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Wednesday, 14 March, 2001, 15:13 GMT
Can Bush avert recession?
Mr Greenspan and Mr Bush need to be working together
Mr Greenspan and Mr Bush need to be working together
By BBC News Online's Steve Schifferes

The Bush administration is facing its first major economic challenge earlier than expected.

The US economy is undergoing a sharp slowdown which some fear could lead to a full-blown recession.

Lawrence Lindsey: Leading advocate of tax cuts
Lawrence Lindsey: Leading advocate of tax cuts
To fight the downturn, the US central bank, the Federal Reserve, has already cut interest rates twice - down from 6.5% to 5.5%. The Fed is expected to cut rates further at its next meeting in March.

To boost the economy even further, Mr Bush is now pushing strongly for a $1,600bn tax cut to help revive the economy.

That has been passed by the House of Representatives in the US Congress, but faces a tough test in the Senate, which is split 50-50 between Republicans and Democrats.

However, in order to pay for the tax cut, Mr Bush has ordered a severe squeeze on spending programmes - which Congress is less happy about.

How deep a recession?

The depth of a possible US recession became a political issue even before Mr Bush took office.

Earlier comments by Bush officials, which suggested that the US economy was already in recession, were disputed by the out-going Clinton administration whose final economic report painted a glowing picture of the longest boom in US history.

Paul O'Neill: a fiscal conservative
Paul O'Neill: A fiscal conservative
But despite the in-fighting about who to blame, there is no doubt about the pace of the US slowdown. In the summer, the economy was growing at a rate of more than 5% annually.

But in the final three months of 2000, the growth rate shrivelled to a mere 1.4% - its slowest rate for five and a half years.

The confidence of US consumers is collapsing. Retail sales during the crucial Christmas selling season have shown virtually no growth, and have continued to be weak ever since - with sales of automobiles particularly hard hit.

After eight years of uninterrupted economic growth, much of it at a rapid pace, it is not surprising that the US economy is slowing down.

But economists differ on how long the slowdown will last, and how deep it will be.

International organisations, like the International Monetary Fund and the Organisation for Economic Co-operation and Development, are forecasting a relatively shallow recession, with the economy picking up again in the second half of the year - giving an overall growth rate of about 2.5%.

Some US economists, and some private forecasters, believe the slowdown could be more severe, with an annual growth rate of between 1% to 2% continuing into the second half of the year and beyond.

This would have much more severe consequences for growth in the rest of the world.

Pessimists are especially worried by debt, with heavy borrowing by companies and individuals and with little savings to cope with any hard times ahead.

And with most Americans owning stocks, the fall in major stock indices during the past months has meant that they can no longer rely on the gains from the booming stock market to repay their debts.

Fed takes pre-emptive action

It was worries about credit problems, which have already made it more expensive for companies to borrow money, and slowing business confidence, that led the Fed to make its two interest rate cuts in January.

It was also significant that the Fed's first action came action during a meeting that President-elect Bush was holding with business leaders to consider economic policy.

Some interpreted that move as a warning shot to the new administration that the Fed wants to take the lead role in averting the recession.

Most economists believe that interest rate cuts work more quickly than tax cuts in reviving economic growth, as they are instantly transmitted through financial markets.

But the Fed is constrained by several factors.

Firstly, higher oil prices could lead to inflationary pressures on the US economy.

Secondly, a dramatic weakening of the dollar, due to the US slowdown, could also push up the prices of imported goods, unless the Fed keeps rates up to defend the currency.

Would tax cuts help?

The Federal Reserve's chairman, Alan Greenspan, has given the tax cuts his guarded approval.

However, a close reading of his comments appears to suggest, that he prefers tax cuts to come in only once government debt has been slashed.

Another problem with the Bush 10-year, $1,600bn tax cut plan is that most of the benefits do not occur in the first few years, when the recession might bite.

The original plan would only reduce taxes by $21bn in the first year, and $57bn in the second year.

And 60% of those tax cuts would go to people who earn more than $100,000 a year, who might be more reluctant to spend their tax refunds and boost the economy.

Allen Sinai of Primark Decision Economics estimates that it would only boost economic growth by 0.1% annually, "a minuscule tax cut".

Even so, it might take some time for the new administration to negotiate a deal with Congress, which although Republican-controlled is nearly evenly split between the two parties.

Many Republican leaders, and some Democrats, want to consider an accelerated tax cut that would be retroactive to 1 January.

But agreement might still be difficult to reach, except on some bipartisan issues like abolishing the married couples penalty, without addressing the issue of who benefits most.

And other Democrats would like to debate the Bush budget plans before agreeing to any tax cuts.

Conflicts among advisers

The Bush administration may also face an internal debate about how far, and how fast, to pursue tax reform.

Mr Bush's chief economic adviser, Lawrence Lindsey, is a strong advocate of the tax cut which he helped design, and clashed with Mr Greenspan over the issue during the campaign.

Mr Lindsey is also believed to want to go further, endorsing business calls for further cuts in capital gains taxes to stimulate investment - a stance backed by many Republican Congressmen.

However, Treasury Secretary Paul O'Neill is a strong advocate of a balanced budget, which he fought for in previous Republican administrations.

Although he has publicly backed Mr Bush's plans, he is likely to want to avoid any major conflict with Mr Greenspan, his old colleague.

The huge budget surplus gives both sides more room for argument than in the 1970s and 1980s, when there was a growing budget deficit.

But the Bush administration will want to avoid the conflict with the Fed that hurt his father's re-election campaign, when the Fed raised interest rates over worries about a spiralling budget deficit and higher inflation.

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