Commentary: A Slow Road to Recovery
By Michael J. Mandel
Economies evolve. Change is gradual and often hard to assess while it is happening. That's exactly the situation that the U.S. finds itself in now. On Nov. 26, the National Bureau of Economic Research, the Cambridge (Mass.) economics organization, officially declared that the U.S. had entered a recession as of March. That puts a punctuation mark at the end of the longest expansion on record.
But the recession is a comma, not a period. The New Economy, which started life as a tech-driven boom, has not disappeared. Instead, it's evolving in some surprising ways. In the short run, the U.S. will continue to struggle with the first technology-driven recession. It may not last long--most forecasters expect low interest rates and tax cuts to bring economic growth into positive territory by mid-2002. But with no sign yet of an upturn or even a bottom to the tech-spending dive, any recovery will be anemic.
Moreover, higher productivity growth, one of the virtues of the New Economy, could actually undermine consumer spending in coming months by driving up unemployment and holding down wage gains. In the past three recessions, productivity fell. But since this recession started, productivity has been rising at a 2.4% annual rate. Why? Companies are making better use of their existing investments in technology even as they restructure their operations for greater efficiency. The combination is enabling them to boost profits by shedding workers. So even if the recession officially ends soon, the U.S. is likely to see months more of rising unemployment and weak growth.
For the long run, the picture is brighter. Economic growth depends on the ability of companies to do existing tasks more efficiently and the willingness of entrepreneurs to create innovative businesses and products. There is no sign that that process has stopped or even slowed. The number of patents being granted is running at an all-time high, and despite the woes of dot-coms, venture capital firms were still investing at a $30 billion annual rate in the third quarter of 2001. That's way ahead of any year except 1999 and 2000.
The forces pushing innovation argue for growth to accelerate over the next few years as new companies form and new ideas come to market. But the next expansion will likely have a different character than the last one. Information technology will probably never regain the accelerated growth of the 1990s. Instead, there are early signs that innovation in biotech and health care will fuel the next period of growth. In addition, stronger growth overseas may give the U.S. a kick from foreign trade rather than having it be a drag on the economy.
Still, that's little comfort for the short term, which remains gloomy. The past few months have been tough on an already struggling economy. First, the September 11 attacks caused further damage by hurting consumer confidence, raising business costs, and putting airlines into a tailspin. Now, the rapid deterioration of Enron Corp.'s finances is causing investors to broadly rethink corporate creditworthiness.
Nor will the economy be bailed out by the tech sector. Past business cycles suggest that the main driving forces of one expansion often lag in the next period of growth. New orders for information-technology gear are still way below where they were just a few months ago. And while Intel Corp.'s (INTC ) CFO announced on Nov. 27 that he is comfortable with his forecasts of Intel's sales so far this quarter, new orders for semiconductor-manufacturing equipment fell 12% more in the third quarter.
But tech is hardly the only sector to suffer from a broad pullback of capital spending. The telecom industry is awash in capacity, and airlines are cutting back on plane purchases. In manufacturing, which accounts for roughly one-sixth of capital spending, factories are running at only 73% capacity. It would take two years of 4% growth before companies started thinking about adding more capacity. That's as fast as manufacturing grew in 1999.
And while consumer spending has held up surprisingly well so far, it may start flagging soon. American households have benefited from six years of rising real wages. Indeed, workers have steadily claimed an increasing share of national income. The latest figures show that wages and benefits now account for 86% of nonfinancial corporate output, by far the highest level on record. Meanwhile, after-tax profits have fallen to only 6% of corporate output, according to figures from the Bureau of Economic Analysis. That's way below the 10% peak they reached in 1997.
That state of affairs will not persist. In the 1990-91 recession, companies started slashing jobs and holding pay increases below inflation. Even after the recession ended, companies kept the lid on labor costs until healthy profits returned. The unemployment rate rose for 15 months after the recession ended in March, 1991, and real wages fell until 1995. As a result, profits jumped sharply.
The "jobless recovery" may be even more pronounced this time because productivity growth is stronger than it was a decade ago. The current consensus among economists is that business productivity is likely to keep rising at a rate of about 2% annually. Given that the workforce grows at about 1% annually, that means output needs to grow at 3% to just hold unemployment constant. A sluggish recovery, with growth under 3%, would send unemployment soaring--perhaps as high as 6.5% or 7% by the end of 2002. That will hold down consumer spending and slow growth.
As a result, the Federal Reserve may be forced to keep rates low well after the recession officially ends. That's similar to the aftermath of the 1990-91 recession, when the Fed continued to ease into the fall of 1992. Moreover, the Fed may feel an obligation to keep rates low in order to protect the financial system, which was coming under increasing stress even before the Enron disaster. All but the most creditworthy of borrowers now have to pay a widening premium to account for the possibility of default.
But there is a big difference between stressed and broken, thanks to Federal Reserve Chairman Alan Greenspan's aggressive interest rate cuts. They began in January, 2001, before the recession even started. The willingness of the Fed to keep pumping money into the economy enabled companies and investors to start the process of writing off and absorbing the excesses of the 1990s. With interest rates low and money easily available, it has been much easier to deal with the enormous overhang of bad telecom debt and lost investments in dead dot-coms.
As result, the economy is able enough to deal with financial shocks, including the September 11 attacks. What prolongs a recession--and potentially turns it into a depression--is a collapse of the financial system. But that isn't happening in the U.S. Banks are still willing to lend, corporations are still issuing bonds in large quantities, and consumers can still easily get mortgages and car loans.
Even venture capital firms are still pumping money into new companies. And those funds aren't just going to prop up struggling companies. So far in 2001, venture capital investors have funded more companies at the startup and seed stages than ever before--including the boom years of 1999 and 2000. These young companies, which are still very small, could be the foundation of the next boom.
To be sure, it's hard to predict which ones will blossom into the next Internet, powerful enough to propel the entire economy. That's because innovations are fundamentally unpredictable. Thus, virtually every economic forecaster underestimated the growth of investment, productivity, and jobs in the 1990s because they simply didn't see the Internet coming.
Still, it's a good bet that a sector that keeps growing during a recession will help drive the next expansion. During the recession of 1990-91, information-technology investment, adjusted for inflation, barely dipped. That was a sign of strength for the future, showing that companies and consumers put a high priority on information-technology spending even as the economy slowed.
This time around, health-care spending has stayed strong through the downturn. That argues for health care, led by biotechnology, to emerge as one of the driving forces in the next upturn. By contrast, medical spending growth slowed sharply in the last two recessions.
An expansion driven by health care would be very different than one driven by information technology. Instead of boosting productivity, medical innovation would have much more of an impact on improving longevity and quality of life. These are not aspects of the economy that are well measured by GDP. The other difference is that unlike technology investment, health-care spending depends closely on government spending. That means it can be slowed by political deadlocks.
Another possible new fuel for the next expansion is foreign trade. In the second half of the 1990s, the U.S. grew faster than the rest of the world, which set up a self-sustaining cycle. Lured by the prospect of higher returns, foreign investors poured money into the U.S.--$1.4 trillion in five years. That fueled the capital-spending boom and the U.S. stock market. They in turn boosted growth even more, making the U.S. ever more attractive to foreign investors. Meanwhile, imports far outstripped exports, turning trade into a drag on growth.
This time around, the dynamic could be quite different. The U.S. economy is being held back by the capital-spending bust. Moreover, countries such as Britain and Germany have made strides in opening their markets to foreign competition. As a result, economists at Merrill, Lynch & Co. (MER ) forecast that the European Union will grow at almost double the U.S. rate in 2002. Asia, outside of Japan, could grow faster than the U.S. as well, with China and India expected to turn in 7%-plus growth rates. Such faster growth overseas could turn foreign trade into a boon for the U.S. economy.
To be sure, no one yet knows what the next expansion will look like or when it will arrive. But thanks to continuing productivity growth and innovation, at least we can be sure that one is on the way.
Chief Economist Mandel covers the New Economy.