TIMES BOARD OF ECONOMISTS / A. GARY SHILLING : Blinded by Their Training, Economists Miss the Abyss
Most economic forecasters finally believe that the U.S. economy is recession prone. With the nose-dives in stock prices and economic confidence flowing from the Persian Gulf crisis, the scales fell from many eyes. Better late than never, right?
Perhaps. But for many purposes, the usefulness of a recession forecast made after the stock market has fallen sharply is limited. And, in any event, almost no one yet agrees with me that the business slump will be deep and global.
Why are economists so reluctant to face the reality of big economic trouble? Maybe it’s because they’re looking at the wrong statistics. Economists are trained to study the economy’s income statement as shown in the gross national product accounts, which show where consumers, business, government, and foreigners spend their money, and the wages, profits, interest, rent and taxes that generate funding for these expenditures. Those accounts are well documented with reams and reams of data, and forecasters swarm around data like bees around their queen.
From their beehive perspective looking at this income statement, economists see no major imbalances that could unwind into a deep recession. The inventory-to-sales ratio remains low and consumer spending growth has been moderate recently. They’ll point to plant and equipment spending as another income statement component that shows that few excesses exist. Indeed, the only time when capital spending was strong in this expansion was early in the recovery.
And everyone will agree with them that construction in general, and housing activity in particular, is a long way from being out of hand and able to pull down the economy by slumping sharply. A mild recession is possible because of the Iraqi invasion, these economists will tell you, but there will be no serious--much less global--decline.
But the problems that can turn a modest business dip into a disaster aren’t reflected in the nation’s income statements, but in its balance sheets. That’s where all the under-collateralized debts lie, but lack of data and training keeps the average economist from looking there.
I believe the Iraqi invasion merely put the final nail in the coffin of the expansion, which had already died from the effects of high interest rates and an ongoing credit crunch. The Persian Gulf crisis added more weakness by creating immense uncertainty, causing consumers and business here and abroad to hold back on spending.
Furthermore, the related surge in oil prices reduces purchasing power of the United States and other oil-importing countries. And unlike the 1970s, when oil exporters spent their increased revenue like drunken sailors and Third World countries borrowed to offset increased imported oil costs, today most Organization of Petroleum Exporting Countries members and oil-importing Third World countries have huge debts. The OPEC nations must use their enhanced revenue to service oversized debts in most cases.
With the business slump under way and likely to intensify, excessive debt problems here and abroad are boiling and could explode as recessionary fires heat up. Never in the history of consumer self-indulgence have so many borrowed so much in such a reckless way. Now, recession-caused layoffs are depriving consumers of the income needed to service their crushing debt loads.
But with layoffs mounting, the squeeze is on. Already many are desperately turning to credit card borrowing to stay afloat. The growing concern over credit card delinquencies is only a sample of the problems that banks and other consumer lenders will face if the unemployment rate climbs to double digits, as well it might.
The downturn is also drying up corporate cash flow, squeezing debt-heavy leveraged buyouts and slashing corporations’ ability to service their gigantic junk bond issues. Investors are well aware of the risks, and junk bond prices have collapsed.
As stocks, bonds, real estate and markets for other assets fall, liquidity is shrinking faster, doing away with funding for real estate. This reinforces the pressure on real estate prices that are already very weak in the commercial area and rapidly becoming so in residential properties. That’s much to the detriment of S&Ls; that haven’t already been sunk by bad loans, and banks. As a result, funding for real estate is disappearing, only adding to the pressure on lenders from regulators to become experts at saying “No!” to requests for almost any loans.
To make matters worse, the stock holdings of Japanese banks have collapsed along with their stock market. That has turned those institutions from lenders to borrowers as they seek to not only restore their capital but also increase it in line with the new international bank capital standards. In the process, some American banks are being crowded out of the capital market, and the possibility that more than one major bank here or abroad will fail is no longer remote.
The recession is already spreading, with weakness in Canada and Great Britain. In Europe, the surge in economic activity appears to be over and weakness may follow, especially as softness elsewhere spreads to the Continent. High interest rates, the collapsing stock market and highly vulnerable real estate will probably push the Japanese economy into decline before long.
A global recession will dramatically reduce demand for exports from Third World countries and eliminate what little ability they now have to service their debts. This includes oil exporters because, as usual, they will probably fail to cut production as fast as demand falls in a worldwide recession, leading to a nose-dive in oil prices.
We will no doubt see further debt crises met with S&L-style; bailouts as governments and central banks labor to preserve the financial system. But will confidence be preserved? If consumers, business and investors see Argentina and Brazil default just as several familiar LBOs bite the dust and the Federal Deposit Insurance Corp. runs out of money, will they assume that bailouts will prevent the cancer from spreading? Or will they lose all confidence and generate a much deeper recession--or even worse--as these problems compound and as the falling economy, Mideast military expenditures and bailout costs push the true federal deficit toward $500 billion with frightening speed?
I don’t know how deep the recession will be because we haven’t been here before. Widespread financial crises aren’t new--the last was in the early 1930s--but this is the first since government bailouts came into style and there’s no way of knowing whether confidence can be preserved. I do know, however, that the risks are on the downside, and extreme caution is in order.
