Volume CXXXIII, Number 5 October 12, 2001 f

Economic Update: The morning after
GREGORY DECOSTER AND KERRY PANNELL
STAFF WRITERS

You have no doubt heard that the U.S. economy is in recession. The obvious questions are: Why? What is to be done?

The U.S. economy in the late 1990's can best be described as a "bubble economy." Stock prices increased far beyond levels justified by economic potential. The "bubble" in prices was, of course, most spectacular in the technology sector with wealth, on paper, being created at an astonishing rate. But in a capitalist economy, the prices of financial assets direct the creation of productive capacity.

When the prices of particular assets, for example, tech stocks, rise to excessive levels, too large a portion of society's scarce savings is allocated to expansion of the affected sector. Unwarranted business creation and growth become the order of the day. Afraid of being left behind, even established, conservative corporations overinvest in the "hot" sector. Talk is of a "new economy," within which the old rules of economics no longer apply.

Eventually, prudence re-emerges, the "bubble" bursts, and we awaken to the reality that, over a period of years, a significant quantity of resources has been wasted. Financing opportunities that would have enhanced society's productive capacity have been bypassed in favor of the more fashionable "bubble" sector. Human resources have been devoted to ultimately unproductive pursuits. The consequence is that society's productive capacity is lower than it could have been, and the economy must endure a substantive, time-consuming, and painful reallocation of resources.

Some businesses fail, others need only to downsize. Also, to the extent they indulged in fashionable over-investment, companies, even those businesses with strong ongoing business prospects, find retrenchment a necessity. This process manifests itself through a dramatic decline in business investment, 10-15 percent in the current case, resulting in a decline in the economy's level of production. Of course, it is also necessary to reallocate workers, which takes time. As this occurs, unemployment rises above its long-run sustainable level. In a word: recession.

Seven decades ago, commentators would have said that a recession was necessary to purge the excesses from the system, a reckoning, if you will. A more modern, less judgmental statement might be that a recession is a nearly inevitable consequence of the reallocation of resources necessitated by the deflation of a major "bubble." It is important to understand that there is little that can, or should, be done to curtail this economic adjustment. What should be done has been done.

In response to similar episodes in the past, society introduced economic institutions that prevented temporary disruptions of economic activity (like the current recession) from escalating into deep depression. Under normal circumstances, only additional policy actions, designed to reduce the pain foisted upon individuals as the necessary adjustment occurs, would be appropriate.

However, the events of September 11th and the emerging war have the potential to complicate matters. The consumer psychology, partly responsible for the "bubble economy" of the 90's, can also work in the reverse direction. Consumers may react to fears of additional terrorist attacks by dramatically curtailing their spending for a substantial period of time. This would cause business in some sectors to contract more than is required by the deflation of the economic "bubble." The ultimate severity of the recession and timing of the recovery will, therefore, depend upon how consumer psychology evolves over the next few months.

Consumer psychology can be manipulated. As government leaders devise policies to assist those affected by the recession, they also are attempting to identify policies that will restore consumer confidence, and, presumably, the willingness to spend. These proposals will include some combination of increased government spending and tax cuts.

As long as the actions taken have only a short-term negative effect on the government's finances, they likely will be harmless and may even achieve the desired results, leading to a quicker recovery. However, if policy-makers implement proposals with negative long-term effects on the government's finances, future economic performance will be harmed.

Recognizing that the current economic situation is a temporary, albeit painful, period in our history, is the prerequisite for a wise governmental and, more broadly, societal response.