The Economy -- Factoring In Sentiment

In the past the fate of the economy was tied closely to what happened to consumer durables and housing. Now, it seems, those two sectors are almost irrelevant. They have held their own while the rest of the economy has been weak. As a result of this dichotomy, monetary policy recently has played a much smaller role than in previous cycles. The two sectors that are the most directly affected by monetary policy, namely cars and housing, have not weakened. The high-tech sector, on the other hand, hardly depends on monetary policy at all, but probably will not start to recover for another year. This does not imply that monetary policy, if altered dramatically, would fail to have a substantial impact on the overall economy. Instead, it indicates that the changes in policy have actually been quite moderate. While the federal funds rate rose from 4.75% in November 1998 to 6.5% before falling back to 3.5%, these changes have been much less significant than in the past because long-term rates did not move nearly as much. On a quarterly average basis, the Aaa corporate bond rate rose from 6.3% to 7.6% at its recent peak, then declined only to 7%. Thus if only the credit-sensitive sectors are considered, the federal funds growth rate would have remained near 3%. It is not fashionable these days to quote John Maynard Keynes, the British economist of the 1930s, since his views on the economy are unalterably intertwined with the canard that the best way to boost economic growth is to increase government spending. Yet many of the concepts that Keynes introduced remain valid, particularly his insight that changes in capital spending are influenced as much by consumer sentiment and perceptions as they are by economic variables such as the cost and availability of credit, cash flow, output, and the rate of capacity utilization. I don't have a variable for sentiment in the models, and to the best of my knowledge neither does anyone else. That presumably is why economists and financial analysts, to say nothing of Bureau of Economic Analysis statisticians, missed the sharp downturn in capital spending that occurred in the first half of this year. Recently it has become commonplace to blame the go-go analysts of yesteryear for continuing to recommend stocks even as their prices were tumbling 70%, 80%, even 90%. One could easily argue that these analysts are incompetent or even dishonest, but while that makes interesting headlines from time to time, it misses the core of the issue: What caused this irrational exuberance, and now that it has disappeared, how will this affect the economy in the coming years? For if Keynes' comments are correct, the extended boom in capital spending that was unsupported by underlying economic factors might turn into a multiyear bust even as the factors that ordinarily influence capital spending turn bullish again. Maybe financial analysts ought to be smarter than the rest of us, but there is no evidence that that was true, or ever will be true in the future. In essence, they reported what they were told, which was that business was fantastic and would always be fantastic. The exuberance that propelled the economy to above-average growth rates was fueled by fantasies that shipments were the same as sales, and that 50%-plus growth rates could continue indefinitely. The major challenge facing forecasters at this juncture, then, is not to determine how much Fed Chairman Greenspan will change the federal funds rate, how much the overvalued dollar will hurt exports, or even the short-term impact of the tax rebate. It is to determine whether the noticeable sag in business sentiment will continue for several more quarters if not years, or whether the black cloud will dissipate by the end of the year and the economy will return to good health. For those who believe the former, the U.S. economy will go through another extended period of stagnation similar to 1979-1982, when real growth averaged only 0.9%, or 1990-93, when it averaged only 1.7%. Those who believe the latter expect that real growth will rebound to 4% next year and remain near that level for the next several years. A slightly less ebullient, although still fundamentally optimistic, forecast says that more moderate growth in the high-tech area will trim the long-term growth rate to 3.5%, still high enough to keep the economy near full employment, but not enough to spark another round of irrational exuberance. That is what I expect will happen. Michael K. Evans is chief economist for American Economics Group, Washington, and president of the Evans Group, an economics consulting firm in Boca Raton, Fla.