A hard landing?
Dec 7th 2000
From The Economist print edition
The risk of a hard landing in America is real
FOUR years is a long time in central
banking. On December 5th 1996, Alan
Greenspan, chairman of America’s Federal
Reserve, gave his famous warning about
irrational exuberance in the stockmarket.
Yet four years on, to the very day, and
with stockmarkets considerably higher
than in 1996, Mr Greenspan injected some
irrational exuberance of his own. With a
reassuring speech that was taken to imply
that the next move in interest rates would
be downwards, and that the Fed was ready to ease if
the
economy slowed too sharply, he lifted share values by
almost $600
billion in a single day. The Nasdaq rose by over 10%,
its
biggest-ever daily gain.
Mr Greenspan’s soothing words were lapped up by
investors who
had become nervous that America’s economy was heading
for a
hard landing. The economy is slowing more than
expected; and
last year’s tech bubble has clearly burst. Yet, as Mr
Greenspan
pointed out, none of the recent economic numbers
should
themselves cause alarm. A slowdown in the economy’s
breakneck
speed is exactly what was needed. Demand has outpaced
supply
for several years; to ease tight labour markets and
to stop
inflation rising, the Fed has raised interest rates
by 1 3/4
percentage points since mid-1999, to 6 1/2%. Mr
Greenspan
seems to believe that a soft landing is on course, as
weaker share
prices and tighter financial conditions dampen
consumer spending.
The fact that evidence of a slowdown generated so
much gloom
has merely highlighted the extent to which
expectations were
inflated. There is, indeed, a worrying circularity in
the response to
Mr Greenspan’s speech. Share prices soared because
investors
think that interest rates will be cut early next
year. But that will
happen only if consumer spending slows. If
stockmarkets bounce
too far, consumer spending will stay too strong—and
interest rates
will not be cut, and might even have to be raised.
The markets are now discounting a half-point cut in
interest rates
in the first half of 2001. This is surely premature.
Both the core
rate of inflation and the increase in wage costs have
edged up this
year. To relieve inflationary pressures, growth needs
to stay below
its sustainable rate for a longer period. And the Fed
should be
careful not to give the impression that it will
underwrite share
prices by cutting interest rates. The Fed’s past
success in steering
the economy may have created a moral hazard: if
investors
believe that monetary policy will support share
prices, they will
tend to take bigger risks.
Many investors also believe that tax cuts can be
called in aid of a
soft landing. Dick Cheney, who will be vice-president
if George W.
Bush moves into the White House, said this week that
America
may be on the “front edge” of a recession, and
pledged that Mr
Bush would push to cut taxes quickly. With a large
budget surplus,
this might seem sensible. But, not least because of
the long lags
before tax cuts take effect, they are a bad way to
fine-tune
economies. Fortunately, a weak presidency, combined
with
near-balance in Congress, should make it harder than
ever to
agree on changes in fiscal policy.
Although the Fed may yet steer the American economy
to a soft
landing, investors are underestimating the difficulty
of its task (see
article). History shows, in fact, that central banks
rarely manage
it. That is partly because slower-growing economies
are more
vulnerable to external shocks than booming ones. It
is also
because slower growth exposes all sorts of economic
and financial
imbalances. The borrowing binge that has taken place
in America
on the assumption of ever-rising profits and share
prices may seem
especially unwise as growth slows. And pessimism can
be as
contagious as exuberance. There is a risk that
America’s virtuous
circle of high investment, faster productivity
growth, and rising
profits and share prices could turn vicious. If it
does, the Fed will
need to cut interest rates—but not before.
New worries, old economy
What does America’s economic slowdown and the
bursting of its
tech-share bubble mean for the fabled “new economy”?
One
lesson is that the old rules of economics still
apply: the business
cycle is not dead, and profits do still matter. As
growth slows, the
new economy will face its first big test: it should
become clearer
how much of America’s recent productivity-growth
improvement is
cyclical rather than structural. Some of it may
reflect the fact
that in boom times firms work employees harder; that
will
disappear in a downturn.
As GDP growth has slowed, productivity growth has
also eased,
from an annual rate of 6.1% in the second quarter to
3.3% in the
third quarter. Where will it go now? If productivity
growth falls only
modestly, keeping inflation in check and supporting
profits, a soft
landing remains plausible. But if productivity growth
comes down
faster, it will make the Fed’s handling of a downturn
far trickier.
Unit labour costs would accelerate, and the dollar
might
tumble—making it hard to respond by cutting interest
rates.
The Economist has long argued that the American
economy is
suffering from a financial bubble. The IT revolution
is delivering
genuine economic gains, but the markets are also
being driven by
unrealistic expectations of future productivity and
profits growth.
This should be no surprise: historically,
technological revolutions
and bubbles have gone hand in hand, from Britain’s
railway mania
in the 1840s to America’s enthusiasm for cars and
electricity in the
1920s.
When those bubbles burst, investors lost their
shirts; yet the real
economic gains endured. That may happen this time,
too. But the
experience of past revolutions should give pause to
many
new-economy enthusiasts. Their claim that information
technology
has boosted America’s sustainable rate of
productivity growth to
3-3 1/2% is extraordinarily ambitious: it suggests
that IT will have
a bigger impact than electricity. That is one good
reason to fear
that, in a downturn, America’s productivity may slow
by more than
most economists expect—adding to the chances of a
hard landing.
Mr Greenspan may have some explaining to do in
December 2001.
This archive was generated by hypermail 2b29 : Sun Dec 31 2000 - 00:00:04 EST