Recession Isn't My Greatest Fear

A slowdown in productivity growth is my biggest worry, because it would hamstring the Federal Reserve

A whiff of recession smoke seems to have entered the room, and those of a pessimistic bent can already see the flicker of flames outside the window. Nouriel Roubini, an economist at New York University who was worried about a global recession in 2004, is now predicting that "the U.S. is heading toward a sharp recession by early 2007." In his view, "current economic and financial conditions in the U.S. eerily resemble those that led to the stock market crash in October, 1987."

The recession and financial meltdown are coming, according to Roubini and other pessimists, for a well-known set of reasons. They paint a negative picture that includes higher interest rates leading to a housing slowdown or crash, high oil prices causing stagflation, burnt-out and debt-ridden consumers being forced to stop spending, and the dollar plunging in response to the unsustainable trade deficit.

Of course, just because Roubini has been predicting recession for years doesn't make him wrong this time. I know as well as anybody else that booms can be followed by busts, since I successfully predicted the end of the tech boom of the 1990s. And I wouldn't be surprised at all to see a deep decline in housing prices.


  But I'm far less worried about the possibility of a steep recession than Roubini is. Economists don't know much, but they do know how to cushion downturns through sharp cuts in interest rates and injections of liqudity into the financial system.

The 1987 stock market crash did not do any great damage to the economy, despite what was feared at the time. And the recession of 2001 and the steep market decline of the early part of the decade did not seem to do any great damage to the economy either. Fed Chairman Ben Bernanke, an economic historian, knows as well as anyone else that the primary function of a central bank is to aggressively step in when it looks like a downturn is about to get out of control.

I also believe that some economic volatility is not a bad thing. A slowdown weeds out weak companies and gives the stronger, more innovative ones an opportunity to thrive and take over more of the market, much like a forest fire clears the ground for the next generation of growth. In my 2004 book, Rational Exuberance, I called this a "pulsating economy"—booms and busts following each other, leading to faster growth and more innovation in the long run.

However, we do run one big risk, which amplifies all the others. The biggest danger is a slowdown in productivity growth. Currently productivity is rising at roughly a 2.5% rate on a year-over-year basis. If it continues at that pace, then the Fed's task of avoiding a deep and prolonged recession becomes relatively easy, since the economy and incomes will keep growing even if employment dips a bit. But if productivity growth slows, then even a mild drop in jobs can cause production to fall and start feeding on itself.


 Unfortunately, the Fed and economic policymakers have no good immediate solution to a productivity slowdown, if one should occur. Interest-rate cuts boost demand but do little in the short run to increase underlying productivity. The same is true for tax cuts: They are great at fueling demand, and may even encourage more investment in the long run, but in the short run have no effect on productivity.

Do I see signs of a productivity slowdown yet? Not yet. The 1.1% growth rate in the second quarter by itself means nothing, since productivity trends have to be measured over years. But by the same token, we wouldn't know if a true slowdown had begun. I'm keeping my fingers crossed.

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