The Economy -- Slower-Growth Scenario

Dec. 21, 2004
Pricing pressure and higher benefit costs to shrink profits.

Now that the Fed has engineered another soft landing while keeping inflation from accelerating, it is worth taking a look at some of the longer-run factors that are likely to influence the economy in the next four years. Here's my top-10 list: 1. Sluggish growth will prevail for the next several years, with real GDP rising an average of 2.5% to 3%, similar to what happened in the mid-1980s. I do not foresee any recessions. 2. Productivity growth will return from its stratospheric levels to the 1.5% to 2% range. The labor force will continue to rise 1% to 1.25% per year, so there will be little change in the unemployment rate, although it probably will rise slightly. 3. The inflation rate will remain near 2.5% because of massive excess worldwide capacity. Commodity prices will generally continue to decline. 4. Easy stock market gains are over. Profitable companies still will be brought public, but we have seen the end of the mania for companies with no revenues or sales. Major market averages will rise, but most individual stock prices will fall further. There will be no more 200 price/earnings ratios; the P/E of high-tech companies will subside to the expected annual growth rate in earnings. 5. The breakup of Microsoft won't matter to the consumer, and the high-tech sector will continue to grow by leaps and bounds. But no one will be able to amass a monopoly position again, so high-tech profit margins will shrink. 6. Fringe benefit costs (health-care costs and pension benefits) will rise sharply, but firms won't be able to boost prices. As a result, profit margins generally will shrink. No matter who is elected, the cost of health-care benefits will rise sharply, whether paid directly by business or indirectly by government. 7. Slower growth and a sluggish stock market will lead to decreased growth in imports, which in turn will generate slower growth abroad. The more sluggish worldwide economy will intensify downward pressure on commodity prices. 8. The personal saving rate will start to rise again as the stock market effect fades. Consumer spending will no longer serve as the principal engine of growth. 9. Housing prices rose far too much in high-tech land, so there will be a major bust in these areas. Homeowners will walk away from 125% mortgages, and the banking sector will come under fire again. The situation won't be as severe as the 1989 S&L crisis, but lending standards will be tightened. 10. Technology investments will continue, but growth in other capital spending will become quite sluggish. This isn't a terrible scenario. In fact, 2.5% to 3% growth, a stable unemployment rate between 4% and 5%, an inflation rate of 2.5%, relatively stable interest rates, and moderate growth in the major stock market indexes may sound like the ideal solution. If you think so, fine. However, this situation won't benefit everyone. In particular, it will become much more difficult for firms to boost profits. Government figures show that pretax profits rose to almost 10% of GDP in the first quarter. In 1989, which was a full-employment year, they were only 7% of GDP. That is an exceptionally large increase and will be partially reversed over the next few years because of the factors mentioned above: higher fringe benefit costs and the inability to boost prices. Also, profit margins zoomed because firms had to contribute relatively small amounts of money into their pension funds due to unprecedented gains in the stock market, which obviously won't continue. In forthcoming years, the stock market won't rise as rapidly, so they'll have to put up more real money than they did during the 1990s. The U.S. economy has now enjoyed five years of 4% growth and unprecedented prosperity. We should indeed consider ourselves fortunate if the growth rate averages as much as 3% over the next four years.

Michael K. Evans is president of the Evans Group and professor of economics at the Kellogg School of Business, Northwestern University, Evanston, Ill.

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