by Fred Moseley

Professor of Economics


In recent years, the US economy has been called the "Goldilocks economy" because it was rolling along "just right, not too hot and not too cold," with both unemployment and inflation at the lowest levels in 30 years, a booming stock market, etc. The US economy has been so strong that almost all economists have thought that the spreading global economic crisis would have only minor effects on the US economy and would not cause a US recession. However, in recent weeks that optimism has begun to erode. Unfortunately, it looks more and more like Goldilocks might be about to meet the big bad wolf.

So far, the US economy has actually mostly benefitted from the Asian crisis, mainly through cheaper imports (computers less than $1000, gasoline under $1.00 a gallon, etc.) and thus a lower overall rate of inflation. Interest rates have been lower than they otherwise would have been due to the inflow of foreign capital seeking a "safe haven" from the Asian crisis. However, the negative effects are starting to kick in and are likely to intensify in the months ahead.

The first negative effect of the global crisis on the US economy is through a reduction of US exports. The devaluation of the Asian currencies makes US goods more expensive and the depression in Asia further reduces their demand for our exports. Most economists so far have argued that this negative effect will be relatively minor, because less than 4% of US output is exported to Asia. Therefore, although US exports to Asia so far have declined by about 20%, the negative effect on the US GDP is less than 1%. However, if US exports to Asia continue to decline and this decline spreads to Latin America as well, then the negative effect on US economy would be greater. Plus there is also the negative effect of US consumers buying cheaper Asian imports instead of US goods.

A second negative effect of the global crisis on the US economy is that it has brought the US stock market boom to a halt. Now there seems to be a real possibility of a significant stock market decline in the months ahead. If a severe stock market decline were to occur, then consumer spending would also decline, especially the consumption of "high-income goods" such as houses, cars, computers, vacations, etc. This is called the "wealth effect" on consumption. During the recent stock market boom, the wealth effect seems to have been unusually strong. But now it has started to turn negative and may be equally strong in a downward direction.

A third negative effect of the Asian crisis is what economists call a "credit crunch" - a reduced willingness by banks and other creditors to loan money. Such a "credit crunch" appears to be developing in the US economy at the present time, as lenders have been increasingly spooked by events such as the Russian default and the near-bankruptcy of the Long Term Capital hedge fund (which had borrowed over $100 billion from the major banks in the US and around the world for speculative investments). Such a credit crunch would cause business investment to decline, along with exports and consumer spending. It seems increasingly likely that such a triple whammy will land the US economy in a recession in 1999. Such a US recession would in turn have devastating effects on the Asian economies, which are depending on a booming US market as their main hope for recovery.

The main hope to avoid such a dangerous US recession is expansionary monetary policy by the Federal Reserve Board. Expansionary monetary policy lowers interest rates which is supposed to lead to higher business investment. However, there are certain circumstances in which expansionary monetary is not very effective. One such circumstance is if the "credit crunch" is so severe that banks and other creditors are unwilling to increase their lending, even though the Fed increases the money supply. Another circumstance is the unwillingness of businesses to increase their investment in a weakening economy, even though more credit is available.

We can certainly hope that these extreme conditions are not present in the US economy today and that expansionary monetary policy will indeed be successful and will enable the US economy to avoid a recession (or at least avoid a serious one). But we cannot be sure. The next year or so seems to shaping up to be a very important test (before our very eyes) of the ability of expansionary monetary policy to avoid a serious economic downturn. Will the Fed be able to protect Goldilocks from the big bad wolf?

Stay tuned.