Commentary: Why A Second Half Slump Could Still Kick In

The U.S. economy is teetering precariously on the edge of a sharp divide. On one side, all the ingredients are in place for a truly nasty recession as a slumping technology sector, a slowing economy, and a falling stock market feed off one another. On the other, Federal Reserve Chairman Alan Greenspan, with his bold move to cut interest rates, is clearly willing to act aggressively to prevent an economic unraveling.

Which of these two forces are likely to prevail? In the wake of the rate cut, many investors and economists assumed that Greenspan had taken care of the impending downturn. Sure, growth in the first half of 2001 would be weak because easier money works with a lag. But the conventional wisdom holds that the second half would be much better.

FALSE HOPE? That assumption, though, may be just a little too easy. Lower rates may bump up housing and auto sales, but such Old Economy industries will not be enough to revive growth. Instead, the prospects for the second half depend on such New Economy factors as the behavior of venture capitalists, the size of technology-driven job cuts, and the willingness of companies to keep investing. Those are the forces determining whether the economy will recover or swoon further.

A sharp pullback by venture capital investors later this year, for example, could help trigger a deeper slump. Up to now, venture-capital cash has kept flowing at high levels, despite the dot-com collapse. Third-quarter VC outlays ran at a $104 billion annual rate, according to the National Venture Capital Assn., just under their early 2000 peak. And the money keeps coming. On Jan. 8 Calient Networks Inc., a developer of optical high-speed switches, announced that it had received $195 million in new equity funding from a group of venture-capital firms and communications equipment makers.

Still, it's too soon to celebrate. It takes about a year or so for venture outlays to react to a stock market downturn. Starting in late spring and summer, venture capitalists will come under increasing pressure to sharply limit the money they invest, especially if the stock market is still sluggish. Such cutbacks would remove one of the major supports for the all-important tech sector. In addition, a venture pullback would dramatically weaken the still-tight labor market for IT workers.

Indeed, the unemployment rate in the second half could be driven up further if businesses become more aggressive in using cost-saving information technology to replace workers. That would be far different than during the boom, when growth was so strong that many companies could boost productivity without cutting back on jobs. Now, as the economy slows, companies will face much tougher decisions. Investments in new technology can cut costs, but most of the savings will have to come from labor, which accounts for the biggest chunk of most corporate budgets. In other words, without the growth to absorb gains from higher productivity, something has to give, and that something will likely be jobs. So if the economy stays weak, companies may make deep job cuts--and that could hobble consumer spending.

Next, business investment could slide further in the second half than expected. A hallmark of the New Economy has been soaring capital spending, which rose from an average of about 8% of gross domestic product in the 1980s, to a stunning 11% in the third quarter of 2000.

If the slowdown is relatively mild, most businesses will try to keep up these very high rates of spending. But a lengthy downturn will make it much harder to justify laying out money now for an investment that may not pay off for years, even with lower interest rates. Especially hard hit will be telecommunications companies, which are investing enormous sums with uncertain returns. The result could be a downturn in capital spending that will drag down productivity and growth.

Greenspan has acted with remarkable speed. But no one has ever seen a tech-driven downturn like this one before. The danger of a second-half slump remains very real.

Before it's here, it's on the Bloomberg Terminal.