The University Record, March 11, 2002

Gramlich focuses on easing recession

By Martin May

Recessions can be dealt with, for the most part, by applying the existing system of fiscal and monetary shock absorbers, says Federal Reserve Board governor, and professor of economics and of public policy Edward M. Gramlich. Gramlich, who is on leave from the University, was the lead speaker at the March 7 program “Policies to Escape Recession: What Should We Do?” sponsored by the Gerald R. Ford School of Public Policy.

“Recession was an appropriate topic of discussion during the Ford administration, and certainly it is today,” said Public Policy Dean Rebecca Blank as she introduced Gramlich.

Acknowledging that there is debate as to the current state of the economy, and as to whether the recession is ending, Gramlich said he would focus his talk on the general strategy of combating recession rather than discuss specific actions or pieces of legislation.

“In a recession, it is natural for the [federal] budget to move into a deficit, but that’s fine—nothing wrong with that,” Gramlich said. He said budget deficits act as a fiscal bulwark against economic shocks, such as unemployment, when deficits are a result of either increased government spending, tax decreases or both. While deficits are excusable in a recession, Gramlich continued, they are not desirable in general. “They shouldn’t be there in average, and the target should be zero over the long run,” he said.

While these fiscal actions help to stabilize the economy, the main burden of fighting recessions falls on the central bank, in this case the Federal Reserve, Gramlich maintains. “The central bank uses open markets operations to raise the short-term rate above this equilibrium in response to threats of inflation, and to lower the rate below equilibrium in response to threats of unemployment,” Gramlich said.

Turning his attention to tax policy, Gramlich said that in order for tax cuts to be effective in curtailing and ending a recession, they must stimulate spending, be instituted quickly and be reversed quickly and automatically when no longer needed. Tax cuts should be curtailed quickly when economic expansion returns in order to keep inflationary forces at bay, he said.

“Consumers spend relatively little out of one-shot increases in their income,” Gramlich said in referring to temporary tax cuts. “In such cases, moving up rate cuts might have a stronger perceived effect on permanent income and consumption.”

Moved-up cuts also would satisfy the requirement that they can be reversed quickly and automatically.

Gramlich pointed out that while the Federal Reserve is always keeping an eye out for inflation and has had to deal with strong inflation in the past, such as in the 1970s, the downside must be guarded against as well. “We don’t want deflation to get loose,” he said. A deflationary environment like Japan’s—where interest rates are practically zero and a recession has taken hold—is a situation that has to be guarded against early on, he said.

Paul McCracken, the Edmund Erza Day Distinguished University Professor Emeritus of Business Administration, Economics and Public Policy, also spoke at the event.

“I think monetary policy during the 1990s was executed extremely well,” McCracken said. He said the Federal Reserve did the right thing in quickly lowering rates early in 2001. “I do find a good rule for fiscal policy is ‘keep it simple,’” he said. “The economy generally tends toward stability unless the Congress or White House meddle with it too much.”

Michael Moscow, president of the Federal Reserve Bank of Chicago and a member of the Federal Open Market Committee—the Federal Reserve’s monetary policy committee—was the last speaker. Moscow believes the current recession is likely to be more shallow than the 1974–75 recession.

“The federal funds futures market has built in Fed rate increases,” Moscow said, alluding to the market’s expectation for an economic recovery. Moscow also said that productivity has remained unusually high during this recession.

In closing, Gramlich said that U.S. capital and labor markets function well, which is a positive factor in economic recovery.