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Jewish World Review Jan. 8, 2001 / 13 Teves, 5761

Mort Zuckerman

Mort Zuckerman
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How the bottom fell out -- IS THE ECONOMY pausing or plummeting? Will the soft landing turn into a hard crash? These are the key questions facing America's policymakers and business community. Business executives, forecasters, Wall Street analysts, and even Federal Reserve officials are astounded at the speed and extent of the slowdown and the abrupt transition from euphoria to neurotic melancholy. Six weeks after a Wall Street Journal headline predicted "[The] Feast Will Go On," Fed Chairman Alan Greenspan tried to feed the shriveling economy with a half-point cut in interest rates.

The slowdown seemed all the more startling because the economy had experienced such a dizzying ascent: an acceleration of the rate of productivity growth; the fastest capital investment as a share of GDP; the greatest GDP increase over five years; the largest net growth in employment (over 55 million net new private-sector jobs since 1970); an unprecedented rise in national worth–over $22 trillion or 90 percent–since 1991; the greatest fiscal turnaround ever, from deficits equal to 6 percent of GDP to surpluses equal to 3.5 percent of GDP; and the highest rise in corporate profits. The only negatives had been the low rate of household savings and an exploding current-account deficit, requiring large capital inflows from abroad.

Downward spiral. Why did the economy hit the wall? The Internet bubble burst; energy prices soared, siphoning off close to 1 percent of GDP; earlier Fed rate increases began to squeeze; liquidity virtually disappeared from the highest-risk credit markets; bankers grew cautious, cutting back on syndicated loans; inventories began to pile up; the newly elected Republican leadership unwisely began to badmouth the economy; unrestrained optimism gave way to widespread pessimism; the decline of the stock market since March subtracted about $3 trillion in wealth, depressing consumer spending on Main Street by about $80 billion. Projections of profit growth nose-dived: One study predicted a drop from 16 percent to 5 percent in the fourth quarter and 14 percent to zero in the first quarter of 2001. Manufacturing is down to the lowest levels since the 1991 recession, while job growth has slowed dramatically as layoffs have increased. Most disturbing, technology firms that were thought to be most resistant to a cyclical downturn are tumbling fast. Technology profits, up in the third quarter by about 40 percent over the same period in 1999, are expected to rise at best 15 percent in the fourth quarter and are declining. The fall in tech-share prices may not yet be over because their price-earnings ratios are still well above market averages.

One of the most powerful recessionary forces remains below the radar screen of public awareness. It is that we are in the midst of a stealth credit crunch. Numerous bank consolidations have restricted bank financing and bank syndication, and the comptroller of the currency is intensifying pressure on loan quality. Many corporations borrowed too much during the boom and are going to have trouble paying back debts in slow times. Debt-to-equity ratios of nonfinancial corporations have risen from 70 percent to 80 percent since 1997. Overall, nonfinancial debt nearly doubled to $4.5 trillion, according to recent Moody studies, with information technology companies, especially telecoms, leading the way. Corporate America has been downgraded by the big credit agencies at a faster pace than at any time since the early '90s, so banks facing increasing loan losses have axed their lending. Only the very best companies can get any kind of credit, and many of them have become highly leveraged because they bought back large amounts of their shares, reducing their equity. With weakening demand, corporate profit margins are shrinking, reducing the cash flow to finance more capital expansion. The collapse of global equity markets has sharply curtailed that source of new money, as has the thinning of the massive capital inflows from foreign investors attracted by our vibrant financial markets and relatively higher economic growth.

It is the same story wherever you turn. The highest-risk credit markets–so-called junk bonds and leveraged loans–have virtually collapsed as investors pulled billions out of high-yield bond funds and dealers declined to make markets. The percentage of distressed high-yield bonds in the Merrill Lynch index has almost tripled since March alone, making high-yield issues virtually impossible to sell today.

The short-term effects of all this on growth have been stunning. As recently as the fourth quarter of 1999 the U.S. economy was expanding at an 8.3 percent annual rate. By the third quarter of this year the GDP growth rate had shrunk to 2.2 percent. Many economists believe that economic activity will decline even more in the fourth quarter and that we may face flat to negative growth in the first quarter and even into the second. This is a decline of over two thirds of the rate of growth and is a truly extraordinary deceleration and compression, about double that of the magnitude of the contractions at the end of the two previous long-cycle expansions in the United States, during the 1960s and the 1980s. The sudden shift from boom to sub par growth is like slowing from 70 mph to 20: It makes your head snap back. The economy now feels as if it is in recession, though it may not actually contract.

All of this happened at a sensitive time. Businesses were finalizing their 2001 budgets, and consumers were shopping for the holidays–with considerable restraint, according to available evidence. Now we face the risk of an economy falling into a cycle of lower confidence, falling investment, and lower spending.

The biggest barrier to the economy's revving up again turns out to be what had been its greatest strength, namely capital spending. During the 1990s, business investment in plant and equipment more than doubled, from slightly over $600 billion to approximately $1.4 trillion annually. Much of the increase went into information technology, which now makes up about 50 percent of capital investment. The share of U.S. GDP generated by capital spending increased to 20.6 percent from 17.1 percent at the beginning of the 1990s. By contrast, investment spending as a share of GDP actually fell in Japan, Germany, France, and the United Kingdom. The dramatic growth in information-processing investment spending by businesses accounted for about 30 percent of overall GDP growth, a truly unprecedented phenomenon as American companies put heavy bets on new technologies on the assumption they would cut costs, raise productivity, and enhance profits.

Great collapse. Now nonresidential fixed capital spending is rapidly slowing. It grew about 20 percent in real terms during the first quarter of 2000, slipped to 15 percent in the second quarter, slid again to about 8 percent in the third quarter, and may drop to as low as 3 percent in the fourth quarter and during the first part of 2001.

The problem is that this kind of investment spending doesn't just slow when financing disappears, excess capacity appears, profits decline, or business confidence plummets. It stops. Capital orders are eliminated, not reduced. That is why investment-led booms screech to a halt when investment spending collapses.

The failure of the financial markets and equity prices to continue their upward movement, and thus support continued capital investment growth, may well be compounded by the impact on American households. American families, watching their nominal wealth soar in stocks and houses, had come to rely on those asset gains, seeing the appreciations as savings, as "money in the bank." In the latter part of the 1990s, the real savings rate was dramatically reduced to the point that in 2000 Americans literally spent more than their after-tax incomes. Households were using borrowing to spend in excess of income, based on the increase in their home equity and the runaway stock markets of 1998 and 1999.

Without wealth creation, particularly after our high expectations, we may face a sharp drop in consumption, particularly if Main Street loses confidence and begins to save rather than spend disposable income. The result may be a double whammy with both capital investment and private consumption dropping simultaneously, raising the risk of a sharp recession.

We know from bitter experience that "little" recessions, like bad colds, can take hold and last longer than anyone imagined–and that they can reach a point where even monetary stimuli don't work. Just ask the Japanese: They have trouble finding borrowers even though their interest rates are near 0 percent.

So if Greenspan and the Fed had waited to act, they ran the risk that business confidence would have eroded to the point where even lower rates would not have stimulated investment spending. The accelerated rate of decline in business confidence could have developed an irresistible momentum.

In the short run, only the Fed possessed the potential to reverse the waxing business pessimism. The governors have worried, and rightly, about the possibility of an unnecessarily large tax cut being advanced by the Bush administration. If they do not act again, they must reckon with the political consequence that they will put more steam into the Bush tax cut plan.

The leaves may be falling. The snow may be falling. But the sky is not falling. The American economy still enjoys the most competitive technological and scientific base in the world. The unemployment rate remains very low (the rate announcement last Friday showed joblessness holding steady at 4 percent). Real incomes are still increasing, home values are still going up, and the business community and financial markets remain superbly efficient. But all these positive signs rest on the intangibles of consumer and business confidence. The Fed's swift and decisive intervention stanched the bleeding for now. But Greenspan & Co. will have to move again soon to keep the American economy on course.

JWR contributor Mort Zuckerman is editor-in-chief and publisher of U.S. News and World Report. Send your comments to him by clicking here.


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© 2000, Mortimer Zuckerman