Pity the new President, whoever he may be. Upon taking the oath of office in January, he is likely to immediately face a sharply declining economy that Wall Street fears just might slide into recession. Unless he is careful, a legacy of bitter partisanship from the election could pressure the President to take policy measures that are either too extreme or simply wrong for what could turn out to be the first big downturn of the New Economy. As Bob Woodward shows in his new book, Maestro: Alan Greenspan's Fed and the American Boom, it took an unusual deal on fiscal policy between President Clinton and Federal Reserve Chairman Alan Greenspan that actually went against core elements of the Democratic Party to lay the conditions for a decade of growth. The new President should be prepared to be just as flexible.
The unalloyed truth is that the forces of higher interest rates, higher energy prices, and a growing tech wreck are pulling down the growth rate from 6% toward 3%. The only question is how low it will go. The political uncertainty and limited mandate that will surround the next President threaten to contribute to the slowdown. One of Greenspan's favorite arcane leading indicators, the price of scrap steel, is already at a 14-year low. Economists at J.P. Morgan & Co. and elsewhere are already on a "hard landing" watch, giving recession a 30% to 40% chance of occurring next year.
It is the shape of the slowdown that represents the clear and present danger to economic policy of the new President. This downturn in the business cycle may turn out to be like no other. Capital investment for information technologies, not consumer spending, has been the driving force in the long expansion. Growing at 30% to 40% annually, IT outlays are now being scaled back, as the dot-com bubble bursts, telecom giants stagger, and high-tech companies forecast slowing earnings ahead. How far corporations will go in cutting back their high-tech investment is a key question.
The stock market will be a major influence on whether there is a soft or hard landing. With the Nasdaq already down about 40% from its highs of last spring, a big pullback could weaken the economy. The stock market plays a bigger role in the New Economy than in the Old--attracting capital from overseas and keeping the dollar strong, boosting consumer spending via the wealth effect, generating a federal budget surplus through capital-gains and income taxes, seeding startups and sparking innovation with initial public offerings, as well as financing corporate investments in information technologies. With more people owning stocks and margin debt at record highs, the economy is clearly more vulnerable today to a drop in the stock market than before.
Adding to this vulnerability is an increasingly fragile global economy. Without much fanfare, the world economy has hitched itself to the New Economy business cycle. Asia, in particular, rises and falls with tech.
The good news is that the budget surplus provides the new President with plenty of fiscal fodder to combat any serious economic downturn. But will politics blind the President--and Congress--to its proper use? In the runup to the election, both parties betrayed their promises to cap spending by blowing billions on pork. This stimulative fiscal policy worked at cross-purposes with Greenspan's efforts to slow the economy down. It made his job that much harder.
The new President will be tempted to fall back on campaign promises, be it massive tax cuts or enormous new spending programs. Either one will avoid paying down the debt and will extend far into the future. The correct policy is much more modest, short-term, and cyclically oriented. Indeed, in a New Economy downturn, new fiscal policy tools may be required that specifically focus on reinvigorating capital investment in information technologies. Greenspan, a serious student of productivity-driven economic growth, may already have ideas on dealing with a high-tech slowdown.
The bottom line is politicians cannot make fiscal policy in a vacuum. Consulting the Federal Reserve is as important in keeping the recovery moving as it was in getting it started.