Struggling to recover.

Struggling to RECOVER

The struggle to recover from the 1990-91 recession has been a troubling experience for the U.S. economy and for American citizens. Recoveries from earlier postwar recessions were generally joyous events - with job opportunities, living standards and confidence all

These characteristics have been sorely lacking in the recovery that got underway last spring. For a time, activity in the industrial sector appeared to be moving up briskly, increasing at an annual rate of 9 percent from March through July. Then, the rise in industrial output abruptly came to a halt. Although employment in the private sector rose through the second and third quarters of last year, the improvement in jobs fell far behind the standard for postwar recoveries. Gains in consumer incomes were, therefore, of paltry proportions, limiting the rise of consumer spending.

Activity in housing responded last year to lower mortgage interest rates but did not achieve the robust gains characteristics of earlier postwar recoveries. By year-end, there was still no sign of a self-sustaining momentum of expansion. Indeed, with consumer and business confidence faltering, concerns have developed that the U.S. economy in 1992 might experience yet another recession.

Expectations a year ago were realistic enough. Recovery from the 1990-1991 recession was expected to be of moderate dimensions, and the Mortgage Bankers Association of America (MBA) economics department forecast was actually at the low end of the consensus. Failure to realize even these modest expectations has given rise to sober questions: What is wrong with the U.S. economy? What can be done to improve the economic outlook in the near term and over a longer time horizon? Is there any way out of the existing morass?

I approach questions of this kind optimistically, because I am impressed with the strength and resiliency of the U.S. economy and its ability to cope with difficult problems. Think back over the past generation and the obstacles the U.S. economy has surmounted: the highly inflationary method of financing the Vietnam War; two major oil-price shocks during the 1970s; a collapse of world oil prices in 1986; mandatory wage and price controls from 1971 through early 1974; the shock therapy adopted by the Federal Reserve (Fed) in late 1979 to break the fever of virulent inflation and the explosive rise of the federal deficit in the early 1980s. If the economy can shrug off these problems and continue to prosper, as it has, then it can deal successfully with the economic aches and pains currently plaguing us. What is required is a judicious choice of remedial economic medicine.

Choosing the right medicine requires a correct diagnosis of the disease - not an easy task, but not, I think, impossible. Let's look back, first, at the economy's performance during the past several years.

Growth slowdown

Long before the recent recession began in the summer of 1990, the economy's growth had slowed dramatically. From increases of 4.5 percent in real gross domestic product (GDP) over the four quarters of 1987 and 3.3 percent during 1988, economic growth slowed to 1.7 percent during the six quarters ended in mid-1990. This slow-down partly reflected the Fed's efforts to reduce inflation, which pushed up interest rates in 1987, 1988 and early 1989. The more fundamental reason, however, was the existence of structural problems that were, and still are, sapping the economy's strength.

Mortgage bankers have felt the brunt of some of these problems directly - for example, the effects of changing demographics that have weakened the demand for single-family housing, the high vacancy rates in apartment buildings, the "credit crunch" and the collapse of prices and activity in the commercial property field. Other problems, such as the increasing burden of consumer debt during the boom years of the 1980s, the overleveraging of business enterprises and the worsening fiscal problems of state and local governments have eaten away the private economy's foundations for growth. Federal fiscal policy, moreover, is in a straightjacket. At a time like this, fiscal help from the federal government in the form of tax cuts could be of short-term benefit, but increasing still further an already bloated federal deficit would have damaging long-run effects on the economy.

Which of these factors is playing the largest role in stifling the economy's efforts to recover is a matter of judgment. My own view is that a combination of several of them has led to a logjam in the markets for private credit.

Evidence of that logjam can be seen in Chart 1 showing the growth of private debt. This is a financial variable that displays substantial cyclical variations - rising during economic expansions and falling in recessions. It is hardly surprising, therefore, that growth of private debt slowed during the recession of 1990-1991. What was not expected was that private credit expansion would continue to diminish after the economy turned up again in the spring of last year, bringing the rate of growth of private debt down to the lowest level in 40 years. The 2 to 3 percent annual rate of growth of private debt in evidence recently is simply not enough to finance a 2 to 3 percent growth of real GDP along with a 3 to 4 percent rise in GDP prices.

Credit crunch

Changes in federal bank and thrift examination policies got the credit crunch underway around the middle of 1989. Once in motion, the credit crunch developed a life of its own. All around the country, lenders and borrowers alike have altered drastically their attitudes toward borrowing and lending, turning back the clock to the standards of prudence and conservatism that prevailed a generation ago. Major institutional lenders are seeking to rectify the problems they created for themselves by two decades of shoving credit down the throats of borrowers. Borrowers, in turn, are struggling to emerge from the mountain of debt piled up during the inflation of the 1980s and the financial heyday of the 1980s. Our financial chickens are coming home to roost, and the flock is not all back yet.

If my diagnosis of the problem is correct, the new attitudes now prevailing among lenders and borrowers are likely to persist for a considerable period, for it will take a least several years, and perhaps much longer, to achieve significant improvements in borrowers' and lenders' balance sheets. However, that does not mean that we are condemned to several more years of subpar growth. What is needed are further steps to lower interest rates, led by aggressively easier monetary policies pursued by the Fed. The Fed has to deal with the credit logjam in the same way that the auto industry deals with an excess supply of autos in dealer showrooms - that is, by cutting prices dramatically.

Interest rates

Real interest rates on long-term Treasury securities are still roughly 4 percent - lower than in the 1980s, but well above their average levels in the 1960s and 1970s (see Chart 2). In the mortgage market, real interest rates have actually risen fairly sharply in the past four or five years because of declining homeprice appreciation. Effective interest rates on fixed-rate mortgages at 9 percent are not great bargain, and at those rates many middle-income families can't afford a home. At effective rates of 8 percent on fixed-rate mortgages, the pool of families that could afford a home would be larger, and at 7 percent, larger still.

Lower interest rates would also help to produce a stronger economy in ways that don't directly involve attitudes of lenders and borrowers. For example, lower rates would reduce the value of the dollar and increase exports, while raising stock prices and, thereby, increasing consumer wealth and confidence.

To obtain these results, the Fed will need to continue moving towards ease until signs are visible of an improvement in economic activity. How much lower interest rates will have to go to break the credit logjam is difficult to judge, because we are passing through economic and financial territory that is largely uncharted. I would not be at all surprised, however, to see the 30-year Treasury bond yield fall to around 7 percent before mid-year, and perhaps even below that level.

Economic recovery

Based on these expectations for Fed policy and interest rates, I expect the economy to pull out of the doldrums in the second half of this year, with the credit-sensitive sectors of the economy, especially housing, leading the way. The second half will not be a barn burner, but we should see a 3 percent or somewhat higher real GDP growth rate by the fourth quarter, and enough momentum to the recovery to keep the growth process alive during 1993.

For the longer run, as I am sure we all recognize, regaining the dynamism necessary to compete successfully in the world economy and achieving solid increases in living standards for all Americans will require more fundamental changes in economic policies - particularly tax and expenditure policies. The U.S. needs to invest much more in physical capital, in the public sector as well as the private sector, and to invest more in human capital as well. The principal means to such ends are well known: balancing the federal budget, changing the tax system in ways that encourage saving and discourage consumption, avoiding inflation and directing financial and real resources to more productive uses. We in the mortgage banking industry have much to gain by staying in the vanguard of efforts to foster more sensible economic policies and to restore fully the health of our economy.

PHOTO : CHART 1 Increase in Private Debt

PHOTO : CHART 2 Real Interest Rates on Treasuries

Lyle E. Gramley is senior staff vice president and chief economist for the Mortgage Bankers Association of America in Washington, D.C. He was a governor of the Federal Reserve Board from 1980 to 1985.