Recession or Depression?
MAKIN, JOHN H.
Recession or Depression? The worst-case scenario ... and how we might avoid it. BY JOHN H. MAKIN Economists are very shy about mentioning the word depression. If they do mention it, they "hasten...
...Even with a modest contribution of a half percentage point of growth from government spending, well above the average 0.2 percentage points contributed since 1991, a drag on this year's growth of more than 5 percentage points is entirely plausible...
...economy...
...The most recent and spectacular example of the insanity that accompanies equity market bubbles is the experience of Yahoo!, a company whose primary source of revenues is online advertising...
...At the end of an investment boom, a sharp slowdown in investment spending produces an unusually sharp drop in growth...
...If they do mention it, they "hasten to add" that it is "contained," as in Japan, or that it "can't happen here," as in the United States...
...The assertion that the United States could experience a year of negative growth is certainly a long way from saying that the United States will enter a depression...
...Some movement in that direction will presumably occur if the sharp slowdown in the U.S...
...A stimulative 3 to 3.5 percent is needed...
...The onset of the U.S...
...So the sharp drop in investment spending may well subtract 1.5 percentage points from GDP growth, and a slowdown in consumption spending another 3.5 percentage points, while falling exports from a global slowdown could subtract half of a percentage point...
...future earnings of new companies...
...But in February, retail sales dropped by 0.2 percent...
...It starts with a period of euphoria about the outlook for the economy and the John H. Makin is a resident scholar at the American Enterprise Institute...
...economy enters what looks to be a serious recession, a Republican president is proposing tax rate cuts and a modest fiscal stimulus equal to barely 1 percent of GDP while the ratio of publicly held debt to GDP is 33 percent and falling and the surplus is approaching 3 percent of GDP Today's protests about tax cuts being too large because the debt paydown is threatened are the result of a dangerous, mistaken idea that somehow debt paydown caused the prosperity of the 1990s...
...Leading up to the bubble, a virtual prosperity mania sets in, with households contemplating undreamed-of wealth, firms bidding for and stockpiling precious skilled labor, and governments marveling at— and promptly spending—tax revenues that far exceed their most optimistic expectations...
...the dangers inherent in making the transition from unusually good times to unusually bad times need to be recognized...
...To be sure, the American economy still looks robust...
...Earnings expectations for Nasdaq companies have already fallen by more than 75 percent in many cases...
...5.5 percentage points lopped from our growth right there...
...Yes, Japan is in a depression, complete with rapidly falling prices, zero interest rates that are not low enough to stimulate spending, public works expenditures on counterproductive projects, and paralyzed policymakers at the Finance Ministry and the central bank...
...growth slowdown over the past six months fits this classic post-bubble pattern...
...Ominously, the consumption boom in January was financed by a $16.1 billion jump in consumer credit...
...During the 1990s, when capital gains came to augment and then to replace saving out of income as the way in which American households accumulated wealth, the sum of saving out of income plus expected capital gains averaged about 15 percent of after-tax household income...
...Large wealth losses replace large expected wealth gains...
...Wall Street, as the politicians like to say, is not Main Street...
...Consider what makes a depression...
...Such benign behavior creates serious problems for policymakers...
...The Yahoo...
...economy, not to mention the global economy, are serious enough to justify far more aggressive tax rate reductions...
...capital spending growth went from a 21 percent annual rate in the first quarter of 2000 to a negative 0.6 percent annual rate in the fourth quarter...
...Then, too, there is the usual denial that accompanies the shock of a rapid sell-off...
...Both monetary and fiscal policy will have to be sharply reoriented toward stimulation of the economy in coming months...
...A powerful negative shock to the financial sector, like the collapse of a stock market bubble, sets in motion a deceptively straightforward set of events that seems, somehow, to leave policymakers caught like deer in the headlights...
...Indeed, the most prudent course would be to aim for moderate budget deficits and an attendant moderate rise in the ratio of debt to GDP...
...That's We are probably moving toward an unusually intense recession...
...That is because, after a bubble, earnings fall faster than any central bank can, or will, cut interest rates, and when earnings or, more ominously, expected earnings fall faster than interest rates, then stock prices plummet...
...I have used these words myself...
...Monetary policy is also disconcertingly complacent in view of the dangers facing the U.S...
...swoon alone wiped out nearly $80 billion worth of wealth, while the more general Nasdaq collapse has erased over $2.5 trillion in wealth...
...From 1959 through the end of 2000, investment growth accounted for 0.6 percentage points of an average 3.5 percent annual growth rate...
...consumption spending, which grew at an extraordinary 7.6 percent annual rate in the first quarter of 2000, slowed only to a still-respectable 2.8 percent annual rate in the fourth quarter...
...An insidious feature of a post-bubble period is the—at first—deceptively benign behavior of the real economy...
...It is the dangers inherent in making the transition from unusually good times to unusually bad times that need to be recognized...
...But we are probably moving toward an unusually intense recession...
...Since excess capacity resulting from accelerated, bubble-driven capital formation quickly becomes a problem after the bubble bursts, capital-spending growth slows...
...But that political cliche is not very reassuring in light of economic history...
...By May, most observers expect the Federal Reserve will have cut interest rates by 2 percentage points, from 6.5 to 4.5 percent, or by about 30 percent...
...Normally, investment growth accounts for about one-sixth of the total growth of the economy...
...Subtracted from the underlying average growth rate of 3.5 to 4 percent, this means negative growth in the region of 1 to 1.5 percent is highly plausible...
...equity market losses over the past year have totaled over $4.5 trillion...
...household wealth from all sources...
...The end comes, as it has during the past year in the United States, when extraordinary events like expected, unfailing growth of 25 to 30 percent per annum have come to be seen as ordinary...
...Today, as the U.S...
...Fed chairman Alan Greenspan's advocacy of a destabilizing fiscal measure that raises tax rates in a recession—the debt trigger mechanism—only reinforces the misplaced leaning toward restrictive fiscal policy at a time when stimulative measures are needed...
...the growth slowdown could easily be longer and deeper than many have been willing to admit...
...The central bank consoles itself with similar notions of the therapeutic benefit of a slowdown in capital spending...
...Both times, depression resulted...
...Consumption growth slows, then turns negative, and stock prices of more companies fall because weaker demand erases those companies' pricing power and, with it, their prospective profits...
...The linkage between financial markets and the real economy is a basic and enduring theme of macroeconomics...
...In 1962, a Democratic president, John F. Kennedy, proposed tax rate cuts equal to more than 2 percent of GDP to stimulate economic growth...
...That perception makes investors view as unremarkable the purchase of equities at prices 200 times current earnings, or at more than 10 times the normal price-earnings multiple...
...The nightmare of a vicious circle of falling prices, employment, and output has settled over Japan like an invisible cloud of poison gas...
...There have been two instances in the past century in which a stock market collapse followed an investment-led boom—in the United States after 1929 and in Japan after 1990...
...Why, precisely, do we think that can't happen here...
...Such pricing cannot be sustained...
...The 5 percent annual growth rate at the beginning of 2000 became a 1 percent annual growth rate by the fourth quarter of 2000, with an unusually large portion of that slowdown attributable to a slowdown in investment growth...
...In 2001 the negative pressures on the U.S...
...In truth, the prosperity of the 1990s caused the debt paydown...
...A longer version of this article appears as the April 2001 AEI "Economic Outlook...
...That wealth loss amounts to about 60 percent of a year's household disposable income and over 12 percent of total U.S...
...But history offers no such consolation...
...Demand falls further, and deflation sets in...
...That, however, seems highly implausible, and indeed a look at past data suggests that in recessions, saving out of income plus capital gains falls to 5 percent of disposable income, or about a third of the normal rate...
...The resulting "firming" of the economy together with the growth of wages and employment contributed to an environment that kept the Federal Reserve from lower interest rates rapidly enough...
...economy was entering an expansion, but Kennedy wanted tax reform and sustained economic stimulus from a better-designed tax system...
...A failure to do so would only reinforce the uncanny tendency toward depression after equity market bubbles have burst...
...But with zero capital gains, even a 5 percent increase in savings would mean lowering consumption by $350 billion...
...In January of this year, retail sales surged by 1.3 percent, enough for an annual growth rate above 15 percent...
...The euphoria finally becomes unsustainable, and the stock prices of the new companies collapse...
...Spending will remain depressed for some time as the realization sinks in that the acquisition of wealth requires some saving out of income and not simply the acquisition of "hot" stocks whose value seems to rise inexorably...
...Indeed, many commentators, especially those eager to sustain flows into stock market investments, suggest that the slowdown in capital spending is a healthy sign of the economy's ability to regulate itself...
...Not only have Yahoo!'s profits failed to grow, they have collapsed—virtually to zero in 2001 with a hoped-for rebound to $60 million in 2002— down sharply from earnings of nearly $300 million in 2000...
...A sharp drop in consumption is in fact likely...
...Holding the Federal Funds rate at a still-restrictive 5 percent (even after a reduction of 0.5 percent on March 20) will unnecessarily prolong economic weakness...
...But the extraordinary investment surge that characterizes an investment-led boom carries the seeds of its own destruction...
...Indeed, U.S...
...He did this at a time when the ratio of publicly held debt to GDP was 44 percent and the deficit was higher than 1 percent of GDP...
...economy over the coming months turns fiscal policy debate from the current dangerous quarrel about whether tax cuts are too large into a healthy contest between Republicans and Democrats to determine who can cut taxes by the larger amount...
...Taken together, U.S...
...That's a very nasty recession...
...The initial reaction of markets is to embrace the idea that this slowdown can be remedied quickly with lower interest rates...
...If there are no capital gains this year, Americans could maintain their recent rate of wealth accumulation only with severely lowered consumption—a full trillion dollars less to achieve savings equal to 15 percent of disposable income...
...With after-tax disposable income now equal to about $7 trillion, the 15 percent rule means we should expect to see $1.05 trillion in savings, composed partially of capital gains and partially of savings out of income...
...Although consumption slows, it does not collapse in an environment identified as a beneficial correction...
...American households, which collectively at the end of last year had lost more than $4 trillion on their equity holdings, spent the month of January splurging on automobiles, furniture, appliances, and clothing and paying by credit...
...We are not moving—and need not move—inexorably in that direction...
...Indeed, U.S...
...However, during the twelve quarters ending in the first quarter of 2000—the peak of the investment boom—investment spending accounted for 1.5 percentage points of the 4.6 percent overall growth rate, or nearly a third of all growth...
...The U.S...
...The decline in stocks becomes the major transmission mechanism running from financial markets to the real economy...
...Sound familiar...
...So the Fed is left looking powerless, cutting interest rates aggressively, but failing to stabilize equity prices...
...Policymakers therefore need to rouse themselves from a state of complacency about the need for stimulative measures...
...The bursting of an equity market bubble can readily lead to a prolonged collapse of the real economy...
...Although reductions in interest rates cannot eliminate the recession, they can cushion it...
...The linkage from wealth to savings and consumption suggests that households will spend less and save more of their incomes in an attempt partially to compensate for the severe damage to their balance sheets...
...That $350 billion is 3.5 percent of GDP In other words, the drop in consumption during 2001 could subtract 3.5 percentage points from the nation's economic growth...
...The focus of a post-bubble growth slowdown on investment spending creates a dangerous complacency among both investors and policymakers...
...Since Yahoo!'s share price surged because of an expected perpetual acceleration of earnings growth, the reality of a sharp deceleration in earnings growth has brought the stock from a high of about $240 per share early in 2000 to $17 on March 9, the first anniversary of the 5000-level peak of the Nasdaq...
...That would be a large move by historical standards, but not enough to stabilize equity prices...
...In a depression, the central bank discovers (to its horror) that stock prices, not interest rates, are in the saddle...
...Tax rate reductions are an even better investment in 2001 than they were in 1962...
...The Nasdaq itself, with its collection of dot-com and technology stocks, fell by 60 percent, from 5000 to 2000, from its March 2000 peak to March 2001, and has declined another 15 percent in the past month...
...Since consumption is two-thirds of total spending, it is easy to pin hopes on the notion that lower interest rates will support consumption and overall spending growth...
...Given the huge losses Americans have suffered in the stock market, the outlook for consumption growth is bleak...
...It is worth noting that although the Kennedy tax cuts were not enacted until February 26, 1964, three months after the assassination of the president, they helped to sustain three years of noninflationary growth averaging 6.6 percent from 1964 through 1966...
Vol. 6 • April 2001 • No. 30
