A Little Bit of Slowing in the Economy Wouldn’t Be All Bad

While there currently is some risk of a recession, the economy continues to look good when you balance the strong positives, such as rapid productivity (output per worker hour) growth and high employment, against the negatives, such as the large and growing U.S. trade deficit.

The economy may well slow down in 2001, but that slowing is welcome. The high pace of growth in the economy over the last year is unhealthy and unsustainable. In the second half of 1999, the economy grew at an annual rate of 7% in real terms; in the first half of this year, that rate continued at over 5%. Even with the strong productivity growth that has been the hallmark of this expansion, that fast pace of growth could not continue without additional harmful effects on inflation and the trade balance.

The slowing of the economy has already set in, with growth in the third quarter of this year estimated at 2.7%. That figure is likely to be adjusted downward when more up-to-date statistics come in. The slowing now means that there will be less inflationary pressure in the months ahead and therefore less risk of a rise in interest rates that could lead to a hard landing.

The current expansion has been the longest on record, but the big story has been the acceleration of productivity growth. Rising productivity allows higher real incomes and a higher standard of living. Productivity growth since 1995 has been well above the trend of the previous two decades and has continued to accelerate, rising in the second half of 1999 at more than twice the average rise of the previous three years.

The productivity improvements are directly related to the growing use of the Internet for business and the rapid advances in telecommunications. These technical advances will continue and even accelerate. But at some point the acceleration in the total productivity growth will have to slow.

Closely linked to the productivity story has been the ability of the economy to absorb growing numbers of workers with only limited inflationary increases. Unemployment--recently at 3.9%--continues to be extraordinarily low by the standards of recent decades. In response to the huge demand for workers in a tight labor market, compensation per hour has been rising at an accelerating rate. This key driver of producers’ costs and prices recently hit an annual rate of increase of 6.4%, more than double the level in 1995 to 1997. The slowdown in the economy that we expect in 2001 is likely to reduce these wage pressures and therefore help to keep inflation in check.

Another extraordinary feature of today’s economic environment that gives cause for optimism is the federal budget surplus. The surplus is expected to be more than $200 billion this year and will probably rise substantially next year. When the government runs a surplus, it is not competing with private borrowers for investment funds. That helps to keep interest rates lower than if the government were a net borrower.

Despite the good economic picture, the business sector is worried about the future. Stock markets have become skittish and the spread between the interest rates paid by lower quality and higher quality borrowers has widened.

The critical risk factor is the international position of the U.S. economy. The U.S. trade deficit has jumped in the last few years from $167 billion in 1998 to $265 billion in 1999 and is now running at a rate of more than $400 billion. Consumers and businesses are substituting low-cost imports from Europe and Asia for U.S. produced goods. Excess imports are financed by increased capital inflows from abroad as foreign investors purchase a growing volume of U.S. stocks and bonds and make major acquisitions like the Daimler purchase of Chrysler.

If foreign lenders and investors conclude that they have enough U.S. assets, there could be a sudden collapse in the value of the dollar. That would mean a surge in inflation. In response to the higher inflation and as a byproduct to keep foreign investment flowing in, interest rates might rise substantially, raising the risk of pushing the economy into recession.

Sooner or later the trade balance must be restored, but it need not happen suddenly or any time soon. A gradual decline of the dollar relative to the euro and the yen could remedy our trade imbalance without a recession.

On balance, conditions are right for the economic expansion to continue in 2001.