CAMBRIDGE: America’s economy is entering a risky phase. The conditions that underpinned its long boom are weakening. It is a fool’s game to try to predict changes in public sentiments. Nonetheless, good economic reasoning can help us to anticipate the economic turbulence ahead.
The US boom has been a mix of reality and wishful thinking. The reality is that technological advancement, combined with flexible and dynamic labor and capital markets, led to a rapid rise in productivity growth and the spread of new technologies. Lives in the US changed remarkably for the better recently, with improvements in the service economy, new medical technologies, access to information, and the like.
Wishful thinking transformed economic gains into visions of easy wealth. The New Economy – which is real – became the “invincible” economy where risks are discounted, stocks always rise, world economic conditions are always beneficial, and budget surpluses continue forever. Optimism manifested itself in two ways. First, American stock markets rose giddily – adding $8 trillion in paper wealth to owners of US equities in a five-year period. Second, American consumers increased spending as a result of their paper wealth, reducing or eliminating their savings from income because their stock market wealth would protect them in the future.
The combination of large business investments in new technologies, combined with high levels of consumer spending, fueled a spending boom. For every dollar of income produced in America, spending by consumers, businesses, and the government now equals one dollar and four cents. The extra four cents per dollar is paid for, in essence, by borrowing from abroad. Foreigners have been keen on buying US stocks and bonds, while American businesses and households used that capital to support their investment and spending.
All of this will work out fine if the rosy scenarios continue. The problem is that many contrary economic signals are now appearing. Suddenly, doubts have arisen, and the cumulative effect of them could to turn a boom into slowdown, or even into recession.
The first doubt is about the stock market. Euphoric investors acted as if profits would continue to grow at unprecedented rates. Recently, profits have not cooperated. As forecasts of profitability drooped, the stock market declined. The easy wealth of recent years has become less easy. Nobody is panicking yet, but nobody can rule out more declines.
The second doubt concerns the world economy. Soaring oil prices will cut corporate profits and household purchasing power. Interest rates in the US might be raised to head off the inflationary effects of higher oil prices. Violence in the Middle East makes matters worse.
The third doubt is about US economic management. While nobody can predict the outcome of the presidential election, we can be certain that a new, untested Administration will take over in January. George W. Bush’s proposals for a massive tax cut are risky – gambling on large future budget surpluses that might never appear, and gambling that a sharp tax cut won’t trigger a jump in interest rates. A Gore Administration would have more continuity with present policies, but first-year Administrations always create uncertainties and anxieties, and many of Gore’s spending proposals will create uncertainties about future budget prospects.
The great economist John Maynard Keynes taught that changes in market sentiments – which he called “animal spirits” – have a life of their own; that swings in sentiment could swing an economy. Optimism turns to euphoria turns to pessimism turns to panic. America has had its share of euphoria; pessimism is now setting in. Panic is by no means assured, but cannot be ruled out. What would happen if more shocks undermine the confidence that fueled America’s boom?
Suppose oil prices remain high, profit forecasts continue to fall, and the new Administration unsettles the markets. Stock prices would fall; interest rates would rise; budget surplus projections would be cut. Trillions of dollars of paper wealth already factored into spending decisions by households, firms, and government would disappear. Households would cut spending, and investors would reduce their American holdings, driving the dollar down against the Euro and other currencies. American politics would dramatically heat up, with a fierce debate over priorities. This would incite even more economic uncertainties.
Depending on how rapidly and deeply such a swing occurs, America could merely slow down (the so-called “soft landing”), or fall into recession (the increasingly feared “hard landing”). Normally, a cutback in optimism reduces interest rates, helping sustain investment and consumer spending. But here, who knows? The Federal Reserve might keep interest rates high to fight the inflationary consequences of high oil prices. Or interest rates might remain high because of increased uncertainties about the size of future budget surpluses, or the risks of large tax cuts.
For the rest of the world, economic maneuvering would be tricky. For many economies, exports to America would slow, and growth would depend either on finding new markets (say, increased sales in Europe and Japan if those economies picked up), or on being able to increase domestic consumption and investment within those economies. If investors take money out of the US and park it in other markets, those economies would enjoy a boost of wealth and spending. No doubt, then, that the world could compensate for slower growth in US by faster growth abroad, but there is also no doubt that such transitions are hard to manage. This is especially true because financial systems in many countries have still not recovered from their own recent crises.
I am no pessimist, even less a doomsayer. Events in the world economy are notoriously hard to predict. America’s economy could continue to charge ahead. More realistically, the combination of optimism and productivity growth that powered America’s boom looks likely to be less robust in the coming year.