Commentary

Wartime Economics … Then and Now

This article was first published in the Washington Times, October 25, 2001.

The economy was also troubled by simultaneous war and recession a decade ago, when George Bush Senior was president. Yet the current situation is quite different from 1990 and in some respects better. Most important, oil prices and interest rates are already much lower, and businesses have been working off excess inventories all year.

The last recession began in August 1990, just as Iraq invaded Kuwait. One reason is obvious: The price of oil more than doubled in three months, from $17 a barrel in July to $36 by October. In fact, a sharp rise in oil prices preceded every recession of the past three decades, including this one. The difference this time is that oil prices have now been falling for quite a while, slipping from more than $34 last November to around $22 lately. That’s the good news. The bad news is that demand for energy fell largely because industrial production has declined every month for an entire year.

In 1990, U.S. industrial production did not even begin to fall until September, and then for only six months. Ironically, that difference may now make the future a bit easier to handle. Businesses have already been cutting inventories and jobs for months, unlike 1990, so there is less need or room for further cutbacks. Any store with empty shelves cannot empty the shelves a second time. Also, the fact that we begin this battle with manufacturing operating below 75 percent of capacity makes it ridiculous to fret about overstressing the economy with too much “guns and butter.”

The current recession did not begin on Sept. 11. It began no later than March, possibly as early as last October. Weakness first appeared in profits and investment, not consumer spending. Poor profits forced companies to first slash investments in inventories and equipment and later to lay off workers.

Over the past year, profit margins were squeezed by rising labor costs, energy costs and interest costs. Energy and interest expenses are clearly abating, and labor costs will too. Labor costs per unit of production rose at an 8.9 percent annual rate in last year’s fourth quarter, even after adjusting for productivity gains. With business prices rising by only 1.5 percent and labor costs by 8.9 percent, something had to give. Fortunately, it looks as though pay and benefits have moderated, minimizing the only alternative (layoffs). Economic recovery will further reduce unit labor costs by increasing the number of units each worker produces (productivity).

Just as cheaper energy will be good news for many industries that use a lot of fuel or electricity, cheaper credit will also be good news for companies that got themselves too deeply in hock. Oil prices came down after October 1990 too, which helped end that recession. But interest rates were much slower to move.

In 1990, the Federal Reserve kept the fed funds rate above 8.2 percent in September and lowered it very gradually. The funds rate was not reduced to 3 percent until December 1992 — 21 months after the recession ended. This time, by contrast, the funds rate is already down to 2.5 percent and many think it is going lower still. That has to make a huge difference. Families and firms can refinance their old debts at lower rates. And those sitting on money market funds have a stronger incentive to invest.

Before Sept. 11, as some diehards were still debating whether recession had even begun, key statistics suggested the recession may instead have been close to ending. Leading indicators had risen for a few months. And the September survey from the National Association of Purchasing Managers (NAPM) came in at 47 — down fractionally from August but up significantly from 42.1 in May and 43.6 in July. A decade ago, that NAPM survey dropped all the way to 39.2 in January, 1991, from 46.1 the previous August. When the NAPM survey turned up the following month, however, that did indeed signal that the recession’s end was only another month away.

If you want to know what lies ahead, keep an eye on such measures of production and profits, not unemployment or “confidence.” Focus on the supply side of the economy, which ultimately drives demand.

Unemployment is a notorious lagging indicator, which rose by a full percentage point long after the last recession ended. Consumer confidence reacts to economic news rather than causes it. The Conference Board’s confidence survey hit a cyclical low of 55.2 in January, 1991, much lower than today. Yet consumer spending rose in the month after that dismal confidence survey and continued rising by 3.1 percent over the following year.

Higher oil prices and interest rates have always shoved the economy into recession. Lower oil prices and lower interest rates have always had the opposite effect. Why should today be any different? Sure, consumers are likely to postpone some purchases for a few months. But buying less now and more later just makes next year stronger. And when people spend less on one thing they invariably spend more on something else.

Rising stock markets have always been followed by rising consumer confidence. Fortunately, we know what normally happens to stock prices shortly after the initial wartime panic. When Iraq invaded Kuwait on August 2, 1990, the market was hit hard. But the U.S. did not fight back until Jan. 17, 1991. On the following day, a New York Times headline read “Stocks Soar and Oil Drops on War News.” Within two months, the Dow was up 19.8 percent. Similarly, two months after the U.S. stood firm in the Cuban Missile Crisis, the Dow was up 21.3 percent. Resolute action evidently inspires confidence.

Soon after Sept. 11 (a bit too soon), several prominent economic writers advised buying stocks for patriotic reasons. Judging by what happened within a couple of months after similar situations, even such premature advice should soon pay off. Patriots should not feel too guilty about making money by investing in U.S. industry. It’s the American way.

Alan Reynolds is a Cato Institute senior fellow.