Slashing Interest Rates May Not Cure Current U.S. Economic Downturn
Commentary by Michael Lehmann, Professor of Economics
The Federal Reserve’s recent interest rate reduction disappointed many who had hoped that a larger cut would jump-start the stock market and the economy.
But their confidence in the Fed’s abilities may be misplaced. In the 1970s and 1980s, when the economy followed the consumer’s lead, the Fed could start and stop the business cycle at will. Lower interest rates encouraged consumer borrowing and spending, while higher rates choked them off. So confidence in the Fed’s abilities grew with time.
Unfortunately, business capital expenditures rather than consumer demand drove the 1990s boom. High-tech investment in computer and communications hardware and software led the economy and the stock market higher. Consumer expenditures followed; they did not lead. Now the boom is drawing to a close because a decade of soaring enthusiasm pushed too much business investment into too many endeavors. The economy cannot at the moment justify all of its new infrastructure. Earnings will shrink and some firms will take losses. As business retrenches by curtailing its expenditures, the stock market swoons and consumers cut back, as well.
The recent expansion, with its investment in computer, internet, and telecommunications infrastructure, is reminiscent of the railroad booms of the 19th century. Railroads built on the expectation of future settlement. Sometimes, as in the 1870s and 1890s, a decade of depressed economic conditions followed overbuilding and railroad-construction cutbacks. Eventually settlement caught up with the tracks and a new expansionary cycle began. Only time could absorb the excess capacity and rekindle economic growth.
Today, the global economy is awash in excess capacity. There are too many automobile factories, too many chip plants, too many malls, and too much retail space. This excess stems from the technology boom of the 1990s that boosted incomes and asset values and thereby spurred investment in secondary and tertiary activities. Now that high tech is leading the economy into recession, the worldwide economic redundancy in these secondary and tertiary activities will become manifest, too.
If a severe global economic downturn is in the offing, it is not reasonable to expect that the Fed can prevent it or swiftly reverse it. High interest rates did not create the problem, nor will reducing interest rates cure it. Only time can absorb the excess capacity. Like the volcanologist who sees the volcano erupt in human time but must contemplate its significance in geological time, we observe the unfolding recession as a current event but may require a decade to place it in historical context.
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