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This Recession Wasn't So Mild

There are lots of ways to assess the severity of an economic downturn, including the increase in the unemployment rate or the drop in gross domestic product. By any of these conventional measures, the downturn of 2001 was moderate, at worst.

But a look at household net worth gives a completely different picture. The latest figures from the Federal Reserve flow-of-funds accounts, released on June 7, show that total household net worth, adjusted for inflation, fell by 12.3% from its peak in the first quarter of 2000 to its low point at the third quarter of 2001. That represents a total loss of wealth of more than $4 trillion, or roughly 40% of GDP, with rising debt and a declining stock market only being partly offset by higher housing prices. The only postwar downturn that hit household wealth as hard was the recession of 1973-75.

The decline in household wealth over the past two years pulls down BusinessWeek's index of household prosperity (first described in the Apr. 29 issue). This index is based on the idea that households care about both wage income and wealth, especially in an era when so many people own their own homes and have stock investments. The index is calculated using a weighted average of real wage income per worker and real net worth per household.

At its low, in the third quarter of 2001, the index of household prosperity was down by 2.8% vs. the year before (chart). By contrast, the index's worst year-over-year decline in the 1990-91 recession was only 2.1%. During the 1981-82 recession, the prosperity index dropped only by a meek 0.7%. That may help explain why President Ronald Reagan's political support stayed strong during the downturn.

Since the third quarter of 2001, both household net worth and the BusinessWeek prosperity index have inched up. Indeed, the prosperity index, through the end of the first quarter of 2002, stands about 1.7% higher than it was the year before, buoyed by a year of rising wages and a strong housing market.

But this gain in the prosperity index may not persist. The stock market has fallen sharply since the first quarter, and real wages seem to have stopped rising. Meanwhile, housing prices across much of the country appear to be levelling out, despite soaring values in a few areas. This combination could well leave many Americans feeling a lot poorer. One of the remarkable things about the 1990s was the way most companies relied on debt to fund their operations rather than taking advantage of high stock prices to raise money by issuing equity. Indeed, nonfinancial corporations bought back some $870 billion in equity from 1995 to 2001. That reflects stock buybacks and equity extinguished as part of mergers. Meanwhile, corporations added debt like crazy, borrowing $2.1 trillion over the same period. In effect, Corporate America was borrowing to finance its stock repurchases.

But the pendulum may finally be starting to swing back. In the first quarter, despite the drought in initial public offerings, net stock issuance by nonfinancial corporations was actually positive. Meanwhile, net borrowing fell off the cliff, to an average annual rate of less than $13 billion. That's compared with a rate of more than $200 billion in the fourth quarter. Companies were still issuing bonds, but they were cutting way back on short-term debt.

This is the first tangible sign of the de-leveraging of the corporate sector. How long might it go on? After the recession of 1990-91, the process of shifting from debt to equity went on for about two years before companies started borrowing at high levels again. It may take even longer to work off the excesses of the last decade. Should countries let their currency exchange rates float freely or peg them? Economists have debated the topic for decades. While leading thinkers such as Milton Friedman argued for floating rates, the data seemed to show that countries with floating rates had high inflation and sluggish growth.

But economists Carmen M. Reinhart and Kenneth S. Rogoff say those findings can't be trusted because they were based on faulty data from the International Monetary Fund. Reinhart and Rogoff both work for the IMF but did most of the analysis before joining the fund. Their study, published by the National Bureau of Economic Research, isn't an official IMF document.

Reinhart and Rogoff say that the IMF routinely misclassified countries' exchange-rate regimes, especially before 1997, mainly by relying on governments' often inaccurate self-classification. Many currencies that were described by the IMF as being pegged to another currency or currencies were actually floating, and vice versa, the economists say. Reinhart and Rogoff also say the IMF classification method was skewed by high inflation in some countries.

So the two devised their own classification system, drawing on monthly data from 153 countries going back to 1946. They reclassified countries among the four IMF categories and created a category for countries with high inflation and "freely falling" currencies.

Countries with freely floating currencies look much better under the reclassification. Their annual inflation rate from 1970 to 2001 was 9%, the lowest of any currency regime. Under the IMF classification, freely floating currencies had 174% inflation, the highest of any regime. Likewise, real GDP per capita for countries with floating currencies grew 2.3% a year from 1970 to 2001 under the Reinhart-Rogoff classification, vs. just 0.5% under the IMF's. The outcome may mean a lot more support for floating rates.

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