Downturn With a Difference

The present recession, compounded by the war on terrorism, could fundamentally transform the economy.
December 2001
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

After the calamities of September 11, speculation about whether we were having a recession ceased. The great parade of economic growth-- unbroken since 1991--and fiscally prosperous times clearly halted. The questions now are how deep the recession will be and how long it will run. For many in business and government, coping with declining revenues, layoffs and deficits will be a first-time experience. To compound the complexities, the nation is engaged in a war on terrorism. With each new threat, we are reminded that a new era is at hand, one in which government at all levels has bigger, more intrusive and more expansive roles to play in everyday life. We are already seeing an unavoidable aggrandizing of government as our shield and saber in an unsafe world, a development that distinguishes the current recession from most of the earlier ones.

There are some precedents for today's situation, the most apt precursor being the slowed economy of the early 1970s. It too had seeds sown in the Middle East. In 1973, in reaction to the Yom Kippur war, the OPEC states embargoed oil shipments to the United States. Energy prices skyrocketed. The U.S. undertook a massive energy- conservation program and adopted controls over energy prices. Unlike today, however, the U.S. at that time suffered from severe inflation and high interest rates. The downturn lasted six quarters--from the end of 1973 until the first quarter of 1975. Unemployment shot from 5 percent to about 9 percent, and the number of persons working shrank by 2 million. State and local governments took a beating, running operating deficits for five consecutive quarters. In today's dollars, their deficits ballooned to about $15 billion a year--that's about what states alone are predicting for this fiscal year. New York City, which was then "ground zero" in terms of massive loss of jobs, tried to weather the fiscal storm by piling up short-term debt. That strategy led to default in 1975 when the market lost confidence in the city's finances.

It was a different time in respect to the federal response. The federal government had just instituted general revenue-sharing and was expanding federal aid programs, a phenomenon that softened the fiscal sting. Federal aid was used to keep state and local spending up. By and large, it worked. But a public that saw real incomes plunge amid persistent inflation lost confidence in government generally. Popular discontent fueled the great "tax revolt" of the late '70s and set the stage for the Reagan Revolution.

With lessons from the '70s in mind, will the present recession, plus the war on terrorism, fundamentally transform the economy? We already know that the new "growth" sector will be security. Unfortunately, however, security spending will do little to increase productivity. After all, spending on security means producing the same item at a higher cost. These new costs will be akin to the 1970s spending on cleaning up pollution, spending that had aesthetic and health benefits but did not contribute to more consumer goods and services in the market economy. That was a big part of slow growth in the 1970s. And today, in a society under attack, politicians know, even in the face of declining revenues, that protection of persons and property is paramount. Maybe we were more efficient a few months ago, but it was a fool's paradise--like hiking in the mountains without a jacket.

So, what is the outlook? First, the federal government will spend more money. The first round of federal response to the war on terrorism was $40 billion and an economic stimulus package of more than $100 billion. To the extent that the package includes tax reductions, states are nervous. The increasing integration of state and federal income tax definitions means that federal tax reductions cause reductions in state taxes unless legislators raise rates. On the other side of the ledger, mayors and governors are lined up after airlines and insurers to beseech Washington for a billion or so in aid to offset heightened security and public health costs.

At the state level, new thinking and old collide. Some states may embrace counter-cyclical spending. Florida's Governor Jeb Bush, for one, espouses $1 billion in capital spending in the teeth of a $1 billion-plus deficit. But most states are hunkering down, limiting their deficits by spending reserves and making budget cuts early in the fiscal year. As the recession drags into next spring, quick spending fixes will be exhausted and, with growing service demands, the revenue bullet will have to be bitten.

The beneficial side of this stress could be a push to reform (rather than raise) taxes. Sales-tax simplification and base-broadening are way overdue. Corporate and personal income taxes, which have been subject to willy-nilly breaks and cuts, need fixing in many states. Removing exemptions and distortions may become a patriotic act to ensure a sharing of the burdens of governments that are being called on to do more.