Unknown Territory--Even for the Fed

No one has better understood the New Economy business cycle than Federal Reserve Chairman Alan Greenspan. He realized before most the importance of new information technologies in generating higher productivity. He went against conventional economic wisdom in deftly using monetary policy to promote strong, noninflationary growth throughout most the '90s, zigging and zagging--perhaps too much at times--but always managing to keep the economy pointing straight ahead. Greenspan was lauded by millions who credited him for much of their good-paying jobs and newfound wealth. Today, Greenspan is feeling the heat from many of these same people as the stock market turns bearish, young dot-comers get fired, and corporate layoffs sweep the country. Greenspan had the smarts and the policy tools to maneuver on the upside of a high-tech business cycle. But does he have them for the downside, as well?

On the issue of smarts, the answer is "yes." Greenspan has the right take on what ails the U.S. at this moment in time. He understands that there are two contractionary forces at work pulling the economy down--a traditional inventory cycle and a much rarer boom-bust investment cycle. Most 20th century business cycles were driven by the former, as demand and supply got out of whack, generating inflation. But a credit-driven investment cycle that leads to overcapacity and deflation was seen only twice--in the U.S. in the '20s and in Japan during the '80s. There is a lot known about inventory cycles and how to get out of them. They aren't that scary. A lot less is known about investment cycles, and as history shows, we should be afraid, very afraid.

GREENSPAN BELIEVES that the U.S. is well on its way toward working through its inventory cycle problem. With employment still strong, people are buying cars and houses at a substantial rate. Consumer demand is lower than last year, but remains relatively strong. Detroit and manufacturers in general are slashing production, and the inventory bulge is disappearing. Greenspan's take is that sometime in the second half of 2001, the factories will have to rev up again and growth will recover.

The real problem is with a high-tech investment cycle that sits on top of the inventory cycle. It is far less familiar territory for economists, and even Greenspan doesn't know how bad it will get. Corporations currently are cutting back on their high-tech spending in order to restore shrinking profits. This exacerbates the problem of high-tech overcapacity and prolongs the workout. After years of a capital spending spree, there is huge overcapacity in chips, optical fiber, personal computers, and other high-tech products that will take time to work down.

Eventually, companies will realize that spending on high tech increases their productivity and profitability. At some point, they will begin investing again. But when? Greenspan doesn't know. No one does, really. For the moment, corporations, especially high-tech companies, continue to slash their earnings projections. Indeed, many use the term "recession" easily and describe the near-term outlook as lacking "visibility." Translation? They don't see the bottom. Until they do, companies in general won't commit to new capital spending, and high-tech overcapacity will continue. This will keep the economy from taking off even if the manufacturing inventory problem gets solved soon. The Fed recognized this problem, citing "excessive productive capacity," when it recently cut rates by half a percentage point.

WHAT TO DO? Greenspan appears to be successfully using traditional monetary policy to deal with the inventory problem. The 150 basis-point cut in interest rates is keeping consumer spending up, working off the inventory bulge. Greenspan recognizes that further reductions may be required, especially if consumer confidence begins to crack. The malaise in the stock market and the strong reverse-wealth effect may curb spending sharply in the months ahead. If housing prices begin to tank, deflating asset prices and household wealth even further, consumer spending may grind to a halt. Rates may have to go much lower in the near future.

But it is unclear whether interest rate reductions can deal adequately with a high-tech investment cycle. Greenspan himself recognizes that monetary policy may have limited influence in this sphere. Lower rates may perk up consumer spending but do little to get chief executives, worried about plummeting earnings, to focus on the long-term productivity benefits of spending on information technology. They would rather make better use of the huge amount of technology bought in recent years and save the cash for the bottom line.

Lowering rates, in this scenario, is akin to pushing on a string. In the end, markets may have to do the work of flushing out the excess capacity by themselves without help from anyone. The dot-com debacle came fast and furious. And capacity in chips and personal computers is being whittled away quickly, as well. Unlike Japan, companies aren't being protected, and the markets appear to be working their Schumpeterian magic.

Greenspan has as good an understanding of the twin problems of excess inventory and excess high-tech capacity as anyone around. He admits that monetary policy alone may not be able to combat this kind of Janus-faced business cycle. He could use some help from the fiscal side. A countercyclical tax cut that puts money into American pockets by spring could, at least, bolster consumer confidence.

We are living through a rare economic event that could end soon or continue for years to come. For the economy, as well as Greenspan's legacy, the outcome is uncertain.

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