Evans On The Economy -- What Happened To The Recovery?

Dec. 21, 2004
Excess capacity, lack of new orders signal meager comeback.

It now seems likely that after the surprising 5.8% gain in real GDP in the first quarter, the economy will grow at only a 2% to 3% annual rate not only for the rest of this year, but for 2003 as well. The tax rebate last summer, which George W. Bush has championed, had only a temporary effect, just as was the case in 1975. Rebates only boost spending for a few months, and then something else has to kick in. If nothing else does, then the economy goes back into its old position. What usually kicks in? Sometimes the value of the dollar falls during recessions, because less foreign capital is attracted to the U.S., which boosts net exports for a while. Sometimes low interest rates provide an incentive for capital spending. Sometimes private-sector employment starts to rise, which boosts consumption. So if net exports, capital spending and employment all continue to decline, there doesn't seem to be any reason to expect the economy to grow very fast. According to traditional business-cycle theory, once the economy starts to decline, the Fed eases, and the government cuts taxes -- which boosts discretionary consumer spending and housing enough to entice businesses to start hiring people back, raising capital spending and boosting other purchases as well, which is enough to shift the economy into high gear. This year, however, Act I occurred right on schedule, but at least so far there has been no Act II. Business is not boosting spending for capital goods, employees or purchased services. Thus real growth will limp along at a 2% to 3% rate until business spending starts rising again because we are not going to have another tax cut, and we are not going to have more Fed easing. So when will business spending turn around? The short answer is, about two quarters after the stock market turns around. The fact that the stock market rebounded so strongly starting in October meant the recession was going to end sooner than most economists expected. By the same token, the fact that it has declined so much since the beginning of the year means there probably won't be any substantial gains in profits and business spending at least until near the end of this year and probably much later than that. It is always a good idea to be cautious about putting too much weight on any indicator for any one month, but the 3.0% drop in new orders for nondefense capital goods in March, which wiped out the gains in January and February, has to be considered a serious negative. Even the most die-hard economist will concede there won't be a boost in capital spending until new orders improve. Swings in capital spending have historically been tied to changes in bond yields rather than short-term interest rates. Often, a 4.75% drop in the Federal funds rate also would reduce bond yields appreciably. But that hasn't happened this time. Before the recession started, the AAA corporate bond yield was 6.9%, and currently it's 6.8%. Industrial production rebounded last quarter, but the rate of capacity utilization rose only to 73.9%; generally, capital spending does not start to improve until it returns to 80%, with an investment boom occurring around 85%. Some have suggested that the recently enacted 30% bonus depreciation for capital equipment purchased within the next three years will boost capital spending. My response is: Show Me The Orders. I'll become a believer if capital goods orders pick up, but the month after this legislation passed, orders fell. Based on the continuing overvalued dollar, which will stay above equilibrium even if it declines another 5% to 10%, and the unusually low levels of capacity utilization, I don't see any substantial gains in exports or capital spending this year, and probably not much improvement in 2003 either. That means two years of the economy limping along at about 2.5% growth. Robust growth is not expected to return until late 2003 or early 2004. Michael K. Evans is chief economist for American Economics Group, Washington, D.C., and president of the Evans Group, an economics consulting firm in Boca Raton, Fla.

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