BILLIONS OF DOLLARS AT ANNUAL RATES
Business Change Net
Fixed in Exports Gvt. Natl. Capacity
Period Real GDP Consumption Investment Inventories Purchases Defense Inflation Unemp. Utiliz. FF Rate
1998:I 8,396.3 5,576.3 1,099.5 113.1 -180.8 1,456.1 332.0 1.1 4.6 5.5
II 8,442.9 5,660.2 1,132.3 42.0 -223.1 1,482.6 342.0 1.0 4.4 5.5
III 8,528.5 5,713.7 1,136.6 71.8 -241.2 1,489.9 346.5 1.4 4.5 5.5
IV 8,667.9 5,784.7 1,175.4 80.0 -239.2 1,504.8 345.8 1.1 4.4 4.9
1999:I 8,733.5 5,854.0 1,192.6 83.4 -283.0 1,512.3 342.7 1.8 4.3 81.0 4.7
II 8,771.2 5,936.1 1,214.9 32.7 -313.4 1,516.8 339.7 1.3 4.3 81.0 4.7
III 8,871.5 6,000.0 1,244.6 39.6 -333.3 1,533.2 350.0 1.4 4.2 81.3 5.1
IV 9,049.9 6,083.6 1,262.4 92.7 -337.8 1,564.8 361.9 1.6 4.1 81.6 5.3
2000:I 9,102.5 6,171.7 1,309.4 28.9 -371.1 1,560.4 342.3 3.9 4.1 82.0 5.7
II 9,229.4 6,226.3 1,347.7 78.9 -392.8 1,577.2 354.8 2.2 3.9 82.6 6.3
III 9,260.1 6,292.1 1,371.1 51.7 -411.2 1,570.0 345.1 1.8 4.0 82.4 6.5
IV 9,303.9 6,341.1 1,374.5 42.8 -421.1 1,582.8 353.8 1.9 4.0 81.3 6.5
2001:I 9,334.5 6,388.5 1,373.9 -27.1 -404.5 1,603.4 360.3 3.3 4.2 79.2 5.6
II 9,338.4 6,427.5 1,320.6 -38.4 -410.5 1,624.5 362.3 2.2 4.5 77.9 4.3
III 4.9* 76.2* 3.0*
As of August, 2001, economic observers were saying that the U.S. economic downturn might well be over. The consensus forecast was that U.S. real GDP in 2001 would grow by 1.6% (and see unemployment rise by 0.5-1.0%) and in 2002 would grow by 2.9% (with unemployment either stable or rising by a few tenths of one percent) before resuming faster growth in 2003. The weak spot in the world economy was Japan--expected to remain in recession for most of 2001. There was more concern about Europe, where central banks have been unwilling to lower interest rates out of a fear that it might further depress the euro, than about the United States. Four percent per year real GDP growth throughout 1999 and 2000 and 1.8% average real GDP growth in the first half of 2001 lent increased confidence to the belief that the boost in productivity growth in the second half of the 1990s was not a cyclical but a structural phenomenon: a "new economy" that could be expected to continue.
All this, of course, changed on September 11. Those who say that September 11 was like an earthquake or a hurricane--a disastrous reduction in national wealth, but a reduction followed rapidly by a boom in employment and income--are wrong. The main thing that happened on September 11 wasn't that a large chunk of lower Manhattan got blown up. The main thing was that the future became much more uncertain. And when the environment becomes much more uncertain, the rational way to respond is to postpone actions that cannot easily be undone and to gather more information--or simply wait until more information becomes available--until you can make better decisions.2
thus as far as business investment is concerned, September 11 has been followed by a "blanket of hesitation" in which everyone who can postpones whatever pieces of investment they can in the hope that uncertainty will be resolved--such a "blanket of hesitation" played a key role in 1929 and 1930, when the uncertainty generated by the October 1929 stock market crash and the subsequent postponement of business investment played a key role in launching the Great Depression. Louis Uchitelle reported yesterday that 53 percent of firms say that they will cut their investment spending in response to September 11.
As far as consumer spending is concerned, consumers were already spending at a pace out of whack with their incomes--in part because of the extraordinary gains in asset values in the second half of the 1990s, gains that were curbed but not eliminated by the NASDAQ crash. Now coupled to this feeling that consumption spending had to decline sometime, we also have the sharp fall in consumer confidence--a fall of a magnitude that, if not reversed, standard rules of thumb suggest could take consumption spending down far enough to push unemployment up by a percentage point or more.
There's nothing elsewhere in the spending flow to offset these likely declines in investment and consumption spending. Exports pick up only twelve to twenty-four months after the value of the currency has declined--and the value of the dollar has not declined yet. There was--as of September 11--no big increase in government purchases in the pipeline.
So that if government policies continued on autopilot--if the pattern of interest rates, tax laws, and government spending continued unchanged from what had been planned before September 11--we would have changed our expectations from expecting unemployment to top out at 5% or so in the middle of next year to an unemployment rate of 6%-7%, if not higher as the large shocks to spending trigger positive-feedback loops in the economy, as they sometimes do.
But the government is not going to sit there like a potted plant: the U.S. government is going to take steps:
--Monetary policy: The first line of defense against an economic slump is monetary policy: cutting interest rates. Lower interest rates are supposed to persuade businesses and consumers to borrow and spend, which creates new jobs, which encourages people to spend even more, and so on. Interest-rate cuts have pulled the United States out of each of its big recessions over the past 30 years -- in 1975, 1982 and 1991. But the problem now is that interest rates are already low--the shortest-term ones are at 3 percent, after all, and they can't fall below zero. Is there enough room left for monetary policy to work effectively? And does cutting the cost of borrowing boost business equipment purchases and construction spending when the main source of the downturn is a feeling that one needs to gather more information?
Moreover, monetary policy works with long and variable lags. Whatever the Federal Reserve does this fall will not affect the state of production and employment until next summer.
--Fiscal policy: To do much good in terms of boosting demand, government spending needs to take effect next summer, which means that it needs to be planned now. As the mandarins of the British Treasury wrote to themselves in the early 1930s, the key argument--"the one gilt-edged argument" against the use of fiscal policy "is the delay involved" in ramping up spending plans. Unless we see extremely rapid motion on the part of the White House and Congress, proposals for a stimulus package will turn out to have an impact on the economy in 2003 and 2004--but not in 2002. A $50 billion boost to military spending in fiscal 2002 and a $50 billion-a-year tax cut effective in the fourth quarter of calendar 2001 would be, at least in Alan Greenspan's and Robert Rubin's estimation, both the smallest shift in policy that would have any significant effect, and the latest a shift in policy could be and still have a significant effect.
Now there are optimists about production and employment--people who say that wars are a source of inflation, not depression. But wars are a source of inflation and high employment when governments sacrifice everything else to the task of acquiring the resources to fight the war, and spend money like water. That doesn't look like the kind of war we are entering into--at least, not unless a bunch of mobilization and military spending plans are rolled out of the Pentagon in the next two weeks.
What are other governments going to do? The confidence shock has hit their countries' investment spending as well. But neither we nor they nor anyone else knows how big the shock will turn out to be. However, looking at Europe and Japan over the past decade gives one no confidence at all in the ability of their economic policy establishments to respond to changed circumstances. In Europe today, monetary policy is frozen because of inflation fears, devaluation fears and the need to prepare a dignified entry of the hand-to-hand currency in January. Fiscal policy is trapped by the Maastricht Treaty. And there is little political support for "restructuring." In Japan it is hard to see exports booming as the U.S. enters a full-fledged recession, the Bank of Japan has already done everything that monetary policy can do--has pushed interest rates down to zero--and there is little prospect of extra spending coming out of the Japanese Treasury. People in japan seem to be excited about Koizumi's reforms, but it is hard to figure out what they will be. Before September 11 the forecast was for a decline in Japanese real GDP this year and for less than 1% growth next year. It is hard to believe that the slow-moving Japanese government will be able to offset whatever additional downward pressure on production is generated by the unknown magnitude of the confidence shock that has hit since September 11...
Value of the dollar...
And Japan's woes have not only made us aware that depression-type economic problems can occur in the modern world, they have also led to a much better understanding about how to fight them. Without the example of Japan, economic thinking in the 1990's might have been entirely focused on the problems of prosperity. Questions like the causes of slumps and the options for dealing with them would have been a musty field, attracting the attention of only a few economic historians. Instead these questions have been a subject of intense debate, attracting the attention of some of the world's leading economists. (Full disclosure: I've been working on the Japan problem for several years. But the economists I actually have in mind are people like Lars E.O. Svensson, the Swedish macroeconomist, who has produced the most fully worked-out proposal for Japanese recovery.) And this debate has offered some fresh approaches to the problem.
Not long ago, the two lines of defense against slump that I described earlier -- interest-rate cuts and deficit spending -- were pretty much it as far as economists were concerned. They seemed to be enough: interest cuts had ended every postwar recession, and deficit spending on a grand scale -- that is, World War II -- had ended the Great Depression. On the other hand, if they should turn out not to be enough, economists had few ideas about what might come next.
Now, however, it is widely understood that even if both conventional lines of defense fail, there is still a lot that you can do -- as long as you are willing to abandon conventional notions of prudence. For example, normal practice forbids central banks to invest in anything other than short-term government debt, for fear that decisions about what to invest in will become politicized. And since the short-term interest rate in Japan is already zero, there is nothing more that the Bank of Japan can do within the limits of normal practice. But given the economy's grave state, why not go beyond those limits?
For example, why not buy long-term government debt, which does not yet have a zero interest rate and therefore offers some additional traction? Or the Bank of Japan could print yen and use them to buy dollars; this would push the yen down, making Japanese exports more competitive on world markets.
Some economists have also suggested that an economy in Japan's situation can bootstrap itself back to prosperity through ''inflation targeting.'' This means announcing publicly that you intend to push the economy into a state of persistent mild inflation, say at 2.5 percent per year, and that you will do whatever is necessary to achieve that end. If the announcement is credible, potential borrowers will be more likely to take a chance, believing that they will be able to repay their loans more easily, and consumers will have second thoughts about hoarding cash.
Such radical ideas were branded as irresponsible when they first came out but have since become respectable, almost mainstream. And that means that if the worst comes to pass, if the United States economy starts to show signs of the Japan syndrome, we won't be at a loss for ideas about what to do. Admittedly, it would be nice if Japan had actually tried any of these proposals and reassuring if they had been tried and worked. Alas, despite growing support within Japan, they have not been tried. The reason, I think, is fear -- fear of the unknown, fear of trying anything that might fail.
Fear of the unknown was presumably behind a bizarre recent outburst from Japan's finance minister. Earlier this year Junichiro Koizumi, a maverick and reformer who is intensely disliked by political insiders, was nonetheless chosen as prime minister by the ruling party in response to public pressure. Koizumi has promised that he will fix the economy. Koizumi is pushing ''structural reform'' -- measures like forcing banks to own up to their bad loans -- that will be good for Japan in the long run but will actually depress the economy in the near future.
But there was hope that he would also press for unconventional monetary actions -- and some of his advisers have expressed support for such policies. They have been undercut, however, by the finance minister, Masajuro Shiokawa, who declared that this would ''cause runaway inflation and send the economy spinning out of control.'' This at a time when the economy is already spinning out of control and is threatened with runaway deflation. Perhaps Shiokawa is still traumatized by the wartime inflation of his youth.
Meanwhile, the Bank of Japan, which directly controls monetary policy, has refused to do anything unconventional; incredibly, it refused to make any major changes in policy even after the terrorist attacks. This refusal, I believe, is rooted in a pettier kind of fear. After all, if the Bank of Japan were to engage in unconventional monetary policy, it might fail. It would be very embarrassing. It's far safer to declare that your institution has done all it can and that it's up to somebody else to find a way to make the economy recover.
Let's hope that in a similar situation, our policy makers would be bolder and more responsible.
It's worth remembering that wars usually stimulate rather than depress economies; the main economic danger from war is inflation, not deflation. True, we are not at war in the traditional sense; the analogy with Pearl Harbor is a very bad one in many ways. Still, it wouldn't be that strange if the terror attack turns out to be a short-run plus for the economy.
Yet one can't dismiss the possibility that this time will be different, that the terror attack will have a persistent negative effect. Or, alternatively, that the positive effects will be too weak to offset the bad things that were already in train. How bad could it get?
Stopping a Slump
Before the terrorist attack, my great concern was that Alan Greenspan would run out of ammunition. Having seen him reduce the overnight interest rate from 6.5 percent to 3.5 percent since January without stopping the economy's slide, I envisioned him completing the process by reducing the rate all the way to zero without doing any better.
After the attack my great concern is exactly the same. The overnight rate is now down to 3 percent, which leaves only another 3 percent to go. Will it be enough? How much are we like Japan, anyway?
Here one can offer some slightly reassuring comparisons. Both Japan and the United States had stock market bubbles, and they were of roughly equal size: between 1985 and 1989 the Nikkei, Japan's main stock index, tripled; between 1995 and 2000 the S.&P. 500 did the same. But Japan also had an equally large bubble in real estate and land prices. I've never known whether to believe the famous factoid that the land under the Imperial Palace in Tokyo was worth more than all of California, but Japanese land prices certainly reached ridiculous levels. And much of the bad debt that still troubles Japan was run up to support real estate speculation. We had nothing comparable in this country.
Moreover, the United States has a marked advantage when it comes to demography. Japan's persistent economic problem is that consumers want to save more than businesses want to invest. One important reason for that, many analysts agree, is the combination of a low birth rate and a refusal to allow large-scale immigration. An aging population tends to save a lot in preparation for retirement, and it's hard to get businesses to invest all those savings when they know that the working-age population will be shrinking for decades to come. We have problems with an aging population here, too. But they are nowhere near as severe, and our working-age population is still growing steadily.
In one way, however, our situation is actually worse than Japan's. For the past decade, Japan has been an island of depression in a sea of prosperity, its economy stagnating even as other major economies -- ours in particular -- boomed. That was, you might say, quite an achievement. Our current problems, on the other hand, are shared by much of the world -- not least by Japan itself.
In fact, Japan, which remains, despite all its problems, the world's second-largest economy and one of our biggest trading partners, has lately seemed to be on the verge of even deeper trouble: its slow-motion depression seems to be going into fast forward.
In the second quarter of 2001, Japan's economy shrank at an annual rate of more than 3 percent. Indeed, almost all observers believe that Japan was in a severe recession even before the terrorists struck. Aggravating the problem is accelerating deflation: the best measure of Japanese prices, the G.D.P. deflator, has been falling at an annual rate of 2 percent. Deflation adds to the economy's problems, because it gives people an incentive to hoard cash instead of spending.
If you think about this a bit, the story gets even worse. After all, prices are falling because the economy is depressed; now we've just learned that the economy is depressed because prices are falling. That sets the stage for the return of another monster we haven't seen since the 1930's, a ''deflationary spiral,'' in which falling prices and a slumping economy feed on each other, plunging the economy into the abyss. It's pretty scary stuff, not just for Japan but for the rest of us. If Japan slides into the abyss, that will have a direct adverse effect on our economy dwarfing anything the terrorists did.
Yet lately we seem to be living in a world full of dark clouds with potential silver linings -- and this one is no exception. The upside to Japan's troubles is that they leave us forewarned and to some extent forearmed. Think of it this way: without Japan's dismal example, economic officials in the United States might blithely dismiss the risks in our current situation, cheerfully proclaiming that prosperity is just around the corner. That, after all, is what Japanese officials did in the early stages of their slump. They didn't know that what did happen, could happen. We do.
BASIC MACROECONOMIC DATA: BILLIONS OF CHAINED 1996 DOLLARS AT ANNUAL RATES
Business Change Net Unem- Federal
Fixed in Exports Gvt. Natl. ploy- Capacity Funds
Period Real GDP Consumption Investment Inventories Purchases Defense Inflation ment Utiliz. Rate
------ ------- ------- ------- ----- ------ ------- ----- --- --- ---- ---
1998:I 8,396.3 5,576.3 1,099.5 113.1 -180.8 1,456.1 332.0 1.1 4.6 5.5
II 8,442.9 5,660.2 1,132.3 42.0 -223.1 1,482.6 342.0 1.0 4.4 5.5
III 8,528.5 5,713.7 1,136.6 71.8 -241.2 1,489.9 346.5 1.4 4.5 5.5
IV 8,667.9 5,784.7 1,175.4 80.0 -239.2 1,504.8 345.8 1.1 4.4 4.9
1999:I 8,733.5 5,854.0 1,192.6 83.4 -283.0 1,512.3 342.7 1.8 4.3 81.0 4.7
II 8,771.2 5,936.1 1,214.9 32.7 -313.4 1,516.8 339.7 1.3 4.3 81.0 4.7
III 8,871.5 6,000.0 1,244.6 39.6 -333.3 1,533.2 350.0 1.4 4.2 81.3 5.1
IV 9,049.9 6,083.6 1,262.4 92.7 -337.8 1,564.8 361.9 1.6 4.1 81.6 5.3
2000:I 9,102.5 6,171.7 1,309.4 28.9 -371.1 1,560.4 342.3 3.9 4.1 82.0 5.7
II 9,229.4 6,226.3 1,347.7 78.9 -392.8 1,577.2 354.8 2.2 3.9 82.6 6.3
III 9,260.1 6,292.1 1,371.1 51.7 -411.2 1,570.0 345.1 1.8 4.0 82.4 6.5
IV 9,303.9 6,341.1 1,374.5 42.8 -421.1 1,582.8 353.8 1.9 4.0 81.3 6.5
2001:I 9,334.5 6,388.5 1,373.9 -27.1 -404.5 1,603.4 360.3 3.3 4.2 79.2 5.6
II 9,338.4 6,427.5 1,320.6 -38.4 -410.5 1,624.5 362.3 2.2 4.5 77.9 4.3
III 4.9* 76.2* 3.0*
*Estimate
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) In the fourth quarter of 1998, the Federal Reserve cut short-term interest rates substantially out of fear that the economy was sliding into recession. The default of Russia on its foreign debt, the sharp rise in interest rate risk premia, and the spectacular bankruptcy of Long Term Capital Management led everyone to fear that businesses were about to cut back on their baseline investment spending.
If this were to happen--and if interest rates were to remain the same--the fall in investment spending would feed through into the multiplier process. It would reduce consumption spending as well. The fall in investment would trigger an amplified reduction in the equilibrium level of aggregate demand for each possible value of the interest rate.
Such a fall in aggregate demand would be a leftward shift in the position of the IS curve. Unless the government did something to boost investment and move the economy down and to the right along the IS curve, the result of this inward shift would be reduced production, increased unemployment, and an economy in recession.
Hence over the fall of 1998 the Federal Reserve decided to cut its target for the nominal short-term overnight federal funds annual interest rate by three-quarters of a percentage point. Even if baseline investment spending did fall, the reduction in the interest rate should offset or moderate the fall in production. The Federal Reserve's shift in policy was substantial. In combination with then-rising inflation, the short-term real safe annual interest rate fell from 4.5% in the first half of 1998 to 3.2% in the first half of 1999.
The Federal Reserve's shift in policy was successful. As baseline investment spending was slowed in early 1999 by the financial disturbances of late 1998, real GDP growth slowed to a rate of 2.4 percent per year in the first half of 1999. But then, as the effects of the interest rate increases at the end of 1998 made themselves felt in the economy, investment picked up and real GDP growth accelerated to 6.5 percent per year in the second half of 1999.
By the end of 1999 the Federal Reserve was no longer worried about falling investment, rising unemployment, and recession. Instead, it was worried about a stock market boom causing overexuberance, and rises in capacity utilization and falls in unemployment to points at which rapidly accelerating inflation would become inescapable...
For the next year and a half the Federal Reserve engaged in a slow process of raising interest rates. In part this was because inflation was drifting upwards: thus nominal interest rates had to rise in order to keep real interest rates constant. In part this was because of a fear that the continuing rapid runup in stock prices might lead investment to rise further, and push capacity utilization into a region in which inflation would begin rising rapidly. In part this was because of a fear that the economy was already operating at an unsustainably high--and inflationary--level of capacity utilization and an unsustainably low--and inflationary--level of unemployment, and that only good luck had kept inflation from rising rapidly in the second half of the 1990s.
The high and growing baseline willingness of businesses to invest shifted the IS curve outward from its fall 1998 position. If the Federal Reserve wished to reduce the changes of an increase in inflation, higher interest rates were needed to moderate the effect of the outward shift in the IS curve on the level of real GDP relative to potential output.
In the second quarter of 2000, however, the high tech-heavy NASDAQ stock index crashed. By the fall of 2000 it became clear that investment had stopped rising. Real GDP growth had averaged 4.3% per year from 1997 to 1999, and was running at an annual rate of 4.0% in the first half of 2000. The second half of 2000, however, showed real GDP growth slow to an annual rate of 1.5%. The same factors that had induced the NASDAQ crash had reduced the baseline willingness of businesses to invest. Reduced baseline investment was shifting the IS curve inward, to the left. In order to avoid a recession and a substantial rise in unemployment, the Federal Reserve had to react to this inward shift in the IS curve by lowering real interest rates to stimulate investment and offset the decline in businesses' baseline willingness to invest.
As of August, 2001, economic observers were saying that the U.S. economic downturn might well be over. The consensus forecast was that U.S. real GDP in 2001 would grow by 1.6% (and see unemployment rise by 0.5-1.0%) and in 2002 would grow by 2.9% (with unemployment either stable or rising by a few tenths of one percent) before resuming faster growth in 2003. The weak spot in the world economy was Japan--expected to remain in recession for most of 2001. Nearly four percent per year real GDP growth throughout 1999 and 2000 and 1.8% average real GDP growth in the first half of 2001 lent increased confidence to the belief that the boost in productivity growth in the second half of the 1990s was not a cyclical but a structural phenomenon: a "new economy" that could be expected to continue.
Then came the terror attack on the World Trade Center on September 11, 2001...
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