Capitol observer

Agency Sales, Feb 2001

ECONOMISTS IN GOVERNMENT AND INDUSTRY ARE BECOMING CONCERNED about prospects of a soft landing. They still believe an economic soft landing is the likely outcome. But they acknowledge that recent events suggest a hard landing is possible. There are two distinct schools of thought on the economy's future. One suggests that the economy will hold to a slow, but sustainable, course. Even if it shows signs of sinking, steps can be taken to revive it. The other argues that the economy has slowed so far so fast that a weakening is as likely as not, with a recession a possibility.

As of now, it's impossible to say which of the two scenarios will actually come to pass. But the fact that there is some disagreement among these economists suggests that executives need to keep a wary eye on the economy and business decisions.

IN EFFECT, ECONOMISTS ARE LOOKING at the same economic statistics, but are reaching different conclusions. Take the stock market, for example. The hard-landing school believes the recent drop in stock prices will knock two percentage points off the economy's growth rate. And if there is another big drop, it is likely to have an even greater economic impact. In a down market, baby boomers with little in the way of savings outside of their stock portfolios and houses are likely to become scared consumers.

The soft-landing group says the impact of changes in stock prices on consumer spending plans - a socalled wealth effect - is highly overrated. During the 1990s, consumer spending rose pretty much in line with wages and salaries, without reference to stock prices, and it should be the same if stock prices fall. As long as income holds up, so will consumption.

THE HARD-LANDING ADVOCATES NOTE THAT CONSUMERS went on a debt binge during the 1990s, including margin credit, credit card debt, home equity debt and mortgage debt. People need their incomes to grow to service all this debt. Instead, they are looking at the prospect of losing overtime, bonuses, capital gains, and maybe even their jobs as unemployment grows. As a result, the impact on consumer spending and confidence could be huge.

THE STATISTICS THAT SAY HOUSEHOLDS HAVE STOPPED SAVING and consumers are overburdened with debt are pure fiction, the softlanding group says. In calculating household income, the government ignores all profits earned from the sale of stocks or real estate. If one adds that back in, then the household savings rate is about 10% and debt service is less worrisome.

There has been excessive investment in high-technology equipment in recent years, typical for the end of a long expansion, the hard-landing group contends. As profits shrink and companies reduce costs, cutbacks in capital spending are likely. The days of openended technology spending are over.

NOT SO, SAY THOSE WHO PREDICT A SOFT LANDING. Even if companies cut their spending for new equipment in half, which this group now anticipates, it will still grow at a rate significantly higher than the overall economy and well above the norm. Even in a slowing economy, companies have no choice but to invest in new technology if they want to remain competitive.

THE RISK OF REVIVED INFLATION REMAINS REAL, the pessimists contend. Any slowdown brings with it an almost automatic rise in unit labor costs that some businesses will pass on to consumers. And homeowners are now getting their winter heating bills reflecting the higher oil and natural gas prices. Healthcare and prescription drug costs are soaring now.

The soft-landing group agrees that wages have been rising at an annual rate of nearly 4% a year for the past four years. But this has been offset by similar growth in labor productivity. This has meant stable prices, the analysts note. The exception is energy prices, but they have peaked and will head down.

A DISASTER IS READY TO HAPPEN, according to the hard-landing school. The strong dollar has been a major part of the circle in which foreign capital has been used to finance a spending and investment binge. But if the dollar falls and the capital flows slow, the virtuous circle will turn into a vicious downward cycle. The United States cannot finance the $1 billion-a-day trade deficit with a falling currency, analysts point out.

THE DOLLAR IS AN OVERRATED WORRY, the soft-landing economists contend. When it fell sharply in 1987, there was no big spike in inflation and it didn't drive up interest rates. In fact, the economy grew faster because export industries suddenly became more competitive. What people forget is the dollar is a world currency, so the U.S. can't have a currency crisis.

THERE IS A DANGER that the Federal Reserve will find itself in a reactive, catch-up mode, much as it was back in 1990, when it didn't begin lowering interest rates until after a recession had begun. Those who look for a hard landing note that because monetary policy takes time to work, Fed action to lower rates won't really have much of an impact until fall.

The Fed is not about to sit around and let the economy sink into a recession, according to the proponents of a soft landing. It will reduce interest rates if necessary, just as Chairman Greenspan noted recently. With inflation under control, the Fed has plenty of leeway to ease policy.