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Into the Great Unknown

By Robert J. Samuelson

Wednesday, March 21, 2001; Page A29

We will soon learn whether the economy operates by the textbook. As the stock market falters, Washington is making the standard anti-recessionary moves. Just yesterday, the Federal Reserve cut interest rates for the third time this year, reducing the federal funds rate to 5 percent. Meanwhile, Congress is pondering a tax cut to increase people's purchasing power. By the textbook, these steps ought to pep up the economy. But the textbooks could be wrong.

Remember, we've never been here before. This longest U.S. economic expansion -- beginning in early 1991 -- has been exceptional in many ways. Stock ownership soared: from 32 percent of families in 1989 to 49 percent in 1998, says the Fed. Stock wealth quintupled: from $3.2 trillion at year-end 1989 to $17.1 trillion on March 24, 2000, according to Wilshire Associates. And business investment surged, driven by computer, software and communications technologies: almost 60 percent of all equipment investment in 2000, up from 33 percent in 1990, estimates the Commerce Department. None of this was predicted.

Just as the boom surprised, its unraveling may also surprise. The textbooks may need revision. For the moment, faith in the Federal Reserve verges on religious dogma. Last week Merrill Lynch ran full-page ads in the Wall Street Journal proclaiming its belief. "We . . . expect [the Fed] to continue to act aggressively to reboot the U.S. economy," said the ad. Merrill Lynch echoes the conventional forecast: The economy will perk up by late summer or early fall.

The Fed lowers interest rates by injecting money into the banking system. It does this by buying U.S. Treasury securities. Payments for the securities increase bank reserves. Banks then cut short-term interest rates to spur lending of their extra reserves. Once started, this process supposedly feeds on itself.

There's a virtuous chain reaction. Long-term interest rates on mortgages and bonds also decline. People and businesses borrow more. Spending increases. Lower rates permit mortgages to be refinanced, reducing monthly payments. This, too, strengthens households' spending power. As rates drop on money-market funds and bonds, people may look for better returns by shifting into stocks. The market could rise. Finally, lower interest rates might make the dollar depreciate on foreign exchange markets. American exports would become more competitive, aiding manufacturers.

Great. Unfortunately, not all these good things may happen. One problem is existing debt. After a decade of expansion, businesses and consumers may have borrowed so much that -- even with lower interest rates -- they'll hesitate to borrow more. In 1990 all household debts (including mortgages) equaled 85 percent of personal disposable income, says Mark Zandi of Economy.com. Last year that figure hit 105 percent of disposable income. Debt payments -- interest and principal -- are near record levels. Likewise, many businesses have borrowed heavily. Since 1952, companies have borrowed about 8 cents for every $1 of new investment, reports Moody's Investors Service. (The other 92 cents comes from profits and depreciation.) But since 1998, business borrowing has jumped to about 20 cents of every new investment dollar.

Elsewhere, gains from the Fed's easing might also disappoint. Mortgage refinancing? In 2000 the average rate on mortgages was 7.4 percent -- not much above today's rate of around 7 percent, say economists at Goldman Sachs. They estimate that refinancings might cut monthly payments by $6 billion a year: a puny 0.1 percent of disposable income. How about the stock market? Well, if the market is dropping, a 5 percent money-market fund looks attractive. Finally, lower interest rates haven't yet led to much dollar depreciation, in part because the Japanese and European economies aren't that healthy.

A tax cut is the other textbook weapon against recession. It might help -- if the president and Congress matched their anti-recession rhetoric with action. For 2001 the tax cut recently passed by the House of Representatives would total $5.6 billion. "Your share of that is $20. Have a good time," says economist David Wyss of Standard & Poor's. If economic news worsens, immediate tax relief might increase. How much of a tax cut consumers would spend is unclear; Wyss thinks most. A $50 billion cut would equal about 0.5 percent of gross domestic product.

The larger question is whether these textbook tools can cope with the distinctive problems of the fading boom: slipping high-tech investment spending and the falling stock market.

Some high-tech investment has been wasted -- and now comes the backlash. "You can shut off orders for [computer] networking equipment faster than for equipment for a chemical plant," says economist Richard Berner of Morgan Stanley Dean Witter. Thus, the bleak news (lower profits, layoffs) from computer and communications firms. Could it signal a deep drop in investment?

It might, especially if dropping stocks depress consumer spending through the "wealth effect." Feeling poorer, people spend less. Since last March's peak, the market has lost about $4.9 trillion in value. Economists think that for every $1 of lost market value, consumer spending may suffer between 2.5 cents and 5 cents. Well, that's a hit of $123 billion to $245 billion (though the larger losses would occur over a few years). Even in a $10 trillion economy, this would matter.

Of course, all the slump talk could be hype. Unemployment remains near 4 percent. A Gallup poll last week asked respondents whether lower stock prices made them more worried about their personal finances; 29 percent were, but 69 percent weren't. Gerard Baker of the Financial Times (London) writes that the recession has already been so "diagnosed and dissected that the economists may have missed the salient fact that it has not started yet." What we know about the economy today is that, well, we really don't know. Remember, we've never been here before.

© 2001 The Washington Post Company

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-- Martin Thompson (mthom1927@aol.com), March 26, 2001