Feeble economy has experts in a quandary

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USA Today

Making sense of what is happening in the U.S. economy — in recession or not — has flummoxed everyone from Federal Reserve Chairman Alan Greenspan to Wal-Mart shoppers.

Economists, who rely on complex formulas to forecast the economy, are not only divided on where the economy is headed, but on how it got here in the first place. Fed officials say privately that it was 100 percent predictable the slowdown was going to be scary. What they didn't see was the speed of the braking and the dramatic impact it would have.

How did it happen? How did the economy mutate from strongest in a generation to feeblest in a decade?

Some say Greenspan and the other Fed policy-makers went too far in raising the target for short-term interest rates in March and May last year, that they should have started lowering short-term interest rates when the economy first showed signs of slowing last summer.

"I would give the Fed about 100 percent of the blame," economist Law-rence Kudlow said. "The Fed ignored very clear market signals that a significant downturn was unfolding. Their overkill is what we are feeling."

Others say fingering the Fed is too simplistic. If the Fed had been raising rates in isolation, without a stock market boom fueling consumer spending or oil rocketing to $35 a barrel, we probably wouldn't be worrying about a recession today. Trouble is, the Fed never works in isolation.

"I would put the Fed on the low end of the list," said Jim Glassman, economist at J.P. Morgan. "The real reason for the slowdown is that the economy exploded in the fourth quarter of 1999 and first quarter of 2000. People stockpiled. High-tech spending was enormous, and it made the economy feel like it was growing much faster than it actually was."

The fourth-quarter 1999 spending frenzy was stoked by fears among consumers and companies that the Y2K computer glitch would cause major disruptions in markets and supplies. The spending carried over into 2000, propelled by unbridled optimism that resulted in record retail sales and gravity-defying tech stock valuations. Soaring stock prices created a speculative bubble that was bound to burst.

"You can't really point to any one thing that caused the slowdown," said Tom Gallagher, managing director at International Strategy & Investment in Washington. "History says periods of technological innovation are accompanied by times of financial excess. We had that, and we're experiencing the fallout from it now."

Yet, this expansion has been remarkable for relatively tame inflation. Demand hasn't been crimped by high interest rates. It is crumbling because of weaker profits, falling share prices and lackluster investment.

"Greenspan is an easy target, but what caused this was the stock market bubble, not the Fed," said Jeff Osborn, one of the early dot-commers who made his fortune selling UUNet to WorldCom.

"The fingers should be directed at the people who piled into the stock market and high-tech without knowing what they were doing," he added. "This was an accident waiting to happen."

Optimists, such as Diane Swonk, economist at Bank One, expect the economy to pick up as soon as the second half of the year. Pessimists, such as Morgan Stanley's Stephen Roach, expect this is just the beginning of a deeper slowdown.

Then the finger-pointing would really begin.

Rising interest rates a factor, but not sole cause

The simplest explanation for the economic slump is that the Fed did it.

Worried that the economy and the stock market were both out of control, Federal Reserve policymakers raised interest rates six times beginning in June 1999 to cool things down. Typically for the Fed, the first five increases were quarter-point baby steps.

"What always happens is the Fed tries to be cautious," said David Wyss, chief economist for Standard & Poor's DRI. "But eventually they get frustrated because the economy just doesn't slow down."

The textbook says Fed increases in short-term rates ripple through the economy, slowing consumer spending and business expansion. But after 11 months of gradual tightening, the economy appeared to be shrugging off the Fed's moves, and the inflation officials feared seemed to be looming. In May 2000, egged on by nervous markets, the Fed raised rates a comparatively bold half-point.

Over the summer, the economy began to slow, and by year's end, it was looking as if the last half-point might have been too much.

New York economist Kudlow calls the Fed's last two rate increases "massive overtightening" and says policymakers further erred when they "ignored very clear market signals that a significant downturn was unfolding" and held rates steady.

But while many analysts think the Fed might have waited a little too long to begin cutting rates, few think the Fed's increases alone cracked the economy.

"In isolation, (the rate increases) wouldn't have been a problem," said Norbert Ore, who directs the National Association of Purchasing Management's monthly look at the factory sector.

But the rate increases didn't happen in isolation. Simultaneously, energy prices shot up, dealing the economy an extra blow that helped badly weaken it.

"High rates make the economy more vulnerable to shocks," said Louis Crandall, chief economist for Wrightson Associates.

Outlook: Economists expect more rate cuts, perhaps even before the next Fed meeting May 15. And while criticism of the Fed's timing continues, most analysts think the increases were unavoidable. "When you have bubbles, the economy has to pay a price," said Joel Naroff of Naroff Economic Advisors. "If it had gone on for another year, the collapse would have been much more catastrophic."

Overcapacity: Demand needs time to catch up

Typically in economic downturns, businesses wind up with too much stuff and too much of the machinery that makes the stuff. It wasn't supposed to be that way this time, because the Internet, just-in-time production and other New Economy techniques were supposed to smooth the boom-bust cycle.

But it didn't work as well as expected. As the economy slowed, manufacturers found themselves with too much inventory. Late last year, for example, automakers looking at acres of unsold cars sharply cut production. In the usual economic cycle, production cutbacks provoke layoffs, which wound consumer confidence and consumer spending, which can turn a downturn into a recession.

The good thing about inventory problems is that they can sometimes be fixed quickly. In the case of carmakers stuck with about a 100-day supply of cars and trucks last year, unexpectedly strong buying in the first quarter helped knock that down to a more manageable 60-day supply, according to David Wyss, chief economist for Standard & Poor's DRI. Now companies are talking about boosting production this spring.

But where the problem is likely to be more pernicious is in the tech sector, which accounted for about 30 percent of growth when consumers and businesses were snapping up computers and telecommunications equipment, even though it's only about 7 percent to 10 percent of the economy. Now consumers have scaled back their spending, and once tech-crazy companies have gone belly up or drastically curtailed capital investment.

Two years ago, tech demand looked as if it would expand infinitely. Susan Kalla, telecom analyst at Trade.com, said the result is a long-distance telephone service market that's the definition of "glut." For example, providers built huge nationwide telephone and data-transmission networks on the assumption that demand would soak it all up. It hasn't.

She estimated the long-distance system is running at only about 40 percent to 50 percent of capacity and that it will take a year or more for demand to begin to catch up.

Outlook: Optimists say demand for more bandwidth will eventually make today's oversupply look just right. "Of course, when you first put it in place, it's going to look like excess capacity," said James Glassman of J.P. Morgan.

Impact of rising energy prices took many people by surprise

One of the big economic miscalculations of the past year may have been underestimating the impact rising energy prices would have on the economy. In congressional testimony last year, Greenspan, the Federal Reserve chairman, dismissed suggestions that the high cost of oil and other fuels would crimp economic growth.

The conventional wisdom was that the United States was so much less dependent on oil than it was during the last energy crisis in the 1970s that the economy would be able to weather a blip in prices.

But the jump in oil prices wasn't fleeting. The Organization of Petroleum Exporting Countries surprised just about everyone by forging a unified front on oil production in 1999 and 2000. After years of cheating on production quotas, it stuck to the limits and oil prices, as a result, topped $35 a barrel.

At the same time, a strong global economy helped boost demand for energy. Prices for natural gas and heating oil began to climb. Consumers, socked by higher energy bills, cut back on discretionary spending.

Stephen Brown, director of energy economics at the Federal Reserve Bank of Dallas, said if oil prices had remained about $10 to $15 a barrel instead of $25 to $30, economic growth might be three-tenths to eight-tenths of a percentage point higher now. Higher energy prices also squeezed companies.

The economic boom had been fueled by firms spending profits on productivity-enhancing equipment. Increased energy costs ate into their ability to do that, Brown said.