[OPE-L:4646] A hard landing?

From: Alejandro Valle Baeza (valle@servidor.unam.mx)
Date: Fri Dec 08 2000 - 14:03:28 EST

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
                   economy slowed too sharply, he lifted share values by
almost $600
                   billion in a single day. The Nasdaq rose by over 10%,
                   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
                   pointed out, none of the recent economic numbers
                   themselves cause alarm. A slowdown in the economy’s
                   speed is exactly what was needed. Demand has outpaced
                   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
                   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
                   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
                   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
                   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
                   economies. Fortunately, a weak presidency, combined
                   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”?
                   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
                   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
                   tumble—making it hard to respond by cutting interest

                   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

                   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
                   new-economy enthusiasts. Their claim that information
                   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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