The Bush Bust?

CAMBRIDGE: America’s long boom is at risk. Signs abound of an impending slowdown, even of recession. These dark clouds are gathering as transition from the Clinton to Bush Administrations gets belatedly underway.

The quality of economic management in the new Administration’s first year will set the course for many years to come. When President-elect Bush talks about using huge tax cuts to keep the economy humming, it is time to start worrying. Large tax cuts are a short-term “solution” that could do serious long-term damage.

Rapid growth and huge increases in stock market wealth are nowadays almost taken as a matter of fundamental right by many Americans. They can’t imagine the US economy slowing, or share prices falling and staying down. They have read too many phony analyses of the New Economy promising unbounded riches and full employment forever.

The problem with these New Economy prophecies is that a bit of truth is mixed with huge exaggerations. Yes, the New Economy is delivering big increases in US productivity; no, the New Economy has not ended economic slowdowns or recessions. Still, less does it guarantee that companies should have stock market prices set at several hundred times their annual earnings.

America looks set to enter into a slowdown driven by a slowdown in business investment. Undoubted advances in information technology led to an incredible restructuring of the American business sector, which re-wired itself to take advantage of electronic commerce and improved computer-based management, logistics, and communications systems.

The result was an astounding surge in business fixed investment in computers and other information technology hardware. Investments in information processing equipment and software rose by about 19% per year between 1993 and 1999, and in 1999 constituted about half of all US business equipment investment.

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This surge in business spending boosted overall demand. Indeed, it so greatly fueled American demand that total spending (consumption plus investment) actually grew much faster than production. The result is a trade deficit now standing at over $400 billion per year.

That trade deficit is financed by foreign investments in America, as savers the world over increase their holdings of US stocks and bonds. The IT boom also led to visions of a long-term growth miracle in America, which in turn led to unrealistic expectations about future profitability. High profit expectations, in turn, contributed to the unprecedented boom in the stock market between 1996 and 1999.

In short, real gains in productivity due to the New Economy became exaggerated in the public’s mind. Rapid growth is expected; a booming stock market taken for granted. Now the economy reflects the fact that these expectations are out of line with reality.

Business investment spending is slowing down, since firms have already stocked up on information technology systems and don’t need to replace or upgrade them for the moment. Profit expectations are falling to earth, as company after company announces disappointing sales and profits. The stock market has fallen big, by around half since March in the high-technology NASDAQ market.

Everybody counts on Alan Greenspan’s Federal Reserve Board to save the day, and there is little doubt that an interest rate cut would help maintain strength in consumer demand and housing construction. But there are reasons to doubt that such a cut will affect business investment, the part of demand likely to swing sharply in the coming years. Moreover, the Federal Reserve will be cautious in cutting interest rates when the dollar is falling, the economy is near full employment, and higher energy prices are working their way through the economy. The Fed’s ability to control the business cycle at this moment is modest, at best.

In steps the Bush Administration, facing a divided Congress and a cloud over its legitimacy. President-elect Bush talks about his $1.3 trillion tax cut proposal as an “insurance policy” against recession. What was portrayed during the election campaign as a long-term measure, however dubious, is now portrayed as the medicine needed to keep America’s economy growing in the short run.

Several things are wrong with this. First, prolonged debate over the tax cut proposal, virtually inevitable if the new President insists on it, will create huge uncertainties in financial markets and at the Federal Reserve Board. If America spends the spring debating an enormous tax cut, you can bet that business and investor confidence will continue to weaken.

Second, a large tax cut hampers the ability of the Fed to ease interest rates. Third, and most importantly, large tax cuts will undermine the solid fiscal conditions so crucial to America’s boom. A return to fiscal deficits, which could result from the combination of large tax breaks and a much slower-growing economy, would make the economy more vulnerable to shocks in coming years.

We have learned repeatedly that, in the face of a weakening economy, prudence works best. Desperate actions such as huge tax cuts, or huge cuts in interest rates, almost always fail. With prudent management, a slowdown will likely be short and mild. Countries who try to keep their economies growing too fast for too long, using drastic steps such as large tax cuts or highly expansionary monetary policies, frequently end up in a financial mess that takes years to clean up. President-elect Bush’s pronouncements display an unhealthy bias towards short-run macroeconomic meddling, rather than sound emphasis on the long term.

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