U.S. Economy Unlikely to See Greener Pastures Soon

In the famous Bible story, Pharaoh dreams of seven fat cows emerging from the Nile, which are soon followed--and eaten--by seven lean cows. Pharaoh’s dream is interpreted by Joseph to foretell seven years of great plenty in Egypt, followed by seven years of famine.

There were also seven years of unprecedented economic growth in the 1980s, the longest peacetime expansion on record--and one largely financed by debt, as virtually every sector of the economy was borrowing and none was saving appreciably. Now the excesses and imbalances created during those seven fat years are dominating the economic scene. Are we, like those ancient Egyptians, in for seven lean years?

While seven years of retrenchment and consolidation is a long time, certainly there are seven reasons--seven lean cows--that suggest that it will be a long time before the U.S. economy is again grazing in the pastures of plenty.

The first lean cow is the balance sheet recession in which the economy is now mired. This isn’t the typical recession. This time, the underlying imbalances are the debts carried over from the 1980s--and some from the 1970s--that have become difficult to service as the incomes and collateral of Third World countries, leveraged buyouts, consumers and real estate borrowers falter. And now this balance-sheet recession is spreading to the income and spending side of the ledger as the debt-laden consumer is made even more cautious by mushrooming financial crises, such as the Federal Deposit Insurance Corp. takeover of the Bank of New England.

At the same time, confidence is being further eroded by collapsing house prices and mounting layoffs--not only in manufacturing but even in service jobs long considered impervious to the business cycle. Consumers may also be dismayed to learn the hard way that no one insures their money market funds, which contain--in addition to U.S. Treasury securities--jumbo certificates of deposit and commercial paper issued by troubled banks and others that could default on their obligations. And a consumer plagued by troubles from every economic quarter is in no mood to spend with gay abandon!

Furthermore, the second lean cow, the hangover of debt problems and lingering effects of the bailouts, will continue to munch away for years. The junk bonds and loans of troubled LBOs that insurance companies, banks, mutual funds and others hold will take a long time to unwind, dampening financial markets and constantly reminding past and present holders of their losses. Third World debt problems carried over from the 1970s will continue to plague lenders in this decade. Consumers, nailed by the deadly combination of huge debts and declining house prices, will remain cautious spenders and very big savers for some time.

Excessive inventories--barring the well-known problems of auto dealers and less well-recognized difficulties of the nondurable goods retailers--are unlikely to be a major issue in the current downturn. In fact, I expect inventory cuts to account for only about 20% of the peak-to-trough decline in real GNP, only a fraction of the postwar recession average of 78%. But lean inventories give birth to the third lean cow. A key prod to the typical recovery from a recession is the ending of substantial inventory liquidation. Then, sales are increasingly met with new production and less from old inventories. Consequently, a mild inventory cut, as is likely in the present case, won’t lead to a meaningful speedup in production when it’s over.

Lean cow No. 4 is the skyrocketing budget deficit, which is eating the fat cow of fiscal stimulus. Usually, Congress and the Administration would come to the aid of the struggling economy via lower taxes and increased spending. This time, however, the exploding federal deficit--which may reach a $500-billion annual rate when the recession, the S&L; bailout and the cost of the Persian Gulf War are added in--is so big that it will probably eliminate any tax cuts or spending increases beyond the automatic rises in Social Security, Medicaid and so on.

If Congress and the Administration can’t spur the economy with fiscal stimuli, their only recourse is to pressure the Federal Reserve for more monetary ease. But this time the stimulating effect of monetary ease will be much slower in coming and much reduced in size when it does come, due to the ongoing credit crunch.

Lenders, hampered by regulators and burned by so many bad debt problems, will remain reluctant to take chances on any but the very safest of loans. As a result, very little of those Fed-supplied funds will get through the brick wall that this credit crunch has erected. The fifth cow, reluctant lenders, can be expected to feed for years as the go-go bankers of the 1980s are dismissed in disgrace and replaced by skeptical, tight-fisted lenders.

In addition to the inventory bounce, the main source of revival from the typical postwar recession is a pick up in construction resulting from easier credit and lower interest rates. Now, however, commercial construction is hopelessly overbuilt and unlikely to respond to freer credit. As a result of slowing service-employment growth and a decline in the space per employee, demand for space will fall--and the excess office space will take not the five years to eliminate that past absorption rates imply but more like 13 years.

As with non-residential construction, residential building is unlikely to respond significantly to money that does slip through the tight screen of reluctant lenders since the decline in house prices is likely to persist for years. Excess capacity for buildings of all types and falling prices will keep this sixth cow very lean in the economic picture of the years ahead.

In the conclusion of this Bible story, Joseph was rewarded for his dream interpreting skill by being put in charge of Egypt, and he set aside a fifth of the crops in the years of plenty to prepare for the seven lean years that followed. As the famine spread, the people in Egypt and Canaan bought some of the grain that Joseph had set aside, and he took the money to Pharaoh’s palace (the central bank). After their money was gone, the Egyptians, so desperate for nourishment, exchanged their livestock for food. But the famine persisted and Joseph was a shrewd cookie, so he traded food for their land and their labor: Joseph turned the Egyptians into sharecroppers, working the lands that they had sold to Pharaoh and giving him a fifth of the harvest.

There is a clear parallel today. As noted, all U.S. sectors were borrowing and spending in the 1980s, and none saved much. Consequently, foreigners were called upon to provide the shortfall of funding. In return, they gained ownership of substantial amounts of U.S. real estate, securities and corporations. They became the modern day Pharaohs as the U.S. became the sharecropper.

Now a significant amount of U.S. output must go to foreigners in the form of profits, rent, interest and dividends on their holdings of American assets. The U.S. production that is available for Americans to enjoy themselves will be reduced for years to come and will not be restored until this country runs a long string of trade surpluses that cumulatively wipe out its huge net indebtedness to foreigners. Paying the Pharaohs their share of output keeps the seventh cow very lean and hungry.

Whether it takes fully seven years to satisfy these seven lean cows remains to be seen. But business people, consumers and investors should certainly remain cautious about the economy and the growth in corporate earnings for the next several years at least.