Posted: January 29,
We thank Greenspan for his blunt comment last week that the U.S. economy is likely experiencing "near zero growth." Now no respectable economist will insult your intelligence with the claim that the U.S. economy is either not in recession or is not destined to experience one. Starting this week, everyone's on the iTulip.com bus that left in April 2000 when we found our economic coal mine canary resting on the bottom of his cage, knocked out by a blast of toxic financial market gas emitted by the collapsing NASDAQ bubble. As we have discussed for the past two years, the question is not if and not even when we'll have a recession -- we predicted in April 2000 that Q4 2000 was the recession's starting point -- but what kind of recession are we going to have. Long or short? Severe or mild? A gentle glide into contraction or a sudden implosion? Lots of unemployment or only a modest increase? Deflation or inflation? Will the dollar hold up or not? Will long term interest rates rise or fall? Will monetary stimulus end the recession quickly or will it drag on for years as in Japan? Will tax cuts help? Will rate cuts help?
Not a Typical Postwar Recession
Before we adress these questions, let's consider the context. Not since the 1920s has the U.S. headed into recession following an extended period of financial and credit market excess as occurred between 1996 and 2000. To expect the kind of sharp yet brief recession such as those the U.S. has enjoyed since W.W.II is an excercise in extreme wishful thinking. The recession that is the outgrowth of a financial and economic bubble is more likely to approximate the U.S. 1930s experience except that the preconditions are so different as to guarantee a very different kind of economic event. In comparing the preconditions of the 1930s depression with today, we show advantages in black, disadvantages in red.
|U.S. a net foreign creditor||U.S. a net foreign debtor||
|Narrow stock market participation||Broad stock market participation||
|Current account surplus||Current account deficit||A negative balance of payments increases dependency on foreign investment to finance the deficit|
|Outstanding public debt 16% of GDP||Outstanding public debt 60% of GDP||A nation that heads into recession with a large public debt cannot run a fiscal deficit to stimulate the economy without risking higher long term interest rates|
|High household savings||Low household savings||
|Old Economy inefficiency||New Economy efficiency||
|Strong corporate balance sheets||Weak corporate balance sheets||Corporate debt as a proportion of assets has never been higher|
|No derivatives exposure||Derivatives exposure||"Derivatives markets guarantee a winner for every loser, but they will over time concentrate the losses in vulnerable sectors... the predictable likely gains will one day be overwhelmed by an equally predictable disastrous loss."|
|Poor distribution of wealth||Poor distribution of wealth||Diminishes effectiveness of government efforts to stimulate demand as a minority of wealth holders cannot through their purchasing create sufficient demand to create enough employment for the majority to affect recovery (See New Deal)|
|High consumer debt||High consumer debt||
|Ineffective monetary policy tools||Ineffective monetary policy tools||In the year following the October 1929 crash, the Fed dropped the discount rate from 5% to 2% by December 1930 yet the economy continued to contract rapidly anyway - unemployment rose from under 5% in early 1930 to 16% by the end of 1931|
|Weak banking system||Weak banking system||The U.S. banking system was at risk in the 1930s due to margin debt. In 2001, an equivalent if not more ominous risks arise from leveraged corporations and consumers and systemic risks posed by derivatives|
|Low income tax rate||High income tax rate||
|Poorly diversified economy||Well diversified economy||
|Low unemployment||Low unemployment||
|Fiscal surplus||Fiscal surplus||
If we compare the preconditions of our current recession to the preconditions of the depression of the 1930s we find we have two advantages that we did not have then, a high tax rate and a well diversified economy. A high tax rate means a tax cut can free more income for purchasing. A well diversified economy can theoretically keep recession confined to certain areas of the econony, such as the farm economy for the past few years. The theory is that parts of the economy can shrink while others grow, with one area of the economy benefiting from another's distress. The aggregate of these contractions and expansions will be positive.
We share two advantages with our 1930s post-bubble world, a low unemployment rate and a fiscal surplus. These may prove to be common traits of similar economic bubbles. The high employment rate in the 1920s was largely due to extra demand produced by stock market wealth effect. Stock market capitalization in 1929 was 100% of GDP versus 200% of GDP at its peak in March 2000. It's fair to speculate that the reversal of the wealth effect may be more profound in the current case than in the 1930s. The fiscal surplus proved ephemeral as tax receipts due to stock market bubble capital gains fell suddenly after the bubble popped.
We share four disadvantages in our era that were not preconditions in 1930: poor distribution of wealth, high consumer debt, ineffective monetary tools and a weak banking system. Unfortunately, the preconditions of the current recession include seven unique disadvantages: net foreign debtor status, high public debt, a current account deficit, low household savings, New Economy information efficiency, weak corporate balance sheets and the unknown systemic risk posed by derivatives exposure. The last we list as a disadvantage although some will no doubt argue the opposite case. We tend to agree with Martin Mayer, who said, "Derivatives markets guarantee a winner for every loser, but they will over time concentrate the losses in vulnerable sectors. Nature obeys Mayer's Third Law, which holds that risk-shifting instruments will tend to shift risks onto those less able to bear them, because them as got want to keep and hedge while them as ainít got want to get and speculate. The logic behind margin requirements in stock markets and capital requirements in banking also holds in the derivatives markets. Permitting highly leveraged institutions to hold private parties behind closed doors is the political version of selling volatility: the predictable likely gains will one day be overwhelmed by an equally predictable disastrous loss." Will Someone Please Turn on the Lights?
Martin Mayer's opinion is one to take seriously. He is Former Columnist, American Banker; former Member, President's Panel on Educational Research and Development (Kennedy and Johnson administrations); former Member, President's Commission on Housing (1981-82); former Consultant, Twentieth Century Fund and Carnegie, Ford, Kettering, and Sloan Foundations. Derivatives markets represent some degree of systemic risk as they in aggregate shift risk from the strong to the weak, to those less able to pay from those more able to pay. We will not know how serious the systemic risk is until the potential crisis hits.
Worst Recession since the 1930s?
Given the serious disadvantages that the U.S. suffers as it heads into recession in 2000 versus 1930, the conclusion reached by The Levy Institute Forecast and Macroeocnomic Profits Analysis in its January 2001 report is not surprising: "Overall, the present situation involves the most formidable financial dangers since the 1930s." This is not an opinion to be taken lightly as the Levy Institute has been making economic forecasts since 1949 with a record The New York Times describes as, "one of the best records in the country for predicting turning points of the business cycle in the United States for the last 40 years."
Given the differences in preconditions, what is the likely outcome? Below we chart two possible outcomes. They are not mutually exclusive. In fact, the most likely case is that these outcomes represent two phases in a progression of events. Both cases assume that reflation efforts will be ineffective as a means of restarting growth in the U.S. economy, although these efforts will exacerbate a weakening of the dollar.
|Reflation Efforts are Ineffective: Deflationary Recession||Reflation Efforts are Ineffective: Inflationary Recession|
|Discount Rate||Less than 2%||Greater than 10%|
|Price Level||Deflation less than -2%||Inflation more than 10%|
|Duration||More than 2 years but less than 5||More than 2 years but less than 3|
How the Recession May Unfold
Consumer confidence has been falling rapidly for the past few months although confidence is still relatively high by historical standards. The bottom in consumer confidence can probably be identified when the personal saving rate regresses to the mean of around 8% from the current high rate of dissaving. This means we have a long way to go.
Two primary factors affect consumer confidence: wealth and income. Fear of future loss of wealth and income causes consumer confidence to fall. A look at 401K and mutual fund statements this month for the year 2000 cannot have improved consumer confidence for the current month. More importantly, as the U.S. consumer sees more and more media reports of major layoffs, consumer confidence will continue to decline rapidly. DaimlerChrysler reported 25,000 and Xerox of 4,000 job cuts today on the heals of announcements by Lucent of 16,000 and WorldCom laying off 10,000 last week. Falling consumer confidence will have an increasing negative impact on demand. With manufacturers closing plants to reduce over-capacity, a full fledged self reinforcing recessionary cycle is in place. Initially consumer credit will increase even while consumer goods consumption falls as households attempt to compensate for loss of income by borrowing. But as credit card and mortgage bills go unpaid, credit card and mortgage companies will pull in their horns. They will not be able to extend credit to the shrinking pool of credit-worthy borrowers. A debt trap is then in place. This will reduce the effectiveness of future interest rate cuts. This is the main risk posed by the household debt overhang.
As capital continues to contract and corporate profits fall, stock prices will continue to decline, further reducing household wealth and consumer confidence.
For these reasons, reflation efforts are likely to be ineffective initially at stimulating the economy. They may, however, effectively stimulate inflation. The reason is that the money supply may grow quickly ahead of GDP.
A unique characteristic of this recession not present in any previous recession is the high rate of change caused by the efficiency of information flow enabled by the Internet and other technologies adopted by corporate America and U.S. households over the past ten years. As pointed out in this week's Business Week
|That swiftness has several causes. Blame some of it on new technology, which gives managers better information faster. "Firms know exactly what their inventories and sales are moment by moment, so they'll act faster to lay off workers," says economist Marvin Kosters of the American Enterprise Institute. Outplacement expert John Challenger calls that practice "just-in-time employment." Wall Street gets some of the blame for demanding that bosses take quick action when earnings fall short (although, contrary to populist rhetoric, the average companyís stock price doesnít jump on layoff news). Blame another part on the publicís growing acceptance of job cuts as an everyday management tool. CEOs used to face scorn for cutting jobs; today many Americans own stock, watch CNBC and idolize CEOs even as they downsize. "The sense of vilification isnít there anymore," says Jeffrey Sonnenfeld of the Chief Executive Leadership Institute.|
The normal feedback loop of falling consumer confidence, falling demand, building inventories, and workforce reductions has been tightened. A cycle of information flow and decision making that took many months to complete in the 1930s and several months in the early 1990s will be condensed into days or even hours. The big difference between the 2000s depression and the 1930s depression will be the stunning rate of the collapse.
Short Term Predictions
- The U.S. economy will experience negative GDP growth for Q1 and Q2 with possibly some moderation in Q3 but no return to positive GDP growth until 2002 at the earliest
- Unemployment doubles from 4% to 8% by the end of 2001
- The discount rate will be reduced to under 4% by December 2001
- Evidence of a deepening recession by mid-2001 even as rates are cut will cause foreign investors to start to doubt the ability of the Fed to halt the economic contraction. At first foreign capital leaves the U.S. in search of better returns elsewhere. Later, as perception of default and currency devaluation risks rises, capital flows out of the U.S. in earnest
- The fiscal "surplus" of the past few years will turn out to be due primarily to capital gains tax receipts. As tax payers take capital gains losses against gains in 2001, tax receipts will fall by a greater extent than expected. Tax cuts, blessed by Greenspan last week and enacted to help the economy will create an enormous fiscal deficit for 2001. The bond market will price this in before the event, driving up interest rates in late 2001 and further stifling capital formation
- The first stage of the depression is deflationary, the second inflationary