vol. XV no. 2

				W A T C H   O U T   F O R   C E O   G L O O M     -- Rajeev Dhawan       Director of the Robinson College of Business       Economic Forecasting Center There are enough economic signals to proclaim this recession to be "virtually" over and for a recovery to have taken hold. I am using the word virtual to emphasize the fact that there was never a big drop in income production in this economy. Real GDP growth may have been in the positive territory in the last two quarters, but investment spending has been absent. Although the jokesters among economists have labeled this as a "recessionette," which seems to be a majority view, the pain has been felt clearly by workers; upward of 1.4 million jobs have been lost since last March. Every business cycle episode is different. However, this one is unique in one perspective, namely continued gains in productivity. This implies that firms can use the current labor to the utmost, i.e. crack the whip to increase output before going out to hire more people. This boosts profit margins as wage costs are kept in check by an easy labor market, leading to a buoyant stock market. At least this is what the theory implies. The problem is the lack of pricing power that has kept both revenues and profits low across the board. Technological advances are to blame for this situation too. They, along with the deregulation push of the last two decades, imply lower costs of entry into the market. We consumers benefited from the resultant competition, which led to lower prices but played havoc with the profit margins in a slowing economy. In this type of situation, cash flow is critical. Sun Microsystems CEO Scott McNealy summed this up beautifully in an interview with Bloomberg News when he said, "Cash is king in this era, and [firms are] all trying to do everything they can to handle their discretionary investments as carefully as possible." This CEO gloom is what is afflicting the economy right now, and it intensified after 9/11. It didn't help that Enron and Global Crossing went belly up at the same time, leading to "credit hesitancy" by lenders of every type. Commercial paper markets are spooked, and even GE, one of only eight triple A rated firms, has suffered sharp declines in the value of its debt. All this makes for a very cautious approach by executives who have to make decisions about growth and investment. And one macroeconomic fact beyond dispute is that investment today leads to growth tomorrow. So what will stop this cycle of pessimism? Simply put, time is the cure. Profit margins will be slow to recover, but recover they will. Durable goods orders are firming up, and consumer confidence is up sharply since the beginning of this year. Meanwhile, the draw-down of inventories is coming to an end. Producers will add to inventories in light of the new orders and low levels of stock. The subsequent recovery in industrial production, all else being equal, will increase household income and spending. Cash flows will recover by late summer, and that is when aggressive increases in capital budgeting and hiring will occur. In between, GDP growth will slow to a modest 2 percent in the second quarter but grow normally in the later part of the year. Inflation will rise moderately due to high oil prices, and the unemployment rate will hover around the 6 percent level until fall. But the real kick of the recovery comes in early 2003 when job growth returns to normal and the unemployment rate begins to fall in response. Greenspan & company will stay on the sidelines until recovery fully takes hold by late summer. They will first nudge the rates up mildly in fall. Although my Taylor rule calculations indicate that the funds rate should be in the 3.5% range given inflation and growth expectations in the next six months, the downside risks to the outlook are many. The current shaky profit situation will become even shakier if the conflicts in the Middle East and the Indian subcontinent turn into a full-fledged war. All these factors have the potential to derail the nascent recovery momentum and can even put us back in the red zone. Thus, Greenspan will be reluctant to raise rates sharply until early 2003. What about threats to recovery from the international front? Recently, the IMF asserted that the U.S. current account deficit could impede everyone¹s recovery in this increasingly global economy. The deficit is approaching the $500 billion mark and, at almost 5 percent of the GDP, could be a precursor to currency devaluation if one goes by the experience of Asian countries. Add to this worry list the poor health of the Japanese economy and its banking system, a suspect Asian sector and the recent implosion of Argentina, and you have a perfect recipe for staying awake at night. My viewpoint on the current account deficit is simple. The flip side of the current account deficit is capital inflows. This means that of the rest of the world is investing in the united States. Is this by choice or design? One argument is that the United States is the only locomotive of growth, and foreigners find it attractive to invest their savings here. The other argument is that our low savings rate coupled with higher propensity to consume foreign goods draws the capital in. Whatever the reason, foreign capital inflows keep the dollar strong. What if there is a run on the dollar? Would it be bad for the U.S. economy? The answer depends on why it happened. If it is for the fundamental reason that investment opportunities are better overseas, then the weakened dollar will help boost exports and thus the domestic economy as foreigners demand more U.S. goods when their own economies take off. What is lost in the asset sell-off by foreigners is gained on the export market. The constituencies that bear the costs and gains may turn out to be different, but the net cost to the economy may be zero. So when the Japanese sell off their U.S. treasury bonds, it is actually good news for the world economy. If the strong dollar is the result of a bubble, then we are left with this lesson from economic theory: You can neither predict when the bubble will start nor when it will end - or even what will cause it to end. All you can do is go along for the ride. And given our collective experience of riding the NASDAQ bubble, we are in good shape in that case! Top |

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