the cycle returns

[Jim Devine <jdevine@xxxxxxxxxxxxxxx>]

LA TIMES/ December 6, 2000

Cyclically, We're Back to the Past

By EDWARD E. LEAMER

  <ellipsis> -- for the whole thing, see
http://www.latimes.com/news/comment/20001206/t000116760.html

     Not so fast. The personal productivity tools and communication
devices of the New Economy do seem to have magical powers, but these powers
do not end the business cycle. Quite the contrary; the New Economy has
experienced a classic boom-and-bust cycle that is extraordinary only in its
amplitude and brevity. The vivid image of the New Economy that is etched on
most of our minds is the graph of the Nasdaq, which rose from 2,000 in
January 1999 to 5,000 in April 2000 and is now back to 2,500.

     There is a reason for this wild ride. In the Old Economy, the assets
were structures and equipment, which take time to build and have
substantial salvage value. The time to build slows the ride up, and the
salvage value softens the landing. In the New Economy, the assets have been
Internet ideas. These ideas seem to have emerged effortlessly and
instantaneously from the minds of "Interpreneurs," which has made for a
wild ride up. But these ideas have very little salvage value; only a mascot
is left from Pets.com. This has made for a wild ride down and probably a
hard landing.

     Last year's New Economy question was "Is the productivity real?"
Today's humbled question is "How big will be the spillover?" Will the
collapse of the stock markets and the bankruptcy cycle in the dot-coms
create a tidal wave or only an imperceptible ripple?

     My view is that the wave is big enough to end the Bush-Clinton
expansion in 2001. Indeed, it is the New Economy boom that kept the
Bush-Clinton expansion from ending in 1996. Those five extra years of
expansion have allowed more overbuilding and a more precarious situation,
especially in autos and other durables.

     The downturn doesn't have to be very serious. The greater stability
of the economy since 1982 is the primary reason to believe that the
downturn will be short and shallow. Dealing with our external deficit,
however, could make the downturn longer and deeper. Today, net foreign
investment exceeds $400 billion, which is more than 4% of GDP. If global
investors lose interest in acquiring U.S. assets, this external deficit has
to close, meaning we either have to export more or import less.

     If global investors allow us the time, we can close the deficit by
slowly expanding exports more rapidly than imports, as we did in the 1980s,
without serious adjustment problems. If global investors suddenly lose
interest, then the adjustment has to be more rapid, which means that it is
mostly imports that have to do the job. This would require an unhappy
combination of an income effect and price effect: lower GDP and more
inflation from a weakening dollar. Think Mexico in 1995.

     This is very bad news for Greenspan. The stability of the U.S.
economy since 1982 is at least partly attributable to more forward-looking
Federal Reserve policy. Prior to 1982, the Fed had acted like the homeowner
who constantly adjusts the thermostat based on the current temperature of
the house, and the temperature is never right. Especially under Greenspan,
the Fed has adjusted the thermostat in anticipation of future warming or
cooling needs, and the temperature has been much more stable and comfortable.

     Now Greenspan, standing at the thermostat, sees a future that needs
both more heating and more cooling. On Tuesday, he issued an elliptical
promise to "remain alert to the possibility that weakening asset values
could signal or precipitate excessive softening." Investors optimistically
took that Greenspeak to mean that they were enlisted into the front lines
to fight the coming recession and that they would go into that battle with
lower interest rates.

     Though Greenspan may want to lower interest rates to fight off the
looming recession, he may also want to raise interest rates to fight off
the looming devaluation of the dollar and the inflation it may bring. Then
again, he may want to slam the thermostat with a hammer because it doesn't
seem to be working like it used to; it is mostly gyrations in equities
markets, not bond markets, that are driving this cycle. Thus 2001 promises
to give old meaning to the New Economy acronyms B2B and B2C: Back 2
Bankruptcies and Back 2 Cycles.

- - -

Edward E. Leamer Is a Professor of Management at UCLA and Director of the
UCLA Anderson Business Forecast

Jim Devine jdevine@xxxxxxx &  http://bellarmine.lmu.edu/~jdevine