If the Recession Comes

Beryl Sprinkel - Sprinkel has been chairman of the Council of Economic Advisors since April 1985. Prior to that he was Undersecretary for Monetary Affairs at the Department of Treasury. In the following remarks, be vigorously defends the growth record of the Reagan Administration. While Sprinkel worries that mounting business debt will be a problem in an economic downturn, he predicts that no recession is on the horizon.

NPQ: The total debt in the US economy consumer debt, corporate debt, government debt - is now about 170% of GNP. Is such an unprecedented level of debt cause to worry?

Beryl Sprinkel: We should be aware of it and the potential problems it might create. Consumer debt has risen to very high levels in relation to income. But we also have to look at what's happened to consumer assets. Assets have improved in terms of stock, bonds and home values. While total liabilities for households, personal trusts and nonprofit organizations have increased by $288 billion during 1986, total assets have increased $2.7 trillion. Even the more liquid forms of assets, those that can be cashed in quickly, have increased by $650 billion. In my view, the balance sheets of consumers are sufficiently balanced.

The major concern I have about corporate debt is that it makes the corporate sector more vulnerable in the event of another recession. There are essentially two devices by which corporations raise cash to invest in the economy: equity and debt. Unfortunately, when corporations compare debt with equity financing, they still come out with a strong presumption in favor of debt financing.

On the federal side, a balanced budget would have a positive impact on our trade deficit because the overall saving- investment relationship is an important factor in determining the importation of capital. The federal deficit also creates a latent possibility of inflation, which passes sizable costs on to our kids and grandkids. It's extremely important that we continue to make progress in pulling down the federal budget deficit.

We have made considerable progress. Last year we had a $221 billion deficit. Our official target this year was $175 billion, but we're going to come in considerably better than that.

However, we shouldn't reduce the federal deficit at all costs. We want to bring about an adjustment in the trade account in an environment of continued economic growth. Raising tax rates to reduce our fiscal deficit is counterproductive. It would reduce constraints on Congress to spend money and it would have an adverse effect on Incentives to save, invest and work. A tax increase would hasten a recession.

NPQ: Even if we do get under the $175 billion federal deficit target for this year, if there is a recession with that kind of a debt load, we would face real problems.

Sprinkel: If we were to run into a recession starting with a $150 billion deficit, a couple hundred billion dollars or more would be added to our annual deficit. Such levels of federal fiscal deficits would be unprecedented and would either require a policy of severe fiscal restraint in the middle of a recession or continuing unprecedented large deficits.

NPQ: If we are basically talking about a potential $400 billion deficit, the scenario would go something like this: First of all, Japan and Europe are going to be drawn into the recession and therefore have less funds to lend us so that we can finance our own deficit. That in turn contributes to crowding out the market, which in turn drives up interest rates, which in turn deepens the recession. Is that the scenario?

Sprinkel: Perhaps. We will get very large deficit totals in any possible recession. That's why it's important to continue to make progress now, and in the period immediately ahead, to pull those deficits down.

NPQ: Last year M1 grew 12.1%. Yet even at that high rate, economic growth has only been a sluggish 23% annually. If a recession hits, M1 is going to have to jump significantly, stimulating inflation.

Sprinkel: Over the years 1985-86, we saw very substantial reductions in inflation, inflationary expectations and interest rates. The cost of holding idle cash went down so citizens were willing to hold more cash. Velocity, instead of being stable, actually declined. As inflation expectations bottom out, we are not expecting to see continued persistent weakness in velocity similar to what we saw during those two years.

NPQ: Is there really a problem with the foreign debt?

Sprinkel: That depends on whether this recent sizable capital inflow into the United States has been used to finance one big consumption party or to maintain high levels of investment. The answer is that in recent years we have had a level of real gross private domestic investment at postwar high levels or 18+% of GNP.

Maybe we should have devoted more to investment, but it is simply not true that our foreign borrowing has all been devoted to consumption. In relation to our present income, our obligations abroad are quite low, about 6 % of our income. In relation to assets in the United States, the net position is around 2%.

NPQ: What happens if foreigners stop lending?

Sprinkel: They are not going to stop so long as we have good rates of return and good economic performance in the United States. If we were to turn protectionist, if we were to return to high inflation and high regulation and low growth, then I would be worried. But we are not going to do that during this presidency.

NPQ: What about the Latin debt?

Sprinkel: Latin governments, after going through a period of very depressed economic activity and very high interest rates, are now doing better. Economic growth is clearly the best hope for eventually resolving the Latin debt situation in a way consistent with the continued viability of the Latin governments. We have encouraged that.

NPQ: Your predecessor Martin Feldstein has said that if debt service is kept low, to 2.5% of GNP of the respective countries, that will enable the debtor countries both to grow and to afford paying back the interest on the debt.

Sprinkel: Although I don't want to tie into a particular number, his basic idea is correct. There is a balance that must be achieved. We cannot hope to force an elimination of the debt problem in the short run by encouraging a massive shift of resources from Latin Americans to creditor nations. Growth will, however, eventually solve the problem.

NPQ: Is debt and interest rate relief the next step beyond growth?

Sprinkel: There has already been debt and Interest relief Interest rates have come down very substantially. There have also been reschedulings and purposeful delays, both by our government and private creditors, to make the burden less onerous by stringing repayments out over time. To now change policy and adopt debt forgiveness is not the proper course for our federal government to pursue.

NPQ: Do you see the recent Citicorp decision to increase their reserves as a step toward resolving the situation, perhaps by stimulating the secondary debt market?

Sprinkel: I believe so. The major lenders ended up with illiquid assets because payments were frequently rescheduled, interest rates were reduced and lenders' ability to control assets was substantially reduced.

The exchange of debt for equity is one device that can help, and a market is developing. The movement by the major banks toward stronger reserves will provide additional support.

NPQ: In April the savings rate was below 1% for the first time. Public infrastructure is in disrepair, consumer debt and mortgage delinquency rates are at recession levels as are business failure rates. The corporate quick ratio - cash assets to twelve month liabilities - is at a post-Depression low. This suggests a brittle economy of underlying weakness and overarching debt.

Sprinkel: I don't share that view, especially at the present time. Prospects for continued growth are excellent. It is clear to me that the ability for the corporations to make money is significantly improving, partly because of some very painful and costly cost-control efforts, brought on in many cases by a weakness in exports. It's clear we're also seeing a significant improvement in corporate profits which will enable corporations to service all the debt they have acquired.

Productivity has improved very markedly in the manufacturing area. The average annual rate of improvement in manufacturing productivity since '81 has been 3.9%, more than one percentage point above the postwar average of 2.6%. Unit labor costs have been declining. Wage costs, the major cost component, have been only moderately increasing. The dollar adjustment since February of 1985 has improved our cost competitiveness with respect to foreign producers.

The macro numbers are also improving. For the last two quarters - the fourth quarter of last year and the first quarter of this year - trade improvement contributed 1.6% to our real GNP growth.

NPQ: What accounts for this productivity increase in manufacturing?

Sprinkel: Competitive pressures. It's not a painless process. In some cases it did mean job layoffs. Fortunately, the rest of the economy was expanding so we've had net increases since the recession of something over 13 million new jobs. High levels of investment are another factor. The proportion of real GNP devoted to business fixed investment reached a postwar high of 12.9% in 1985 with 1986 not far behind.

NPQ: We have been in expansion for about 56 months. Since the turn of the century, the average length of business expansion has been about 33 months. So we are 22 months overdue, by the average.

Sprinkel: To make it even more striking, this is the second largest peacetime expansion since we began counting in 1854; by October, it will be the longest.

NPQ: That's the good news. The bad news is that the business cycle inevitably turns. The longer the expansion continues, the more likely we are to be on the brink of a recession.

Sprinkel: No, no, no. Economic expansions don't die of old age, they die of inappropriate economic policies that make recessions inevitable. We can avoid a downturn and continue to expand if we continue to put heavy emphasis on deregulation, low marginal tax rates, and incentives to work, save and invest.

I don't want to argue that we'll never have another recession because we will, but hopefully not on our watch.

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