Board of Contributors: Preventing a 1986 Recession
There is a significant risk that Congress will enact legislation this year that will push the economy into recession in 1986. The recovery is approaching its third anniversary and the 33-month average duration of all recoveries. And the statistical evidence leaves no doubt that the recovery has lost the vigor that characterized its first two years. Whether the economy will continue to expand or will slide into recession will depend on what Congress does about tax reform and deficit reduction.</br></br>The easiest way for Congress to push the economy into recession next year would be to accept the administration's proposal to eliminate the investment tax credit on Jan. 1, 1986. Experience shows that the ITC provides a substantial boost to investment in business equipment. Eliminating the ITC would not only reduce the long-term level of investment spending but would have a particularly adverse effect on investment in 1986.</br></br>If it looks as if the ITC is going to be eliminated next January, companies will bring forward to this year as much of their planned 1986 investment as possible in order to take advantage of the ITC while it is still available. When 1986 comes, investment would fall off very sharply, causing a decline in overall demand that could push the economy into recession.</br></br>We will be particularly vulnerable in 1986 to such an adverse shock because, in addition to the natural weakness of a maturing recovery, the economy will be slowed next year by the short-term effects of deficit reduction. Although reducing the deficit will eventually make the economy stronger and healthier, the immediate effect of a cut in government spending will be to reduce demand. The government will spend less on a variety of goods and services, and recipients of transfer payments will have less to spend on consumer goods. The reduction in demand will mean less production and therefore less employment.</br></br>Of course, the reduced deficit will also cause lower interest rates and a more competitive dollar and that in turn will increase investment and net exports. But experience shows that the response of investment and net exports to interest rates and the dollar occurs only with a lag of 12 to 18 months. The 1986 impact of the deficit-reduction legislation is therefore likely to be contractionary.