Scandals May Delay Recovery

Until a few months ago, economists thought America had come up with a surprising invention: the “no-slow” recession, in which growth barely pauses before resuming its upward arc.

But with business scandals spreading, stocks still sliding and the dollar dropping, the stage seems set for a distinctly less pleasant surprise: the no-growth recovery.

Analysts fear that the latest troubles are sapping the power of the tax cuts and reduced interest rates that, by inducing consumers to continue buying, fueled most of the economy’s recent comeback.

“You can’t have corporate America coming out every day and announcing its financial numbers are no good and there’ll have to be more layoffs, and expect consumers to keep on buying,” said James W. Paulsen, chief investment officer at San Francisco-based Wells Capital Management.

In essence, what was supposed to be the nation’s mildest recession is lingering because major parts of the economic system are clashing. Like a hapless bar band, the U.S. economy and stock market can’t seem to play the same tune. Major corporations keep bellowing bad news, fueling a crisis of confidence. Foreign investors dash for the door, toppling the dollar.

The cacophony threatens to drown out the one comforting note: the strong growth rate of the gross domestic product, the chief gauge of the nation’s output of goods and services. In most recessions, the GDP shrinks for at least two consecutive quarters. This time, it has risen almost every quarter.

The Commerce Department said last week that output grew at a 6.1% annual pace during the first three months of the year. That was better than in all but four of 40 quarters of the 1990s boom. It grew at a less impressive but still positive 1.65% rate during the three months before that. The only time it hasn’t grown during the last decade was last summer, and then it shrank by a mere one-third of a percentage point.

Optimists argue that these figures show the economy is moving stubbornly forward and will eventually recover its full flush. “I believe the recovery’s vitality and staying power are solid,” declared Morgan Stanley economist Richard B. Berner.

But others see triple trouble in the growth. First, it is almost entirely the product of consumers hunting for low-interest bargains such as cheap mortgages, rather than businesses investing in plants and equipment.

Secondly, because so much growth is concentrated in housing, there is a danger of a price “bubble” similar to the one that occurred in the stock market.

Although Federal Reserve Chairman Alan Greenspan, among others, has dismissed the risk, arguing that people don’t trade houses the way they do shares, there are some ominous parallels.

Figures out last week show housing sales growing faster than population and, in many places, faster than people’s income. At the current fever pitch, a record 1 million homes will go up this year. Among the markets some analysts think are most in danger of a price bust is Southern California’s.

Finally, there are some signs that consumers, whose spending accounts for two-thirds of the economy, may be growing cautious. Auto and retail sales dropped in May, reversing increases. Figures out last week showed that, overall, personal consumption expenditures declined in May for the first time in six months.

“The consumer is downshifting, and that will have an impact on the economy,” said Allen Sinai, chief global economist at Decision Economics in New York.

What may speed consumers’ caution is the fear that businesses have played fast and loose with their financial books and the truth. Analysts had spent most of the seven months since Enron Corp.’s early December collapse marveling at how little effect the scandals roiling the corporate sector seemed to have on the country and economy. By the end of last week, they were beginning to worry about how big the toll might be.

What caused the shift was the disclosure that WorldCom Inc., the country’s second-largest long-distance phone company, had hidden $3.9 billion in expenses and that Xerox Corp., the world’s largest copier maker, had misreported $6.4 billion in sales, resulting in a restatement of $1.9 billion. That would make each company’s profits look that much larger than they really were.

The immediate effect in Washington was to jump-start legislative and regulatory changes that had been foundering. The Securities and Exchange Commission sped up plans to make top executives of large companies potentially personally liable for the accuracy of their firms’ financial statements. Congress appeared more likely to approve creation of the first new regulatory board in years to ride herd on the accounting industry.

But the effects of the new disclosures are likely to go well beyond such specifics.

Economically, the disclosures could help delay the recovery by pulling down already depressed stock prices and by leaving already shellshocked executives even less willing to take risks.

“We may be seeing executives and accountants going from one end of the spectrum to the other,” economist David Hale said, “from being hyper-negligent--perhaps even criminal--to being hyper-cautious.” Either extreme hurts growth, he said.

Of all the sores that the latest scandals could have inflamed, the stock market might have, in some sense, seemed the least likely. After all, investors already had weathered almost two years of setbacks before the Enron collapse, so they might have been expected to be numb to news of new trouble.

But as Friday’s close to the first half of the business year demonstrated, they were hardly that. Investors pushed stock prices to their steepest first-half declines in more than three decades. If the bellwether Dow Jones industrial average does not lose a single additional point between now and New Year’s Day, it will still have posted its worst record in more than 70 years--down three years running.

“We haven’t seen three consecutive negative years since the Great Depression,” Hale said.

The fact that sustained declines occurred in the face of statistics showing the economy doing better than expected suggests it is not just growth worries that caused the price tumbles; it is also the scandals. The reason is that they threaten to destroy investors’ last hope of recovering part of what they have lost.

Until the scandals, the only explanation for what had gone wrong was that the nation had experienced the biggest stock market bubble in its history. Or, what amounts to the same thing, that what people were willing to pay for a dollar of future corporate earnings had reached an all-time high.

Once the bubble burst, investors lost their chance to profit from the price run-up. But there were still the earnings. Or at least there were, until some companies began admitting that much of their earnings was fake.

“The old answer to what went wrong is that there was a bubble,” said Brookings Institution economist Gary Burtless. “The new one is that even the part you thought was real turns out not to be.”

If the bear market of the last 2 1/2 years disturbs U.S. investors, it absolutely panics many foreigners, who started to pump funds into U.S. stocks and bonds in earnest in the mid-1990s and were making more than half a trillion dollars a year in investments here by 2000.

But most foreign investors did little about the problem until recently, in large measure because the U.S. dollar was continuing to rise in value against their home currencies, partially offsetting their dwindling U.S. gains.

However, when the dollar reversed course and began slipping in February, so did foreign investment in U.S. stocks.

“The correlation between the weak dollar and the weak stock market has got to be a little unnerving to the people at the Federal Reserve and the Treasury,” said Gary C. Hufbauer, an economist at the Institute for International Economics in Washington.

So unnerving, it appears, that the Fed took the unusual step Friday of joining other central banks in a coordinated effort to sell yen. Although the effort was designed to stem a rise in the Japanese currency’s value that is threatening that country’s fragile, export-driven recovery, its effect, and perhaps its aim as well, was to slow the dollar’s fall.

“It’s just not credible we’re doing this only for them,” Hufbauer said. Washington wants to keep the dollar from slipping so quickly that foreigners, rushing to get out of their U.S. investments, don’t send the stock and bond market into dives that damage America’s shaky comeback.

In the end, there is no way to know how many more companies will admit improper accounting. No investor yet has a grip on how much further the stock market has to fall. And no policymaker has the tools that Washington once had to keep the economy from falling into crisis. In the absence of all three, the nation is careening toward a future that will largely be of its own making.

“A year ago, a lot of what happened to the economy was in our control,” said Mark Zandi, chief economist of West Chester, Pa.-based Economy.com. “We could cut taxes or reduce interest rates to keep growth going.

“But now we’re going to have to rely on luck as much as our own doing to avoid a disappointing recovery.”

Or worse.