Lessons Learned from the Recent Business Cycle

Credit & Financial Management Review, First Quarter 2006 by Santomero, Anthony M

Abstract

The U.S. economy enjoyed a remarkable run in the 1990's. As it moved into the new century, however, the economy underwent various fits and starts before entering its current expansion phase. In this article Anthony M Santomero, President of the Philadelphia Federal Reserve Bank, shares his views on the U.S. economy and outlines some of the lessons learned from the most recent business cycle.

This quarter, I would like to share my views on the U.S. economy and some of the lessons learned from our recent business cycle. By way of perspective, it should be remembered that the U.S. economy enjoyed a remarkable run in the 1990s. Then, it stumbled as we came into the new century and struggled to find solid footing, going through numerous fits and starts early in the new millennium. Now, in 2005, the recession and recovery phases of the current cycle are behind us, and the economy has entered an expansion phase that I expect will carry us forward for some time. As the economy moves along this path of self-sustaining growth, the Federal Reserve has been steadily removing the accommodative monetary policy that has been in place over the past few years, as it moves toward a more neutral policy stance.

In reflecting on the current business cycle and the turbulent times surrounding it, I will focus on how recent events, as well as ongoing trends, have affected both the economy and the conduct of monetary policy in this cycle. I will also address how they will influence the economy going forward and how I see the economic expansion progressing.

As most readers will appreciate, it is important that we learn from the experiences of the past. As the saying goes: "Those who cannot remember the past are condemned to repeat it. " Hopefully, some of the lessons we learned from our recent past will be incorporated into the policy decisions we make in the future. Nonetheless, before we start, I must remind you that every business cycle is different. Each is the unique product of (1) a relentlessly evolving economic structure, (2) some surprising new developments, and (3) a sequence of policy actions attempting to stabilize the situation. This most recent experience is no exception.

Examining the Context

To discuss the most recent business-cycle experience, one must start at the beginning: with the revolution in information and communications technology and its dramatic effect on the economic structure of the U.S. Cheap hardware, sophisticated software, and extensive networking capabilities - both Internet and intranet - began transforming business processes in earnest in the latter half of the 1990s. Of course, this was a worldwide phenomenon, but it clearly had profound effects on the U.S. economy.

History tells us, and our most recent experience reconfirms, that a technological revolution of this magnitude does not produce a smooth economic progression. It is, by its nature, disruptive to the existing order of things. Nonetheless, the application of new information technologies brought real economic benefits to our economy. As these technologies were introduced into organizations and infused into business processes, productivity measurably accelerated.

At the same time, however, it spawned unrealistic expectations that were manifested in a stock market bubble and overinvestment in new capital. When the bubble burst and the investment boom deflated, aggregate demand decelerated rapidly, ultimately driving the economy into recession.

The technology revolution has also been an important contributor to globalization - a second fundamental factor of structural change driving the economy's evolution in this business cycle. By slashing communications costs, new technologies made the markets for financial assets, goods and services, and even labor, more globally integrated. Globalization was driven by other forces as well. Freer trade among nations and, even more fundamentally, the triumph of the market system over centralized planning were both movements that spurred integration.

Like the introduction of new technologies, the globalization of the marketplace has been and continues to be a good thing. It fosters greater specialization and gains from trade, affording everyone higher living standards. These benefits are genuine and worthwhile, but they do not come without some costs. The adjustment costs are significant, and in an environment of rapid change, they are ongoing.

I will say more about technology and globalization later in the article. But first, let me turn to the second ingredient of any business cycle, that is, the arrival of new developments and unexpected events.

Shocks to the Economy

There were several new and surprising developments during the most recent business cycle. We often refer to these events as economic shocks. In 2000, the U.S. stock market declined precipitously and the tech bubble burst. The NASDAQ, which was valued at just under 5000 in March 2000, fell to under 2000 in April 2001. This led to a decrease in national wealth and had a negative effect on the economy as a whole. The Dow suffered a similar, if less dramatic, decline, as well.