related materials: A recent talk that I gave on the state of the economy (7/01); The Three Bears Redux! (3/00); The Goldilocks Economy and the 3 Bears (2/00)
A Talk on the Economy
(given to Los Angeles B'rith Ma'arav December 10, 1998, the Hermosa Beach Rotary Club, February 23, 1999, and the Loyola Marymount Manufacturing Executive Strategic Forum, March 16, 1999)
What is going to happen to the key variables in the economy? What is going to happen to production, unemployment, inflation?
It's impossible to predict the future exactly, because of the complexity and uncertainty. Economics is like meteorology on this score, basically only able to extrapolate past trends into the future. Extrapolation predicts low inflation, at least in the near future. Unemployment should be low for awhile, while the economy should continue to grow, maybe at a slower rate. However, the rest of the future is pretty murky, especially as we get to the year 2000. But economists are very bad at predicting reversals of current trends, especially recessions that follow from periods of prosperity.
But rather than throw around a lot of weasel words and qualifications, I am going to make some bold predictions. Better to take a risk than to risk being boring. I will also mostly avoid statistics, for the same reason.
Frankly, the economy is trouble, even though the explicit results of this trouble -- a recession -- are unlikely to show up until the year 2000 or even during the first term of President Jesse "the Body" Ventura. It's a little like a cartoon character -- Wiley Coyote -- who runs off a cliff and only after a delay realizes he's done so and then falls. The U.S. economy has run off the cliff. It's running on borrowed time, or rather, on borrowed money.
- One basic principle is that we should not pay too much attention to financial markets -- and statistics such as the Dow-Jones industrial average. The stock market is fun to watch (and to play) but that doesn't make it important. The stock market crash a few months ago has had little effect on the economy, just as in 1987. The impact of a crash depends on how strong the "Main Street" economy has been. It's been pretty resilient so far.
- Also, we should remember that the stock market recovered from the Crash of 1929 and -- unlike the economy --enjoyed a boom until the Spring of 1930. Just because the stock market is doing well doesn't mean that the economy is doing well.
- The stock market should be seen as more as a trigger than as the actual explosive that destroys prosperity. We need to examine how explosive -- or implosive -- Main Street economic prosperity actually is.
- I should tell you that I am not a natural-born pessimist. In 1994, I published an article on the Great Depression that argued that we weren't going to see another one in the near future. I've changed my mind. But I'm going to refrain from further historical analogies about the Great Depression. Just because 1999 is in some ways similar to 1929 doesn't mean that history is going to repeat itself.
The problem is international. Starting in 1997, several of the major East Asian countries have been though severe crises that have lead to sharp recessions, in places like Thailand, South Korea, Indonesia. These problems have spread to Russia and are spreading to Latin America. Even those countries that have avoided sensational currency crises and financial meltdowns have suffered from high interest rates and slowdowns, if not recessions. (This is starting in Brazil, Ecuador, etc.) Major countries like Japan and Canada have been depressed or are hurting. China seems to be sagging, too.
Like I said about the stock market's role, these financial crises are important, but are not the main story. The basic problem is that competitive export-promotion and austerity. More and more, the success of the East Asian economies has been a matter of active pushing of exports to the rich countries, based on low wages, weak environmental laws, and authoritarian rule. Instead of serving their own domestic markets, these countries' rulers hoped to prosper by selling more and more exports.
The problem is that while this can work for a small number of countries, Japan in the 1960s, S. Korea and Taiwan in the 1970s, it can't work for a large number of countries. Underlying the financial crises of East Asia was depressed consumption demand combined with energetic competitive efforts to produce and investment to increase the capacity to produce.
On top of that, the International Monetary Fund made things worse. They treated the East Asian financial problems like an instant replay of the Latin American debt crisis of the 1980s, prescribing anti-inflation polices where they weren't needed. In general, the I.M.F. doesn't steer the world economy to promote prosperity. Its main roles are to protect the assets of lenders and to proselytize for free-market economics, backing its preaching with the threat of loan cut-offs. It also acts like a collection agency for the wealthy, with little concern for the health of the borrowing nations. It also lacks a global perspective, something needed to see and prevent a global contraction.
The United States
The U.S. and Western Europe have started to suffer from the effects of the recession in the rest of the world's manufacturing. Europe has already been mildly depressed (mild compared to Japan, depressed compared to the U.S.) for a few years. The numbers suggest that the U.S. manufacturing has already started to slow down, though in general the U.S. economy is still doing well. Most forecasters suggest that the U.S. economy is going to slow down in the near future.
On the other hand, the U.S. and Western Europe have benefited from low raw material and primary-product costs, which are a symptom of low global demand for raw materials and to some extent overproduction. (US agriculture has suffered from overproduction due to deregulation.) Oil and gasoline prices not only encourage mergers like that of Exxon and Mobil, but also low or zero inflation and high profits of firms that use petrochemicals. This is why the economic crystal ball is clouded, so that many people are much more optimistic than I am. (Of course, the producers of raw materials and primary products are suffering. They are already in a depression.)
The problem is that U.S. prosperity is not simply a matter of international affairs. In recent years the U.S. has been following a path of profit-led growth, with profits soaring relative to wages. The gaps between the rich and the poor, the CEOs and the average workers, keep growing larger, just as the ownership of wealth has become more and more concentrated.
As a result, and investment (in machinery and the like) growing much faster than consumer demand. (This is a characteristic of the 1990s boom, though not of that of the 1980s.) Increased investment has been the main force allowing prosperity, falling official unemployment, despite the large number of lay-offs and downsizings. (The weak bargaining power of workers has meant that the high employment has disproportionately been a matter of low-wage jobs. Since people are desperate, this has discouraged raises, which is one factor preventing inflation, along with falling raw material prices.)
Eventually, investment cannot continue in this way. Building factories and installing computers creates a greater capacity to produce goods and services, which requires more and more investment growth to allow its profitable use. (Note that a productivity boom, if it's happening, makes this problem worse.) Investment spending is also is much more flaky, dependent on business executives' expectations of the unknown future. A small bump on the road can cause an investment pull-back.
Currently, business profits are much more shaky than they were in 1997, partly because of the Asian mess. The investment boom now suggests that investment could fall a lot next year or the next, when unused capacity encourages business pessimism (and vice-versa), becoming a vicious circle.
But the persistence of the boom depends on the other sources of the demand for goods and services.
Consumer demand (including the building of new housing) has been doing okay, but increasingly it's based on accumulation of debt, dipping into savings, and faith that the stock market will remain high forever. When these become less and less viable, consumer demand is likely to falter.
It should be stressed that even if the stock market doesn't crash, it won't remain high forever. It's the nature of the beast. (Experts like Robert Shiller at Yale point to the extremely high price/earnings ratios in the stock market and suggest that stock prices will fall at least 30 percent in the long haul.) When it goes "bearish," that will hurt consumer spending, including on new housing. People will cut back on consumption to add to their depleted savings (due to the bear market) and because they will feel poorer.
This is making the prosperity of the U.S. more and more dependent on selling products to the rest of the world. This seems less and less likely, as the rest of the world stagnates. Instead, the U.S. is holding up the rest of the world (preventing its further fall) by borrowing a lot of money and buying their products (a balance of trade deficit). It's unclear how long the U.S. can accumulate debt in this way as interest payments to the rest of the world rise.
Real GDP grew about 3.8 percent in 1998. If the trade balance hadn't gotten worse, it would have only grown 2.5% per year. This is one of the biggest gaps of this sort since 1959.
The Federal government is no longer in the Keynesian business of stabilizing the economy. The main emphasis is on balancing the budget or keeping it balanced), which prevents it from saving the economy when and if it begins to fall. In fact, given the current mood (especially in the state governments) a recession would encourage tax hikes or program cut-backs, which would make a recession worse. The Federal emphasis is on keeping a budget surplus. The last time this policy was pursued was during the 1920s. Domestic spending by the government no longer automatically rises as much as it used to do when recessions hit, so that the built-in moderation of recessions is weaker than it was decades ago. (For example, welfare "reform" and changes in the tax code have had this effect.)
So it's all up the Federal Reserve. Alan Greenspan has been cutting interest rates and trying to prevent financial disaster and recession. The central banks of Europe -- I almost said "crowned heads of Europe" -- also cut interest rates in late 1998, clearly alarmed at the situation. So far they have been successful, with some observers abandoning their previous fears for the future. The financial markets have been doing better, not surprisingly.
In theory, this might prevent recession: lower interest rates encourage spending, especially on housing, increasing the demand for goods and services. Indeed, as mentioned, housing demand is doing very well these days.
The problem is that there are other determinants of investment besides interest rates. Just as in 1992, when low interest rates encouraged many families to refinance their mortgages and many corporations to restructure their debts, low interest rates do not always stimulate spending of the sort needed to prevent or end a recession.
If bankers don't want to lend, if consumers are saddled with debt, if corporations don't want to risk their status by building new factories when their current ones aren't running full-tilt, if the prospect of the future begins to look bleak, then the Fed's policies become less and less effective.
If the U.S. falls, it will pull down the rest of the world even farther, since we buy so many of their products. Of course, their ability to buy from us would be hurt, so there would be another vicious circle... The U.S. recession would clearly create a world -- and U.S. -- depression.
It's possible that the Fed might succeed in shoring up investment spending. But this would involved increased accumulation of debt by private individuals and corporations, which will represent barriers to growth in the future. Similarly, encouraging real investment in plant and equipment creates production capacity that can represent a barrier to U.S. growth in the future. Too much housing investment can also get beyond consumer demand, also (causing a fall in housing prices and a slump in the value of people's home equity).
This discussion suggests that the longer the Fed is able to delay the next recession, the more severe that recession will be: the more the recession is delayed, the more imbalances accumulate that can block new prosperity.
Given the very slow recovery of East Asia, including Japan, Russia, and elsewhere, and projected economic slowing in Western Europe, it is unlikely that the rest of the world will recover before the U.S. growth collapses. So the depression prediction is likely to hold.
I don't think that there's going to be a full-scale replay of the 1930s, but this is more of an intuitive guess than a reasoned conclusion. I guess I was born an optimist!
Department of Economics
Loyola Marymount University
Los Angeles, CA 90045-8410
For more on these subjects see My Research on the Great Depression, my Short Article on the Depression, and A New Analysis of the Possibility of a Depression in the future.