Jewish World Review Sept. 4, 2002 / 27 Elul, 5762
http://www.NewsAndOpinion.com | The bear market that has drawn so much media hype may be seeping into the foundation of our economy in a way that could seriously hinder recovery. The enormous loss of wealth is bad enough, but tumbling stock prices are also perceived as a signal to batten down the hatches.
One consequence is a tightening of conditions for corporate credit. Banks are demanding higher-risk premiums despite the fall in yields on government paper. Rising finance costs have exacerbated the long-running contraction of investment. The decline had already been the worst since WWII, stretching to 21 months of consecutive drops. And the investment bust isn't over. Recently, the business spending index created by the authoritative consulting firm G7 Group showed fixed investment still contracting and unlikely to increase for a while.
It was the collapse of business spending that ended the boom, an unusual trigger for a recession. Typically, booms die when consumers, worried by rising interest rates, stop spending. High interest rates force consumers to scale back on big-ticket purchases like cars and homes, while businesses cut production and shed jobs. We came out of just such a recession a few years back by cutting interest rates and easing money.
Overstocked. This time, though, it wasn't the Federal Reserve that put on the squeeze. It happened after businesses woke up and realized that the investment boom of the '90s had raised capacity way beyond foreseeable demand. This was especially true in the tech sector. Inventories of computers, communications equipment, and semiconductors quadrupled between 1994 and 1998, and they doubled again between 1998 and 2000. With an excess capacity of both equipment and employees already in place, investment plunged and the economy started to freeze up.
As a result, corporate profits shrank about 20 percent from the last quarter of 2000 to the middle of 2001. As Stephen Roach of Morgan Stanley has pointed out, business capital spending for the first three quarters of 2001 declined by $88.2 billion in inflation-adjusted terms, more than accounting for the entire $57.2 billion decline in real gross domestic product during the same three-quarter interval.
The decline in information-technology spending alone exceeded the total decline in GDP. The investment bubble and bust was clearly the culprit. In fact, the sectors that usually push us into recession-consumer durables and residential construction-collectively boosted GDP growth, instead of depressing it. The 11 interest-rate cuts by the Fed last year put extra cash in consumers' hands by encouraging refinancing of home mortgages and enabling manufacturers of products like autos to slash rates.
But now we're faced with another conundrum. Conventional recession recovery comes after pent-up demand for cars that weren't bought and houses that weren't built is finally released. Today, there is no pent-up demand in these sectors-they are the ones that have been booming-and they have borrowed from the future.
The post-bubble recovery of the economy is thus far more fragile than might have been hoped. The dangers are twofold-either the economy will dip into recession again, or the levels of economic growth will remain well below potential annual output. That would mean a risk of deflation and increased unemployment, which would knock the pins out from under consumer spending, eliminating our last pillar of strength.
Clearly, as the Fed governors said at their last meeting, "The risks are weighted mainly toward positions that may generate economic weakness." This makes it all the more disturbing that the Fed opted to confine itself to mere words. Despite sharply lower growth in the second quarter and the summer stock-market meltdown, there was no rate cut. If a federal funds rate of 1.75 percent was considered appropriate last year, when we had higher stock indexes and didn't have the shock of corporate scandals undermining business confidence, can it possibly still make sense now?
The Fed's failure to do more is especially puzzling when you consider that we now confront a fiscal deficit of some $200 billion, limiting the option of big tax cuts. The White House is weighing further cuts to stimulate business. But such measures are unlikely to have enough effect on business investment to justify the long-term fiscal costs. A better approach would be for the Fed to support loan guarantees on a fifty-fifty basis, say, with state governments to make sure that local public works and other job-creation programs aren't cut back more.
The danger here is of a double-dip recession. We saw the same thing in
five of the past six downturns; if it doesn't happen this time, we could
see, instead, an extended period of subpar growth that will still feel like
a recession. The gloom, in other words, hasn't quite yet lifted, and
there's still just a bit too much whistling past the graveyard.
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