Don't Bank on a Bounce-Back

Growth may limp along even after the troops come home

For months, economists, policymakers, and investors have been pinning their hopes on the belief that war is the biggest impediment to the economy's recovery. The general view: Once the uncertainties surrounding the runup to war are past, a quick victory in Iraq will bring a surge in demand that will boost output, business investment, and stock prices in a reprise of the aftermath of the 1991 Gulf War.

They don't believe that anymore. Hopes for a post-Iraq rebound are fading fast, and so are forecasts that the second half of 2003 will bring a jump in jobs, orders, and profits. "I retain that hope, but not the expectation," says Michael J. Birck, CEO of Chicago-based telecommunications-equipment supplier Tellabs (TLABS ). Indeed, from high tech and retailing to financial services and autos, executives are throwing in the towel on the second half.

Why the new doubts? As anxiety over the wait for war climbs with every delay, the looming confrontation with Iraq is combining with a myriad of economic disappointments to dampen prospects. For starters, the Administration's tax plan is losing momentum. With the White House economic team struggling to sell it in the face of criticism of the big deficits it would produce, whatever stimulus plan is eventually passed will likely be far smaller than what the President originally proposed. Oil prices have also been driven up by a risky combination of war jitters and low inventories caused by production disruptions in Venezuela. The sky-high prices are already hurting the economy and look increasingly likely to dampen growth at least through the summer.

It gets worse. On Mar. 7, the monthly employment report released by the Labor Dept. showed businesses cutting a stunning 308,000 jobs in February. Even officials at the Federal Reserve were surprised by the size of the layoffs. The huge dropoff could not be explained by cold weather and the call-up of military reservists. Fed Chairman Alan Greenspan is still betting that "geopolitical uncertainties" are holding back demand. But other Fed officials are now fretting that businesses are just using the war as an excuse for inaction and that the economy is still struggling with excesses of the 1990s boom. Fed-watchers now believe that at a scheduled Mar. 18 meeting, policymakers will at a minimum shift their official view of the outlook to reflect the greater weakness in the economy. That's often a precursor to a rate cut, and some economists think the Fed could even cut rates at the meeting.

While lower rates would normally help the economy, many economists are nonetheless revising down their forecasts. The Mar. 10 Blue Chip Economic Indicators shows a consensus of economists expect the economy will grow 2.6% for 2003, down from the 2.8% expected as recently as January. Wall Street, too, is ratcheting down expectations. Since January, analyst estimates for third-quarter profits growth have been cut by two percentage points for companies in the Standard & Poor's 500-stock Index, according to Thomson First Call.

The new list of worries joins a host of structural economic woes. "If you woke up tomorrow and found Saddam was gone, you might get a huge relief rally," says Ed McKelvey, senior economist at Goldman, Sachs & Co. "But then after the visceral response, you would still be back facing the same problems."

McKelvey and others point to daunting problems of overcapacity, rising consumer and business debt, as well as the expectation that there's little further lift ahead from housing. In addition, the lack of pricing power, increased foreign competition, and refunding of pension plans at the expense of earnings still hang over the business sector.

That's not to say that the war isn't a huge factor holding down the economy. The endless talk of conflict has already done much damage. The Administration may have goofed when it began beating the drums last fall. Front-page headlines and Sunday talk shows made war seem imminent and increased uncertainty.

But seven months have passed, and the prolonged wait has given executives a reason not to tackle long-standing problems or to commit to new projects. With drags like excess capacity and weak foreign demand still hanging over the economy, any postwar rally in the stock market and consumer demand could soon peter out.

Patrick J. Moore, head of corrugated boxmaker Smurfit-Stone Container Corp. (SSCC ), is one CEO who thinks the effect of anxiety on the economy is overblown and that other factors will keep second-half growth low. He points to foreign competition as the primary obstacle for U.S. manufacturers. Because of the dollar's 41% rise against a trade-weighted basket of currencies from 1995 to early 2002, he says they simply cannot match foreign prices. So they're relocating overseas. Even a short war won't stop that migration, Moore says.

Overcapacity is another long-term drag that will still be around even if Saddam isn't. The industrial sector is using only 75% of its available capacity, and some sectors, like telecom, will be dealing with excess for years. John W. Rowe, CEO of electric company Exelon Corp. (EXC ), thinks the consolidation process is only halfway done: "It's a classic case of what you have to do to work off the after-effects of a bubble."

The excesses aren't just about building and equipment. With no signs of an uptick in the markets, Wall Street is planning more layoffs this year. At its peak in 2000, the securities industry employed 783,000 people; by the end of 2002, the head count was down to 708,000. Compensation consultant Alan Johnson of Johnson Associates expects payrolls to be slashed 10% more this year, with major firms starting to lay off people in May and June.

Rising unemployment and income-tax losses will put a further squeeze on state and local budgets in the second half. Worse, the dragged-out war process could threaten the tax cuts expected from Washington this summer. "War could preoccupy policymakers and tend to push back talks about the tax plan," says Goldman's McKelvey. A delayed tax plan could be the final blow to the consumer sector. The steep February drop in confidence suggests consumers are getting tired. Beside job worries and terrorism fears, higher fuel prices are cutting into household budgets.

A consumer retrenchment is the last thing the economy can handle. And it would hit autos particularly hard. Sales of cars and light trucks were waning before the February blizzard blew across the East Coast during the important Presidents' Day weekend. Now, both General Motors (GM ) and Toyota (TM ) are cutting second-quarter production, with Ford (F ) expected to follow suit. Second-half plans could be trimmed as well, especially since zero-percent financing has lost its novelty. More important, the key difference between the spending rebound following the 1991 Gulf War and this time out is the prospect of more terrorist attacks on U.S. soil. That could keep families at home, with their bottled water and duct tape.

Further out, the economy will have to digest enormous federal budget deficits, stemming from tax cuts and government spending boosted by the cost of war and rebuilding in Iraq. That threatens to crimp private investment and lift borrowing costs.

For now, the hope remains for a rapid and successful war with Iraq. Yet even the best of scenarios gives no guarantee that the economy, still struggling under the excesses of the 1990s, will benefit much from a postwar bounce.

By James C. Cooper and Kathleen Madigan in New York with bureau reports

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