Feeling the Heat
Federal Reserve chairman Alan Greenspan has guided and presided over the longest economic expansion in the history of the U.S. He grasped the potential of the New Economy early on and let it thrive by keeping interest rates low. During his nearly 14 years as the world's most powerful central banker, the U.S. has suffered only one recession, a brief one in 1990-91. He may go down in history as the most successful Fed chairman since the bank's founding before World War I.
But now, the 75-year-old Greenspan faces an agonizing challenge: an abrupt economic slowdown that neither he nor anyone else fully understands. All of Greenspan's training and experience have taught him how to cope with conventional downturns. And so far, he's dealing with this one in the conventional manner--by cutting short-term interest rates in quick but measured steps. That may well prove to be the right course. But there's a risk that this downturn is different and that far steeper cuts in interest rates are needed to keep the New Economy from tumbling into a long and painful recession.
In short, Alan Greenspan is feeling the heat of a market in tatters and an economy that, by some measures, appears to be on the brink. And after riding triumphantly astride the economic boom times, his very legacy is suddenly at stake.
Right now, at least, that legacy is far from a sure thing. From the last quarter of 1999 to the last quarter of 2000, annual gross domestic product growth tumbled from a supercharged 8.3% to just 1.1%--the most rapid decline since World War II. In fairness, given the pumped-up state of the stock market and the technology sector at the height of the boom, an ugly ending may well have been inevitable. If Greenspan's by-the-book response to the slowdown works and a more healthy growth rate quickly resumes, his lofty reputation will regain its luster. But if he gets it wrong and the world's main engine of growth sinks toward a crisis and a Japanese-style "liquidity trap," much more than his legacy will suffer.
Investors, of course, are already hurting. And lately, they've been betting against their one-time hero. The stock market gagged after the Fed cut the federal funds rate on Mar. 20 by a half-percent, to 5%, short of the three-quarter point cut that many had been banking on. That day and in the following session, the Dow Jones industrial average fell 4.8%, the Standard & Poor's 500-stock index fell 4.2%, and the Nasdaq Composite Index fell 6.2%, leaving it down 64% from its year-ago peak and at its lowest level since November, 1998. The destruction of wealth since the stock market's peak a year ago reached a stunning $5.2 trillion.
It's easy to see what's spooking the markets. Economic growth, which has been averaging 4% annually since 1995, is likely to turn negative in the first quarter. Forecasts for corporate profits this year have been dropping like a stone as one CEO after another has announced that they have no "visibility" for the second half of the year. First Call says analysts are expecting operating earnings for Standard & Poor's 500 companies to rise just 2.2% this year, and that number is likely to drop as forecasts are updated. As recently as Jan. 1, analysts foresaw 9% growth this year. The tech sector, which led the economy upward, is leading it right back down, with such stars as Cisco Systems (CSCO ), Oracle (ORCL ), Intel (INTC ), and Compaq Computer (CPQ ) announcing job cuts. Meanwhile, the stock market's plunge is not only a symptom of the problems but a contributor: Poorer consumers are less likely to spend.
Perhaps the most unsettling aspect of the slowdown is the deep confusion about what lies ahead. An example: Solectron Corp. (SLR ) in Milpitas, Calif., manufactures electronics for companies such as Hewlett-Packard Co. (HWP ) and Sun Microsystems Inc. (SUNW ) Although its revenue rose 86% in the year ended Mar. 2, its fortunes have reversed. On Mar. 19, Solectron announced cuts of 8,200 jobs--10% of its workforce. What happened? Customers have been canceling orders like mad. Says Chief Financial Officer Susan S. Wang: "We are getting open admissions from a majority of our customers that they do not really understand the market dynamics. We have not seen such a situation ever before."
It's too much to blame Greenspan for all this mess. Still, some businesspeople complain that his Fed raised interest rates too much in 1999 and 2000 to choke off what it perceived as speculative growth, then waited too long to cut when the economy cooled. "That sent a signal to business leaders that they didn't really get it," says Ray Smith, a former GE Capital Services Inc. exec who is CEO of Ampent Inc., a San Francisco-based equipment-leasing broker. Even some of Greenspan's former colleagues are warning that the Fed may be a day late and a dollar short on rate cuts. After the latest cut, the real Fed funds rate--that is, the rate after adjusting for inflation--remains around its historical average and far above where it was as recently as 1998. "There's very considerable danger that they've fallen behind the curve," says Lyle E. Gramley, a former Fed governor who is a consultant to the Mortgage Bankers Assn.
Greenspan's problem these days is that he doesn't want to appear to be kowtowing to Wall Street by cutting rates more than he thinks the real economy requires. On the other hand, psychology matters. The message from the market--and many CEOs--seems to be that stronger moves may be needed, if only to restore the confidence of consumers, investors, and businesspeople that the Fed will do whatever is required to ensure that the high-growth, high-volatility New Economy won't sink as rapidly as it rose. "There is a self-fulfilling prophecy aspect to what's going on today," warns Motorola Inc. CEO Christopher B. Galvin.
Compounding his considerable headaches, Greenspan is getting precious little help from the White House in turning the economic tide. Many business leaders and economists say the Bush Administration may have eroded consumer confidence by badmouthing the economic outlook to win support for its long-term tax-cut plan. What's more, they say, the Bush plan would provide too little immediate fiscal stimulus. They're urging President George W. Bush to get a retroactive income tax cut through Congress as fast as possible, even if it means postponing cherished goals such as eliminating the so-called marriage penalty and the estate tax. "Tax cuts are urgent to replace wealth lost in the stock market decline," says Albert M. Wojnilower, a consultant at Monitor Clipper Partners, a New York private-equity firm.
As for monetary policy, the correct course of action very much depends on an open question. Is this, in fact, a garden-variety inventory correction, which is readily treatable, or a more dangerous New Economy slowdown marked by massive overcapacity that could take years to work off?
HOW IT WORKS. Let's start with the optimistic scenario, which Greenspan appears to lean toward. A classic inventory correction occurs when there's a shift in consumer demand from one sector of the economy to another, and it takes a while--usually less than a year--for supplier industries to catch up with the change. There's a lull in overall output as inventories get worked down in the industry where demand fell. The Fed can ease the economy's self-adjustment by cutting rates, which puts more money into consumers' pockets.
There's a lot to be said for this theory. Take autos: Yes, inventories in that industry ballooned, but then they shrank just as rapidly. Greenspan believes that excess inventories are being rapidly liquidated because consumption exceeds output. Although consumer confidence has dropped precipitously, spending has kept growing. One reason may be that the unemployment rate remains within 0.3 percentage points of a 30-year low. That's hardly a sign of an economy on the precipice.
Moreover, the economy has never gone into a recession as long as housing remains strong--and so far, it has. Housing starts are up about 8% from last summer and should get a boost from lower mortgage rates on the heels of the latest half-point Fed cut, which brings the total reduction to 1.5 percentage points since yearend. And a refinancing boom that is allowing homeowners to convert equity into cash could buoy consumer spending.
Lower interest rates also have the potential to boost business investment and send investors back into the stock market by restoring their battered optimism about corporate profit growth. Many economists believe that's exactly what the latest rate cuts will do. "This is not a recession, and the Fed is just as powerful as it ever was," says Conference Board Chief Economist Gail Fosler. She predicts that the current economic slowdown will end up being milder than the one in 1995, which today is nearly forgotten. "It's like being jilted by your high school boyfriend," she says of the market plunge. "There's all of this anger and disappointment," but you move on.
Many Old Economy industries are already starting to look past the slowdown. Auto stocks are up sharply on investors' expectations that the worst is over. Although the overall market has plunged since Jan. 1, Ford Motor (F ) jumped 21% through Mar. 21, General Motors (GM ) rose 5%, and even wounded DaimlerChrysler (DCX ) gained 9%. With the auto inventory correction apparently over, "it's pretty much business as usual," says Mike Kluiber, senior vice-president of global automotive for Milwaukee-based Rockwell Automation Co. "No one is panicking."
Even many execs in the cratering technology sector, having prospered under Greenspan's aegis for so long, are still willing to give him the benefit of the doubt. John W. Loose, CEO of fiber supplier Corning Inc. (GLW ), remains optimistic even though, on Mar. 19, he warned that Corning's earnings will likely be flat in 2001 instead of rising some 15%, as previously forecast. Says Loose: "I don't think monetary policy is a one-time event. Alan Greenspan thinks long-term and is certainly very cautious. So it didn't surprise me at all that [the cut] was just 50 basis points."
But what if a gloomier scenario is unfolding? Even Greenspan believes that this isn't purely an inventory correction. Indeed, we may be seeing the downside of the New Economy. On the way up, the New Economy was marked by four changes: rapid growth in investment, heavy concentration in information technology, a booming stock market and the diffusion of stock wealth to a broader cross-section of the public, and the efficiency of the venture-capital and initial-public-offering markets, which stimulated innovation by rapidly supplying capital to people with new ideas. The New Economy raised productivity and produced years of rapid growth, raising living standards for millions of people without sparking inflation.
But now, the New Economy just might be biting back. Start with the first two changes: investment and high tech. In the Old Economy, when things changed more slowly, companies built just enough capacity to handle their current demand and leave a little room for growth. But in the New Economy boom, tech investment was predicated on expectations of extremely rapid growth in demand for years to come for telecommunications bandwidth, semiconductors, network servers, and the like. When companies lowered their demand forecasts, they concluded that they didn't have just a little excess capacity--they had massive excess capacity, far more than they would have built up in the slower, more stable Old Economy. Companies with too much capacity have no desire to invest, no matter how cheap money is. In the extreme, rate cuts amount to "pushing on a string."
Things haven't gotten to the pushing-on-a-string phase yet, but they might if companies and their customers get any gloomier about the economic outlook. That's why many New Economy economists say the Fed needs to cut rates aggressively and fast to restore confidence before rate cuts become useless. How far? At least one more percentage point on the Fed funds rate, many say. "In order to get another shot [at reviving growth], the Fed funds rate would have to go down to below 4%," says consultant Wojnilower.
Conventional wisdom, of course, has it that inventory overhangs are less serious in technology. Product cycles are shorter, so the excess will be dealt with soon, the argument goes. But that's only true if companies feel pressed by competition to upgrade and if new products are much better than old ones. When investment and innovation slow, neither is the case. "I don't know anyone who put in Cisco routers and a virtual private network last year who's going to rip it out and put a new one in this year or next" just because interest rates are lower, says Christopher D. Wolfe, an equities strategist at J.P. Morgan Private Bank. "So where will incremental growth investors are expecting come from? Nowhere."
Then there's the third pillar of the New Economy: the stock market. The bull market fueled economic growth by encouraging consumers to hike spending faster than their incomes rose. As a result, the savings rate plummeted to below zero. With the market down on lowered earnings expectations, poorer consumers may start saving again. While that's virtuous, it's disastrous for the economy if it happens too abruptly, since consumer spending makes up roughly two-thirds of GDP. Stephen S. Roach, chief economist at Morgan Stanley Dean Witter, says an immediate return of the savings rate to its postwar average--an unlikely event--would send the economy into a depression.
The fourth pillar--venture capital and initial public offerings--looks problematic as well. On the way up, venture capital and IPOs matched up entrepreneurs and investors with unprecedented speed, outdistancing the corporate research-and-development departments that traditionally accounted for most business innovation. But when sentiment turns negative, funding for innovation dries up more abruptly than before. Investments by venture capitalists fell 31% from the third quarter of 2000 to the fourth quarter, according to researcher Venture Economics. "There are companies with decent technologies and a business of real value," says C. Richard Kramlich, a founding partner at New Enterprise Associates in Menlo Park, Calif., who has been a venture capitalist since 1969. "But they are just running out of money, and people are pulling the plugs on them willy-nilly."
It's not clear how much all of this worries Greenspan and fellow members of the Federal Open Market Committee. Greenspan feels he has already loosened credit quickly--it's the fastest 1.5 percentage-point rate cut he has ever made, and the broad money supply has been expanding briskly. Inflation hawks can also point to the fact that rising prices haven't exactly disappeared: The Commerce Dept. reported on Mar. 21 that inflation ran at a 4.4% annual rate from December through February.
But if the New Economy scenario is right, inflation is the last thing the Fed should be worried about now. Indeed, the Fed's cuts to date are less than meets the eye. How? Well, Fed rate cuts usually work through three channels: lowering borrowing costs, stimulating the stock market, and making U.S. goods more competitive in world markets by lowering the exchange value of the dollar. So far, only the borrowing-costs channel is working. The overall stock market is down 15% since the Fed began cutting in early January, eliminating a key source for companies to raise money. Meanwhile, the dollar is at a 20-month high against the yen and a 3-month high against the euro.
The consequences of a U.S. slowdown go far beyond American shores. For a decade, the U.S. has been the main engine of world growth, sustaining other economies by sucking up their imports. Japan's economy is as weak as it has been since its asset bubble burst in 1990, and Europe is beginning to sputter. If the U.S. economy goes cold, it could spell a severe global downturn and possibly even a financial crisis.
Now, the decline in confidence is feeding on itself. Doug Cliggott, U.S. equity market strategist at J.P. Morgan Securities, thinks stocks have more room to tumble. He says investors still expect 15% annual growth in earnings per share, while his group projects them to grow only about 5% a year for the next five years. If confidence does drain further, it could be hard to restore. Morgan Stanley's Roach argues that what he calls "the first recession of the Information Age" has more in common with downturns of the first half of the 20th century, which were also marked by overinvestment and the bursting of speculative bubbles. Recessions lasted longer then: 21 months on average from 1854-1945, vs. 11 months on average since the war, when recessions have generally been easy-to-fix inventory corrections.
For the long term, most worrisome is the possibility that a prolonged downturn will stop innovation, the basis of New Economy growth. Proceeds from IPOs have fallen to their lowest rate since the beginning of 1991, with just $4 billion raised so far this year, says Richard Peterson, chief market strategist at Thomson Financial Securities Data. In the last quarter of 1999, by contrast, companies raised $23 billion in IPOs. The flood of money into new companies put pressure on older ones to innovate rapidly. With that pressure diminished now, predicts Peterson: "Large companies such as IBM (IBM ) and Sun and Cisco will still do research and development and develop products and try to improve services, but at a slower pace and with more caution."
If a New Economy downturn plays out, Silicon Valley and the other tech sectors won't likely bounce back for some time. "I've never seen the economy come to as screeching a halt as it has here. We've been going 60 miles an hour and have come to a complete stop within 20 feet," says Sanford R. Robertson, a longtime Silicon Valley investment banker. Robertson, a partner at Francisco Partners, a new tech-focused leveraged-buyout firm and co-founder of Robertson Stephens Inc., predicts that the tech sector won't even begin to ramp up again until 2003.
To be sure, none of this may happen. Alan Greenspan may succeed once again in steering the economy clear of a recession. Will his legacy remain as it is today--that of a man who adroitly managed the economy through a period of fundamental and tumultous change during which the conventional guidelines for Fed policy went out the window? Or will he go down as a man whose otherwise stellar record was marred by an economic firestorm that scorched the final years of his tenure? Much more than Greenspan's legacy is riding on the answer.
By Peter Coy in New York, with Rich Miller in Washington, Linda Himelstein and Jim Kerstetter in San Mateo, Jeff Green in Detroit, Marcia Vickers and Pete Engardio in New York, and bureau reports