The Economy -- Balance Tipped Toward Recession

Dec. 21, 2004
Signs pointed downward even before the September tragedy.

The terrorist attack last month has driven the final nail into the coffin of the longest business-cycle expansion on record, and it is only a matter of time before the recent downturn will be officially labeled a recession. Real GDP is likely to show no growth at all this quarter, followed by two quarters of negative growth before rebounding sluggishly. In spite of the appropriate uplifting comments by political- and financial-community leaders, consumers and businesses will become even more cautious in their spending patterns for many months. Business spending, which had already fallen sharply, will be cut back further. At least for a while, both business and leisure air travel will be sharply curtailed. Few people will feel like celebrating anything. Yet even without this tragedy, the likelihood had recently increased that the U.S. economy was heading into recession. While there has never been a dictionary definition of recession, the most common rule of thumb is a decline in real GDP for two consecutive quarters. That always has been accompanied by a rise of at least 1.5% in the unemployment rate, and a drop of 5% or more in industrial production. The criterion of a two-quarter drop in real GDP is now close to being met. With the downward revision in second-quarter real growth to 0.2%, there is a 50-50 chance that figure eventually will be revised down below zero. The third quarter had been showing slightly more strength, but the cessation of much economic activity in September probably will cause real GDP to show no gain or even a slight decline this quarter. If real GDP is unchanged this quarter, real growth will have averaged 0.9% over the last five quarters. Based on previous historical patterns, a 0.9% growth rate would boost the unemployment rate by 0.25% per quarter, or a 1.25% rise over a five-quarter period. Taking into account the usual one-quarter lag, the unemployment rate would rise from 3.9% last September and October to 5.2% by the end of this year. For several months it has been obvious that corporate profits, capital spending, and business confidence have cratered, but my forecast had assumed that relatively strong consumer spending would keep the economy out of recession. Now that fragile confidence has been shattered by the terrorist attacks. Since an attack of this sort has never occurred before, no analogies are appropriate. Nonetheless, it may be useful to recall the sharp decline in consumer confidence and spending after the Iraqi invasion of Kuwait and before the U.S. and United Nations responses. If a similar decline were to occur this time, the recession would deepen and last another two or three quarters. Furthermore, recall that after the "great victory" in the Persian Gulf, real GDP rose at only an 1.8% rate for the rest of the year, with real consumer spending advancing at an even more anemic 1.1% rate. Indeed, real growth remained subpar for a year and a half after the Persian Gulf victory-in spite of unusually low interest rates, massive injections of liquidity into the economy by the Fed, and a 40% gain in the S&P 500 index. It is too early to speculate how much longer the recession will last. All along it has been clear that business spending-purchases of capital plant and equipment, more hiring, and discretionary purchases for business services-would start to pick up one quarter after profits began to improve. Previously the turnaround in profits was expected to start next quarter, which would have meant a return to above-average growth in the first quarter of 2002. The devastating blow to the airline, insurance, and financial services industries, plus increased caution in many other sectors, now suggests that the turnaround in profits is probably another two to four quarters away. It takes a long time to slow down the ship of state, but once that has happened, recent evidence indicates it takes a long time to start it up again. Now that the Rubicon has been crossed and the U.S. economy is in recession, the ensuing recovery is likely to be quite sluggish no matter what happens in the military arena. In particular, the economy will not recover until there has been a substantial stock market rally. Not only is a rising stock market an important determinant of consumer and business sentiment, but the economy will not turn around until signs of improved profits are visible-and these signs initially will be reflected in stock prices. The fact that the stock market had given up virtually all of its first-quarter gains in recent months stood as a negative signal even before the terrorist attacks, and those massacres now have tipped the economy into recession. Michael K. Evans is chief economist for American Economics Group, Washington, and president of the Evans Group, an economics consulting firm in Boca Raton, Florida.

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