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Anatomy of a recession.

By now, it is widely acknowledged that the 1990-1991 recession has been different from past recessions in significant ways. The most significant of these differences is that the Federal Reserve Board did not cause the recession by a hike in interest rates, the classic cause of recession. To the contrary, the Fed eased its bellwether Fed funds rate considerably during the 14 months before the recession began.

Even though this recession is different from those that preceded it, the market has stubbornly held to the historicist view that a recovery will arrive later this year, and that it will be fairly robust, with year-end GNP growth in the range of 3 percent.

While positive growth probably will reemerge before the end of this year, the forecast for a robust recovery will most likely prove to be too optimistic. A number of structural changes beset the U.S. economy in the early 1990s, which augur a period of sluggish growth. It is important to note that these are truly structural changes, not cyclical ones. Indeed, these changes predated and, in fact, helped precipitate today's recession - and they will continue to influence the economy after the recession is over.

Restructuring in the service sector

The first of these structural changes is perhaps the least understood by the market and by the financial press in general. Since the service sector is large and heterogeneous, it will suffice to cite developments in three of its constituent sectors.

* Distress in retailing. While debt growth (Robert Campeau, for example) is usually blamed for the distress in retailing, a much more fundamental force is at work. This force is evident in the ongoing slimming down of Sears Roebuck, where tens of thousands of workers continue to be laid off - a development that predates the recession. The underlying cause of Sears' plight stems from a combination of failing real living standards and the advent of huge no-service retailing technologies introduced by the discount chains. People simply cannot afford the level of service associated with traditional retailers, and one result is an ongoing trimming of service workers. By 1995, an estimated 300,000 jobs will have been permanently lost in retailing since this trend began in the 1980s.

* Distress in banking and financial services. Again, adverse developments in this sector predate the recession. The distress in the financial sector allegedly began with the stock market crash of October 1987, but, in fact, these developments were operating even before the crash. Excess capacity in banking and brokerage has been a longstanding problem in the industry, but it reached crisis proportions during the past four years. Booming financial markets with huge transaction profits masked this reality, which has now hit home with full force.

* Real estate brokerage and related fields. Similar developments characterized the explosive growth of real estate brokerage, title insurance, and related financial and legal services during the 1980s. Employment boomed artificially because of demographic, regulatory, and tax changes, and it peaked during the period of 1986-1987. It then began an accelerating decline, which continues today.

* Information technology and productivity in the service sector. The large investments in information technologies during 1975-1990 have failed to make those working in the service sector proportionately more productive. The indiscriminate pursuit of the latest personal computer or word-processor, laden with added features that few employees ever use, has proven cumulatively ineffective. This nonproductive investment is one reason for the widely acknowledged problem of stagnant productivity in the service sector, which, given the increasing role of service employment in the five decades, is one of most serious problems confronting the U.S. economy.

Recessionary implications: The significance of these developments in the service sector is that they are ongoing, not cyclical. Service-sector restructuring will take place throughout the 1990s, just as restructuring in the smokestack industries occurred throughout the entire decade of the 1980s. The turmoil in the service sector will make it more difficult for the economy to regain strong positive growth after the recession than has been true in the past.

Balance sheet and net worth constraints

Throughout the Group of Seven nations, one of the most interesting developments of the post-war period has been an uncoupling of changes in financial market values and changes in the real economy. This uncoupling was very evident in 1987, when the "Black Monday" crash failed to jolt Main Street during the subsequent two quarters. A recession, widely expected following the crash, never materialized.

But in the present U.S. recession, Main Street and Wall Street are now once again "coupled." They intersect in the following three different ways:

* The sharp implosion of real estate and other highly leveraged asset values has impaired the balance sheets of the nation's financial intermediaries, creating today's much-discussed credit crunch.

* The growth of debt in the nonfinancial business sector has left the lowest income-to-interest-expense cover since the 1930s. The record rise in business bankruptcies this past winter evidences this development.

* The reduction in housing values has eroded the net worth of households at the same time that real income has fallen. The implications for consumer confidence and spending are obvious.

The Federal Reserve Board recognizes the gravity of these developments. Indeed, Fed Chairman Alan Greenspan testified on March 13 that the Fed is using new and previously untested strategies for stimulating lending. Among other things, these strategies involve a fundamental change in the ways in which banks write down non-performing loans. Rather than completely writing off a non-performing loan, a bank has to write down only that portion of the loan that corresponds to the percentage reduction of its current market value relative to its book value.

The Fed is resorting to new approaches because the traditional tools of monetary policy address the familiar problem of inadequate bank reserves, but not the essential nature of today's problem: deteriorating balance sheets and net worth. The result of the Fed's new strategies will be smaller loan loss reserves and higher profits, healthier balance sheets, and ultimately increased lending.

Recessionary implications: The recessionary implications of these balance-sheet considerations are somewhat mixed, but probably negative on balance. It is certainly encouraging the central bank finally recognizes the gravity of these problems and is working with the Controller of the Currency to address them. Their actions should certainly help the economy to recover. The problem is that the impact of monetary policy on GNP is significantly less than is commonly supposed, and whatever impact it does have takes a long time to become evident.

History will probably show that the Fed reacted too late with too little. But it is not clear that a more aggressive monetary accommodation would have made much difference, for such evidence as exists suggests that the liquidation of massive amounts of bad debt takes time to run its course. And the overall economy inevitably suffers during this period of adjustment. In our view, Keynes' concept of a liquidity trap offers one explanation of why this is true, and of why the central bank's powers are limited.

The Fed may well increase the supply of credit (through balance sheets and manipulation of reserves). But a climate of rapidly falling asset market values and psychological malaise will depress the demand for fresh credit. The credit supply curve may well swing upwards, but the demand curve may well drop.

The liquidity trap describes what has recently been happening in the U.S., in particular the sluggish growth of bank credit and money that Fed Chairman Greenspan has lamented since this past winter. In such an environment, there is little that the central bank can do for the economy on its own. Badly over-stretched companies and households need time to lick their wounds, let them heal, and regain confidence. Regrettably, the one additional government measure that would help is precisely what is not forthcoming at present: an assist from fiscal policy channeled towards investment spending.

Consumer spending, housing, and construction blues

The growth rates both of personal income and household spending have been decelerating since late 1988. Both growth rates were down to about 1 percent when the Iraqi invasion of Kuwait occurred last August. Thereafter, consumer confidence took its greatest one-quarter dive in decades, unemployment began to rise, and recession began.

From a historical standpoint, consumer spending falls at an average rate of 0.4 percent during the first quarter of a recession. Rather surprisingly, it then rises at an average rate of 0.3 percent in the second quarter and in any remaining quarters of the contraction. As a result, consumer spending has almost always risen on a peak-to-trough basis, and has thus served as a brake on recession.

In our view, it is unlikely that this pattern will repeat itself during the present downturn. indeed, the predicament of the consumer may well exacerbate the downturn. There are four reasons why:

* Consumers typically draw down their savings rates to maintain spending on nondurables and services during recessions. More specifically, the average savings rate drops from a peak entry rate of 6 percent to a trough exit rate of 4 percent. But this time around, the consumer entered the recession with an estimated savings rate of only 4.3 percent. It is difficult to see this dropping to 2.3 percent in a manner mirroring historical experience.

* Consumer "wealth effects" from falling property values are likely to play a more significant role than ever before. Consumer surveys reveal that households understand that today's drop in real estate values is permanent rather than transient. They realize the drop in values results from fundamentals, such as demographic changes rather than from temporary developments, such as a deliberate Fed-induced spike in interest rates.

* Household income will continue to stagnate for two non-cyclical reasons: the absence of further entry into the workforce of formerly non-working spouses; and the prospect of increasing pressure on service-sector wages resulting from the slimming and restructuring phenomena discussed earlier.

* Consumer debt burdens are larger than ever before, as has been widely documented, and as is substantiated by record-high numbers of auto repossessions and mortgage foreclosures.

Above and beyond the plight of the consumer, there is distress in the construction industry. As we expected, housing starts have already dropped well below the one million mark - a drop that has taken place in the absence of any tightening of Fed policy during the past 24 months. The situation in apartment construction is equally bleak. Commercial real estate is in even worse shape. It is now estimated that virtually no new office buildings will be needed before 1995 in 11 of the largest 15 metropolitan regions in the nation.

Recessionary implications.. All of these developments suggest a much more sluggish recovery than usual. The traditional means of exiting a recession may not be as effective as they have been in the past.

Redressing U.S. economic problems

As we peer into the 1990s, four remedies are required if the U.S. is to put its house in order and regain meaningful economic growth and rising living standards.

1. Rationalize the financial economy. Today's financial quagmire is not something natural we are forced to live with. It is man-made. Our world of Glass-Steagall, McFadden, and flat rate FDIC insurance was hatched in response to the depression years of the 1930s and is no longer relevant in the 1990s. This patchwork of counter-productive and irrational regulations can and must be modified. As the globalization and integration of world financial markets proceeds, our existing piecemeal, fragmented system will become increasingly problematic.

2. Restore fiscal policy as policy. it is logically and empirically impossible to achieve the twin economic objectives of price stability and full employment if government avails itself of only one policy variable. Yet this is currently the case. Monetary policy is alive and well, but fiscal policy is dead. it cannot remain so. The fiscal policy that is called for is not simply one of more spending - spending which takes the form of increased transfer payments. What is needed is a policy of greater net investment in public-sector infrastructure and human capital.

3. Demand productivity growth from government. The public sector will inevitably account for a growing share of GNP in the years ahead. Yet, as most everyone now agrees, government is inherently ineffective in both the production and allocation of goods and services. It will continue to be so unless stringent and rational incentive systems are imposed on public-sector managers and employees. To date, they have not been. The decision-making process in Congress and throughout most of government is about as irrational as can be imagined. As the government sector continues to grow in coming years, its flat-to-negative productivity will increasingly depress the overall economic performance of the nation. Negative productivity? One need only look to the public education system for a tragic example.

4. Encourage growth of productivity in the service sector. Flat productivity growth in the huge service sector has been a principal source of anemic growth during the past two decades. Happily, market forces are now driving the restructuring and slimming-down of services that promises to increase productivity of the entire economy. But these market forces are not enough.

Working with business, government must overhaul everything from the tax laws to the school system, with the aim of increasing the nation's investment in human capital to create high value-added workers. The government also will have to play a role in improving the nation's physical and technological infrastructure. We need highways with computer-optimized traffic flows, high-speed railways equipped with fiber-optic communications and computing capabilities - everything and anything that will make the nation more attractive to global knowledge workers.

These, then, are the lessons of the 1990-91 recession, and, more importantly, of its larger context. We ignore them at our peril.
COPYRIGHT 1991 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Brock, Horace W.
Publication:Financial Executive
Date:May 1, 1991
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