifying and Europe probably having slipped into recession during this quarter. No wonder then that both the hitherto recalcitrant European Central Bank and the more detached Bank of England followed the Fed’s 50-basis-point rate cut of November 6 with identical cuts within forty-eight hours. Perhaps the other central banks were responding to the Fed’s pointed reference to deterioration in business conditions “both here and abroad,” and perhaps they were beginning to notice that both output and inflation were falling rapidly within their own countries.

The second and by far more compelling reality underlying the Fed’s sense of urgency in cutting rates is the transition underway from disinflation to outright deflation both in the United States and worldwide. The report that the U.S. producer price index fell by 1.6 percent during October alone was an even more compelling spur to easing than the October Payroll Employment Report that saw elimination of 415,000 jobs, the largest one-month decline since May 1980.

The Fed has no choice but to race to cut short-term interest rates faster than inflation and inflation expectations are falling. The University of Michigan Survey of Consumers reported breathtaking drops of one-year inflation expectations from 2.8 percent in September to 1 percent in October to 0.4 percent in November. That plunge means that a neutral Fed funds policy, one aiming to hold short-term real interest rates constant, would have required more than 200 basis points of cuts since summer instead of the seemingly extraordinary 150 basis points of cuts made so far. Though the sticker shock from the rapid pace of easing will keep markets guessing, another 25 or 50 basis points off the Fed funds rate is probably forthcoming at the Open Market Committee meeting on December 11. After all, combating recession, especially this deflationary one, requires a real Fed funds rate of zero, and with expected inflation of 1 percent or below, a 1 percent nominal Fed funds rate is necessary to push real rates down to zero.

As short-term interest rates fall, markets are struggling to price longer-term government notes and bonds correctly in a disinflationary and possibly deflationary environment, where hopes for recovery swing violently along with the fortunes of the war in Afghanistan and swings in economic data. By early November, yields on U.S. ten-year notes had dropped by a full percentage point since summer, from about 5.4 percent to 4.4 percent, owing to a combination of falling real rates as economic activity weakened and diminished inflation expectations. Then in a few days in mid-November, military successes in Afghanistan and reports of an incentive-driven jump in auto sales reignited hopes for an economic recovery, and long-term interest rates jumped back up nearly to 5 percent. In fact, the market response to enhanced hopes for recovery pushed up interest rates so sharply that recovery hopes may well be scaled back again.

The terrorist attacks on September 11 did not cause the economic slowdown that began a year ago, and there are few signs that the rapid drops in investment, profits, and employment that accompanied it have stopped yet. The sharp jump in interest rates, which was tied to recovery hopes, will slow refinancings and hurt spending, especially given continuing deflation pressures.

Watch Nominal GDP Growth

The intensification of disinflation and deflation, first in goods and now also in services, has changed the focus on the evolution of this extraordinary slowdown from falling growth to an even more malignant combination of falling growth and falling prices. When prices and output are falling together, the best gauge of the economy’s health is nominal GDP rather than the real GDP highlighted in quarterly reports on U.S. growth. While third-quarter real GDP fell at “only” a 0.4 percent annual rate, part of the mitigation of the slowdown in real GDP growth came from falling price indices applied to calculation of real consumption and real investment. The consumption and investment deflators (now inflators, since they are negative) fell 0.4 percent and 0.5 percent respectively, boosting “real growth” in those categories.

Nominal GDP growth in the third quarter fell to a 1.8 percent annual rate from a high of an 8 percent rate in the second quarter of 2000, a reflection of simultaneous sharp reductions in growth and inflation. On a year-over-year basis, nominal GDP growth, a good proxy for yields on five-year notes, dropped to 3.1 percent in the third quarter. This is telling because at 3.1 percent, year-over-year nominal GDP growth is far below its average level of 7 percent at the start of postwar recessions. In coming quarters we can expect nominal GDP growth to continue to fall and to sink below minus 1 percent, because of falling output and prices. Long-term interest rates will follow nominal GDP growth downward.

More Fiscal Stimulus Needed

With nominal GDP growth falling, thereby placing further negative pressure on profits and employment, it is doubly disconcerting to discover that lower interest rates are unlikely to arrest this negative combination for the economy. The only policy instrument left to the United States is greater fiscal stimulus. So far, enactment of further stimulus has foundered on a combination of political roadblocks and wrangling over whether the stimulus should take the form of tax reductions or spending increases. Meanwhile, many in Washington cling to the ridiculous idea that in an economy with collapsing nominal GDP growth, fiscal stimulus is inadvisable because it might push up long-term interest rates. Surely, the fact of a full percentage point reduction in interest rates on ten-year Treasury notes during the July to early-November period that coincided with a sharp rise in estimates of the federal budget deficit cannot escape the notice of even the slowest thinkers of Capitol Hill. Some of them apparently still think the economy is just fine, to judge from their nonchalance about passing even a modest fiscal stimulus package. The rapid deterioration of the economy notwithstanding, the stimulus package, which had been widely promised to be completed by October, now looks headed for delay until Christmas or later as Republicans and Democrats on both sides of the Hill argue about the mix of spending increases and tax cuts.

Further, higher interest rates have coincided with less likelihood of further stimulus, not more. The sharp rise in interest rates during mid-November accompanied a jump in hopes for recovery, but those higher hopes will blunt the drive for fiscal stimulus and further jeopardize an actual economic recovery.

The global economic slowdown, led among major industrial countries by an intensifying U.S. recession, has made the situation urgent enough for the White House to seek a way to induce Congress to put aside its political differences and enact a stimulus bill. The president should, after the release of another disastrous employment report, perhaps early in December, announce his extreme disappointment with Congress for failing to put upon his desk by November 30 the stimulus package that he had requested. Simultaneously, he should suggest that the package be enlarged to $200 billion, with Democrats allowed to specify $100 billion worth of their favorite spending increases while Republicans can specify $100 billion worth of their favorite tax cuts. The tax cuts should be broadly based and permanent, not narrowly targeted and temporary as has been suggested in recent weeks. Permanent measures on the tax side should include earlier implementation of the tax rate cuts passed last spring as well as reducing corporate rates as much as possible and accelerating depreciation. The $25 billion that House Republicans unwisely expended on refunds of past AMT taxes collected should be put toward these measures, while the AMT tax should be eliminated going forward.

One would hope that Democrats and Republicans favoring additional spending could agree on the temporary extensions of unemployment insurance and supplemental health insurance already contemplated. However, those measures need to be made temporary to contain their multiyear cost. It is tax cuts that need to be made permanent so households and businesses can plan to optimize the advantages they offer while temporary spending increases cushion the blow to households of an extended recession. Long-run tax cuts are aimed at enhancing sustainable growth, while front-loaded spending increases provide an immediate demand boost—the right combination for the struggling U.S. economy.

Lessons from Japan

To undertake additional fiscal stimulus, both Republicans and Democrats must abandon the counterproductive idea that such action would be self-defeating by virtue of the higher interest rates it would entail. As already mentioned, the past several months have provided ample evidence to disprove that view, and if further evidence is needed, one only need look to the experience of Japan. In that unhappy country, the government is contemplating additional fiscal stimulus on the order of nearly 2 percent of GDP at a time when the debt-to-GDP ratio is 130 percent and deficits in an economy with falling nominal GDP and falling tax revenues are running close to 10 percent of GDP, the equivalent of a trillion dollars in the United States. It was fear of deficits that caused the Japanese government to raise taxes in the spring of 1997, and thereby quash what was by then a recovering economy and push it back into the virtual state of depression it is in today. It would have been far better had Japan applied fiscal stimulus earlier in the 1990s, when its fiscal picture was far stronger, as America’s is today.

The president is understandably preoccupied with the security problems attendant on the tragic events of September 11 and thereafter. Ironically, recent successes in the Afghan War have triggered a dangerous combination of elevated hopes for recovery, higher interest rates, and less momentum for fiscal stimulus, the latter two of which make actual economic recovery less likely. Help is still needed to overcome the depressing effects on demand arising from an intensifying synchronous global recession and elevated uncertainty created by terrorist attacks in the United States. America remains a wealthy country with a healthy federal budget outlook. Investment of a modest 2 percent of GDP—an additional $200 billion of fiscal stimulus—to avoid or at least mitigate growing deflation momentum that could precipitate a serious global recession is both prudent and necessary.

John H. Makin is a resident scholar at AEI.