The Economy -- Short-Circuiting A Recession

There are more than a few economists these days who claim that if it walks like a recession, talks like a recession, and looks like a recession, it must be a recession. In particular they point to the 6.2% annual rate of decline in industrial production over the last two quarters, fully consistent with the 7.0% decline during the two quarters of the 1990-91 recession. They also emphasize the unprecedented drop in the Nasdaq index and the decline in corporate profits, which is likely to be the largest percentage drop in the entire post-World War II period. I don't see it that way, mainly because of the unusually mild 0.6% rise in the unemployment rate and the continued growth of consumer spending in the 3.5% range. Also, if a recession consists of two consecutive quarters of declining real GDP, the current situation is not even close. The first-quarter growth rate was 1.2%, and real GDP rose an estimated 1.8% in the second quarter. Even so, that doesn't make the declines in production, profits, and stock prices disappear with a mere wave of the hand. Some new theory must be cobbled together to explain how those measures of economic activity could be hit so hard at the same time that other aggregate measures have hardly changed at all. Economists used to think they knew what caused recessions. The inflation rate rose for a variety of reasons, including acceleration in wage gains and declining productivity, so eventually the Fed tightened. Consumer spending declined, as did new orders for capital spending. Layoffs soon started, causing consumers to cut back even more because they were worried about the increased likelihood of becoming unemployed in the near future. That led to even more layoffs. When businesses realized their inventory stocks were too high, production declined. The economy rapidly spiraled downward, but as soon as the monetary authorities realized the recession was under way, policy was eased. Six months later the economy started to recover again. Most of those elements have been missing over the last year. For openers, inflation did not rise. While the Fed missed the boat by not easing until early this year, bond yields and mortgage rates started to decline last July. Consumer spending continues to rise at a 3% to 4% annual rate. While some layoffs have occurred, unemployment has risen at less than one-third of its usual rate in downturns. Hence two of the principal linkages in the downward spiral, massive layoffs and substantial cutbacks in consumer spending, simply did not occur this time. That dichotomy centers on the difference between a downturn that occurs primarily in manufacturing and one that occurs primarily in services. In the old days, consumers cut back their spending on motor vehicles, household appliances, clothing, etc. When that happened, production facilities were shut down and employees were laid off. More recently, though, the fulcrum has shifted to the point where most discretionary purchases are in services: restaurant meals, vacations, entertainment, travel, and so forth. There have indeed been some substantial cutbacks in those areas, yet there has been virtually no negative employment effect. What happens when a fading rock star fails to sell out the auditorium? Employment is not cut; the show still needs just as many ticket-takers, ushers, security personnel, travel coordinators, and so on. Airlines fly with more empty seats, but employment is not cut back. Waiters have fewer customers to serve, and some are sent home early, but employment does not actually fall. Profits get clobbered but the growth in wages stays just about the same. That is precisely what has happened in the current slowdown; during the first half of the year, wages and salaries reportedly rose at a 6% annual rate even though employment hardly increased at all. As a result, there simply is no secondary round of layoffs, and the recession mechanism is short-circuited. Thus, in spite of the claim by a few economists that the U.S. already is in a recession, I think second-half growth will be far stronger than in the first half. Monetary ease and the tax rebate will have the same effect as in the past, which means the growth rate will soar to at least 4% in the second half of this year, followed by a 5% or better gain next year. 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.