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How We Missed Signs of a Slowdown

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It was all going so well.

Joblessness was at its lowest level in 30 years. Prices were in check. Productivity had surged to levels not seen since the 1960s. Early last year the economy was on a luxury cruise ordering umbrella drinks. Conditions seemed so perfect that a new, more cocky breed of economist was arguing that the New Economy had changed history. Recession? A relic. Despite falling stock prices, this optimism continued into autumn, with one prestigious group of business economists predicting "solid growth ahead with no end to the expansion."

And then it happened. After the economy roared at a 6% rate of growth for the 12 months ending last June, economic pundits looked on in horror as it all began to cave in right before their eyes, with the economy edging close to zero growth. Imagine being in a speedboat going 60 m.p.h. and suddenly hitting a sandbar. It was a rude awakening. New Economy or not, the business cycle turns out to be alive and well. And hungry.

"We entered a hard landing sometime last summer," says Allen Sinai, chief global economist for Decision Economics. "And we are in at least a hard landing now. The odds are pretty high that we could end up in a full-fledged recession." Sinai sounded the alarm early last year, but most forecasters were blindsided by the speed with which the economy deteriorated. And they took us down with them.

Why did they blow it so badly? How did they run through the stop signs? And could we have gleaned something they didn't in the months leading up to the slowdown? Here are some of the turning points that ultimately led business activity on a downward spiral.

Long in the Tooth
This expansion was overripe for a downturn. For a half-century the natural business cycle followed roughly the same pattern: three to four years of solid growth followed by a one-year recession. Amazingly, the current economy had been chugging along for 10 years with little evidence of tiring. In March 2000 the expansion officially earned the distinction as the longest in U.S. history. That in itself should have kept us on alert.

But the ebullience that followed distracted many experts from recognizing that the seeds of the downturn had been planted.

"If there's a surprise, it's really that we're going to see the economy slow in the middle of the year, but then I think we're going to see a big reacceleration in the second half 9of 20000, and we're going to end the year very strongly, just as we ended 1999."

— Gail Fosler, chief economist, The Conference Board (on cnnfn's Moneyline, Jan. 3, 2000)

Wall Street's Warning
The stock market has always been a terrific leading indicator of the health of the economy. Though some experts like to poke fun at how Wall Street has successfully predicted eight of the past five recessions, anyone who ignored the market's warning last spring didn't chuckle for long. What followed offered the most telling demonstration of the market's predictive value.

The S&P 500 reached its all-time high of 1527 on March 24, 2000. After that achievement, stock prices didn't just slip; they imploded. Market historians note that every recession in the past 50 years has been preceded by the S&P 500's dropping an average of 7.7%. If economists and investors had remembered that pattern, they would have fastened their seat belts. As it turned out, the stock index plummeted exactly that amount barely three weeks after its March peak.

As equity prices cascaded, so did consumer enthusiasm. The Conference Board's index of consumer confidence reached its high in May at 144.7 and then deflated. By year's end Americans had lost nearly $3 trillion in stock-market wealth. Spending took it on the chin. Outlays by individuals are now about half the pace of the previous two years. "It is wrong to worry that strength of consumer spending is contingent on a strong stock market."

— PaineWebber investment strategist Edward Kerschner (Dow Jones News Service, May 9, 2000)

Yes, Tech Wrecked It
This expansion, unlike previous ones, had been driven mainly by the tech and Internet sectors: software, computers, networking and semiconductors. How much of the downturn in U.S. economic growth can be blamed on the burst of the dotcom bubble? A lot!

Information technology was the fastest-growing sector of the economy over the past three years. Corporate spending on computers, networks and software took off in recent years, rising 23% in 1998 and an additional 26% in 1999. Little wonder that tech stocks soared while the rest of the market was basically flat. For example, in 1999, when the Dow Jones industrial average rose 25%, the tech-heavy nasdaq soared 85%.

An example of how the bubble began to leak came in March when the financial weekly Barron's warned that Priceline.com, a high-profile Internet company, would be buffeted by serious competition. That same month, Priceline's on-air spokesman, former Star Trek actor William Shatner, sold a large chunk of his Priceline shares, netting a quick $3 million. A barrage of other company insiders did the same. Get out, they were saying.

The trickle of bad news among techs turned into a flood. "The breakthrough came last spring, when investors recognized that the business model used by many Internet firms just wasn't going to work," says Ken Shea, director of equity research for Standard & Poor's. Result: the market value of Internet-related companies alone plunged nearly $1 trillion from its March 2000 apex. Never before has an industry skyrocketed to such heights and then plummeted to such abject depths with such blazing speed.

"Investors are continuing to go to where the stocks are doing well, and that's the nasdaq."

— Robert Freedman, executive vice president of John Hancock High Net Worth Funds (Los Angeles Times, Feb. 18, 2000)

Never, Never Ignore Greenspan
Investors are supposed to frighten easily, especially when the Federal Reserve raises interest rates to battle inflation. A tightening monetary policy slows economic growth and hurts corporate earnings and stock prices. But instead of being unnerved by Chairman Alan Greenspan's round of rate hikes the past two years, investors yawned.

The Fed, which was worried about the inflationary impact of our wild shopping frenzy along with a near tripling in oil prices, lifted interest rates three times in 1999 and twice more in the first three months of 2000. Did anyone get the hint? Nope. Investors were too intoxicated by the enormous money being made in the market. The pain of costlier credit was more than offset by all the paper wealth people were accumulating.

Greenspan took off the gloves. The central bank pushed rates up half a percentage point in May, the largest single hike in five years. The benchmark federal- funds rate jumped to 6.5%, the highest in nine years. Now Greenspan had committed to a course that would bring the economy to heel. Or to rest. "The Federal Reserve would have to clamp down on interest rates aggressively to stop this expansion, and that is very unlikely."

— Economist Maria Ramirez, president of MFR Inc. (Wall Street Journal, Jan. 3, 2000)

Who Inverted My Yield Curve?
When interest rates on short-term government debt shoot past those on long-term bonds, it is a phenomenon known as an inverted yield curve. And it's bad. Normally, investors with longer-term debt receive a higher interest-rate payment than those holding shorter-term securities. That's because there is a bigger risk that inflation will hurt the value of a 30-year Treasury bond over time.

But in January 2000, the unusual happened. The Federal Reserve's tight monetary policy led short-term interest rates to climb close to 7%, while bonds were around 5%. An inverted yield curve is one of the most reliable predictors of tough economic times ahead. Eight of the past nine recessions were preceded by such an event. The last time the yield curve inverted was a decade ago, just before the onset of the 1990 recession.

Why is it such an effective gauge? Because it's the clearest evidence that money is getting increasingly scarce. Yet few people took the sign very seriously.

"Normally, that signals kind of a very significant economic slowdown. I don't think that will be the case, but I think we are on the way of kind of slowing this economy down to a soft landing."

— Ed Brown, president of a money-management firm in Baltimore, Md. (Wall Street Week, Feb. 4, 2000)

Pop Goes Petroleum
Oil has proved to be the Achilles' heel of the economy in the past. In fact, higher energy prices played a role in each of the past four recessions. In every instance, more expensive energy forced businesses to pass on the extra costs to consumers. Workers also demanded more pay to offset the higher cost of living.

Now trouble was brewing again. Since crude oil prices had doubled by January 2000 and hit a decade high three months later, economists were starting to be worried about how badly business activity would be harmed even though oil was not as big a component in the economy as it had been in the '70s. Still, Fed Chairman Greenspan feared the latest spike in energy prices might fuel inflationary pressures again.

Surprise! The danger turned out to be the reverse: the economy didn't suffer from a sharp breakout in inflation. Instead the hike in energy prices led to deflation. The oil shock was the equivalent of a $100 billion tax increase on consumers and businesses. Result: the erosion in purchasing power forced ceos as well as ordinary consumers to cut back on spending. Since such general expenditures make up more than 80% of all economic activity, the economy took a beating in the second half of the year and grew at a less than 2% annual rate, compared with a 5% pace in the first six months. "Given that we got through the Asian crisis hardly breaking stride, I think $30 oil isn't really a problem."

— Joe Kennedy, economist, the Manufacturers' Alliance (Fortune, March 20, 2000)

The Quiet Credit Crunch
In the past three years, the banking industry, perhaps overconfident because of its eight-year string of record earnings, gave lots of money to companies such as telecom start-ups that, in retrospect, shouldn't have been funded so richly. If you had a business card and were breathing, you could have got a loan. By June 2000, total borrowing by nonfinancial U.S. companies stood at $4.6 trillion, up 60% from five years before. Total household debt surged to $7 trillion, up nearly 50% in that time period.

The sand was now running through the hourglass. With the economy turning down in the summer and revenues falling, firms had to dig deeper and deeper into their pockets to service their ious. By winter, four times as many companies had their credit rating downgraded as had it upgraded, the worst such ratio since 1990, according to Moody's Investor Services.

As fears of loan losses began to mount, banks started to put the squeeze on new lending. Venture capital also dried up. The scarcity of new bank loans and venture capital can be deadly for business. There is no faster way to shut down an economy than by denying it credit.

"We used to talk about the Goldilocks economyŚnot too hot and not too cold. Now it's like the Energizer-bunny economy. It just keeps going and going and going."

— David Bowers, professor of banking and finance at Case Western Reserve University (Knight-Ridder Tribune Business Service, March 27, 2000)

There's No Bad News on Wall Street
Finally, when it comes to making predictions of an impending recession, private economists either have no such skills or they just lack the nerve to issue dire warnings. Being the bearer of bad news can be professionally risky, since optimism sells better than pessimism. Government forecasters are also shy about raising red flags on the economy because of the political ramifications. Politicians generally dismiss talk of an economic downturn, preferring instead to highlight prosperityŚat least if they want to get re-elected. Asks economist Prakash Loungani at the International Monetary Fund: "How good are these forecasters at predicting the end of a boom? Not very. Only two of the 60 recessions that occurred over the globe during the 1990s were predicted a year in advance."

Each of these events had its own subtle impact on the economy. But combined, they may have brought an end to the longest economic expansion in U.S. history. Now, however, a larger question looms. Are there any telltale signs suggesting the economy may soon start to turn up again? Fortunately, yes. If Greenspan keeps pounding down interest rates, the economy will eventually respond. As history shows, cheaper credit, more than any other action by the government, usually succeeds in reviving economic growth. History also seems to have its own internal timing mechanism of inflection points. For instance, the average postwar recession lasts just 11 months. Assuming the slump began last November, as many preliminary indicators suggest, chances are, the economy should rebound again by fall—although, as any economist can tell you, it's tough to predict.