A hard landing? Dec 7th 2000 From The Economist print edition The risk of a hard landing in America is real FOUR years is a long time in central banking. On December 5th 1996, Alan Greenspan, chairman of America’s Federal Reserve, gave his famous warning about irrational exuberance in the stockmarket. Yet four years on, to the very day, and with stockmarkets considerably higher than in 1996, Mr Greenspan injected some irrational exuberance of his own. With a reassuring speech that was taken to imply that the next move in interest rates would be downwards, and that the Fed was ready to ease if the economy slowed too sharply, he lifted share values by almost $600 billion in a single day. The Nasdaq rose by over 10%, its biggest-ever daily gain. Mr Greenspan’s soothing words were lapped up by investors who had become nervous that America’s economy was heading for a hard landing. The economy is slowing more than expected; and last year’s tech bubble has clearly burst. Yet, as Mr Greenspan pointed out, none of the recent economic numbers should themselves cause alarm. A slowdown in the economy’s breakneck speed is exactly what was needed. Demand has outpaced supply for several years; to ease tight labour markets and to stop inflation rising, the Fed has raised interest rates by 1 3/4 percentage points since mid-1999, to 6 1/2%. Mr Greenspan seems to believe that a soft landing is on course, as weaker share prices and tighter financial conditions dampen consumer spending. The fact that evidence of a slowdown generated so much gloom has merely highlighted the extent to which expectations were inflated. There is, indeed, a worrying circularity in the response to Mr Greenspan’s speech. Share prices soared because investors think that interest rates will be cut early next year. But that will happen only if consumer spending slows. If stockmarkets bounce too far, consumer spending will stay too strong—and interest rates will not be cut, and might even have to be raised. The markets are now discounting a half-point cut in interest rates in the first half of 2001. This is surely premature. Both the core rate of inflation and the increase in wage costs have edged up this year. To relieve inflationary pressures, growth needs to stay below its sustainable rate for a longer period. And the Fed should be careful not to give the impression that it will underwrite share prices by cutting interest rates. The Fed’s past success in steering the economy may have created a moral hazard: if investors believe that monetary policy will support share prices, they will tend to take bigger risks. Many investors also believe that tax cuts can be called in aid of a soft landing. Dick Cheney, who will be vice-president if George W. Bush moves into the White House, said this week that America may be on the “front edge” of a recession, and pledged that Mr Bush would push to cut taxes quickly. With a large budget surplus, this might seem sensible. But, not least because of the long lags before tax cuts take effect, they are a bad way to fine-tune economies. Fortunately, a weak presidency, combined with near-balance in Congress, should make it harder than ever to agree on changes in fiscal policy. Although the Fed may yet steer the American economy to a soft landing, investors are underestimating the difficulty of its task (see article). History shows, in fact, that central banks rarely manage it. That is partly because slower-growing economies are more vulnerable to external shocks than booming ones. It is also because slower growth exposes all sorts of economic and financial imbalances. The borrowing binge that has taken place in America on the assumption of ever-rising profits and share prices may seem especially unwise as growth slows. And pessimism can be as contagious as exuberance. There is a risk that America’s virtuous circle of high investment, faster productivity growth, and rising profits and share prices could turn vicious. If it does, the Fed will need to cut interest rates—but not before. New worries, old economy What does America’s economic slowdown and the bursting of its tech-share bubble mean for the fabled “new economy”? One lesson is that the old rules of economics still apply: the business cycle is not dead, and profits do still matter. As growth slows, the new economy will face its first big test: it should become clearer how much of America’s recent productivity-growth improvement is cyclical rather than structural. Some of it may reflect the fact that in boom times firms work employees harder; that will disappear in a downturn. As GDP growth has slowed, productivity growth has also eased, from an annual rate of 6.1% in the second quarter to 3.3% in the third quarter. Where will it go now? If productivity growth falls only modestly, keeping inflation in check and supporting profits, a soft landing remains plausible. But if productivity growth comes down faster, it will make the Fed’s handling of a downturn far trickier. Unit labour costs would accelerate, and the dollar might tumble—making it hard to respond by cutting interest rates. The Economist has long argued that the American economy is suffering from a financial bubble. The IT revolution is delivering genuine economic gains, but the markets are also being driven by unrealistic expectations of future productivity and profits growth. This should be no surprise: historically, technological revolutions and bubbles have gone hand in hand, from Britain’s railway mania in the 1840s to America’s enthusiasm for cars and electricity in the 1920s. When those bubbles burst, investors lost their shirts; yet the real economic gains endured. That may happen this time, too. But the experience of past revolutions should give pause to many new-economy enthusiasts. Their claim that information technology has boosted America’s sustainable rate of productivity growth to 3-3 1/2% is extraordinarily ambitious: it suggests that IT will have a bigger impact than electricity. That is one good reason to fear that, in a downturn, America’s productivity may slow by more than most economists expect—adding to the chances of a hard landing. Mr Greenspan may have some explaining to do in December 2001.
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