ECONOMIC OUTLOOK FOR LATE 1999
Donald A. Nichols
U.S. PROSPERS AMID WORLDWIDE RECESSION
The U.S. economy continues to perform strongly despite the drag of a worldwide recession. As recession continues to be the forecast for the major economies of rest of the world in 1999, we might normally expect that the recession would engulf the United States as well. But the recessionary forces coming from the international economy were also present in 1998 and they were not strong enough to drag our economy down then. Because these forces are likely to be no stronger in 1999 than they were in 1998, I expect real growth in the United States to continue. Specifically, I expect growth here to continue at a rate of 2-1/4 to 2-3/4 percent net of inflation during 1999.
A year ago the question was whether the U.S. economy could thrive in a world of recession. The outcome of the confrontation was that U.S. exuberance won. And while a similar tug of war will take place in 1999, the forces at work are likely to be no more violent in 1999 than they were in 1998. Hence the most likely prospect for 1999 is the same as in 1998, which is that growth is likely to continue.
Do We Need A New Model to Understand The New Economy?
The economy's recent performance has been unusually strong based on historical standards. Most forecasters, myself included, have underestimated its strength repeatedly. Not only have we prospered in the middle of a worldwide recession, but there has been little evidence of inflation despite a reduction in the unemployment rate to levels that led to inflation in the past.
Increasingly, analysts are appearing who claim that the economy has changed in basic ways and to such an extent that the old methods of analysis no longer apply. The claim is that technology has moved so quickly creating new industries that are based on information and not on physical materials that our old ways of measuring and thinking about the economy, which are based on a factory system, are no longer appropriate. I disagree with this position.
In my view, the forces responsible for the unusual performance of the economy today are only in part the result of burst in new technology, and they do not require a new paradigm for us to analyze them. In my view, two forces are responsible for the economy's unusual performance in recent years, and while both are new, they can best be analyzed using the old methods. One is the increasing interdependence of economies around the world B we can call this globalization B and the other is the maturation of the baby boom and its preparation for retirement. Both of these forces have helped to drive stock prices up and interest rates down, making it easy for firms and households to invest in real capital. Hence a major feature of the boom has been a high rate of investment in productive capital by firms and a high rate of investment in housing by individuals.
Two paradoxes need to be explained in order to understand today's economy: (1) Why, if the worlds' economies are becoming increasingly interdependent has the United States become insulated from the worldwide recession? and (2) why, if the baby boomers are getting ready to retire B and hence are presumably saving at high rates B has the overall saving rate fallen to record lows? In my view these are the questions that must be answered if we are to understand the economy's recent performance. I do not see how either of these paradoxes can be resolved by turning to explanations that are based on the criticism that new technologies have emerged and that their importance has been underestimated.
A closer look at what happened in 1998 will help us to understand these paradoxes.
1998 in Perspective
The economy's performance in 1998 was quite unusual from several perspectives. Two features stand out.
Real growth remained strong in 1998 despite a huge drag from a large and growing trade deficit.
Inflation remained low despite a continued tightening of labor markets.
Those forecasters like myself, who accurately foresaw the worsening of the trade deficit, mistakenly thought that its drag would cause a substantial slowdown in the overall economy and might even touch off a recession. Indeed, the trade deficit increased by more than $100 billion in 1998. That is roughly 1 1/4 % of GDP. Normally, a reduction of that magnitude in an economy that grows on average by about 2 to 2 2 % would slow the overall rate of growth to below 1 percent and might even kick off a recession.
Enter Paradox Number2. The unusually large reduction in the trade balance was offset by a huge decline in the household saving rate. Household saving fell to zero in 1998. (Saving was re-defined by the Department of Commerce. On the old basis, the decline was to a rate of about 1-1 1/2 percent.) Consumers simply picked up all the slack that was left by the lost export sales. Overall, the two forces were a wash, though the switch from exporting to consuming caused a large swing in production away from manufacturing and toward services.
The second unusual feature of the economy's performance in 1998 was the absence of inflation despite tight labor markets. In my view this feature does not signal anything new about inflation though it points up the importance of the forces responsible for Paradox Number 1). Weakness in the world economy led to a decline in the prices of raw materials in 1998. Because of the increasing interdependence of the world's economies, the prices of raw materials used in the United States, whether produced at home or abroad, are set in worldwide markets. In 1998, raw materials prices fell by more than 15 percent at home.
Wages, on the other hand, did accelerate modestly in 1998. Modest acceleration is what history tells us to expect when the unemployment rate falls into the 4-5 percent range. While wage increases below 3 percent were the norm a few years back, wage increases of 4 percent are the norm today. Hence tight labor markets in the United States have led to a modest increase in wage inflation here, just as history suggested would be the case. Because the prices of products sold in the United States depend in part on the price of labor in the U.S. -- which was getting more expensive -- and in part on the prices of raw materials worldwide B which were getting cheaper -- prices of finished goods in the United States did not change in 1998. And as a further restraint on inflation, Persian Gulf politics and bountiful harvests worldwide contributed to a decline in oil and food prices.
Note that what was new in 1998 that helps to explain the absence of inflation was not some new badly measured technology, but simply a globalized economy. If we accept the facts that the worlds' economies are more closely integrated than before, and if we recognize that in 1998 the United States prospered in a sea of recession, it is simply a matter of arithmetic to show that on average U.S. production costs in the did not rise last year.
The Oasis of Prosperity Paradox
My last two reports developed in some detail an explanation of why the U.S. economy is thriving amidst world recession. Alan Greenspan has repeatedly questioned how long we can remain an "Oasis of Prosperity" in a desert of recession. While I will summarize here my previous analyses, fuller explanations of some features of the Oasis Paradox are found in my previous reports.
Briefly, the end of the cold war has led to a reassessment of the outlooks for the worlds' major economies. The prospects for the U.S. have been upgraded substantially by investors and consumers worldwide while the prospects for other nations -- China excepted -- have fallen in relative terms. In particular, they have fallen for Japan, which has been mired in a decade-long slump.
The surge in confidence in the future of the American economy has led to a large inflow of capital, which has caused the dollar to surge and fed the frenzy in U.S. equity prices. Real investment in the United States by foreign investors has also surged. Because of the worldwide recession, and because of the increasing value of the dollar, the Federal Reserve has not seen fit to raise interest rates as it normally would in response to the surging U.S. economy. Investment funds remain available at reasonable rates, confidence is high, and high-tech resources are being freed up from military uses.
The resulting boom provides confidence that is self-fulfilling. Meanwhile, collapsing confidence abroad has led foreign consumers to pull in their horns, and the resulting stagnation has also become a self-fulfilling expectation that is now hard to break.
The Saving Paradox
While I think I have a pretty good grip on the Oasis Paradox, I am a bit more tentative about my explanation of the Saving Paradox. It is quite clear, however, that what is keeping our economy strong at this time is the spending of households. Household spending in turn is being supported by the surge of confidence mentioned above. Consumer confidence in the United States is at a level unseen for forty years. This surge of confidence has helped to drive stock prices to new highs. It has supported a surge of home building, and it has led to a surge of purchases of consumer durables. The high stock prices have helped to provide a source of finance to households, enabling them to spend freely without interfering with their ability to finance future goals.
The dis-saving of retirees provides the key to understanding the Saving Paradox. Retirees typically dis-save. Indeed, the purpose of their saving while young was so they could dis-save when retired. It is likely that many current retirees are much better off than they had expected to be, and that they are able to spend at a far higher rate than they had anticipated a decade ago. Meanwhile, the younger generation may well be saving at the same rates as previous generations had, but their saving is being offset by the dis-saving of an older generation that has become the lucky generation in the sense of seeing its retirement savings soar in value.
Classroom models show how young individuals can save by buying assets from older generations, even though the society as a whole does no net saving. For example, if each generation of young workers saves for retirement by buying land from retirees, and if each generation of retired workers finances its retirement by selling land to young workers, a system of personal saving can be established in which there is no net aggregate saving even though each individual has saved. Hence an aggregate saving rate of zero does not indicate that anyone is behaving in an irresponsible way.
The monkey wrench in these classroom systems appears when an extra large generation, like the baby boom, must work its way through the system. This large generation drives prices up when they save and down when they sell. Naturally, their extra saving does not create more land, even in the classroom model, but it does raise the price of existing land.
Something like this is going on now as young workers buy stock from retirees. Perhaps the generations who are saving are putting aside even more today than previous generations did, but their increased saving is simply being offset by increased dis-saving by retirees. Because the young savers want to put larger sums aside than previous generations did, the older generation finds that their stocks have appreciated greatly in value and that they can sell at very high prices. The higher the price at which the older generation sells, the higher its dis-saving.
Whether the household sector as a whole provides net saving depends on both the saving of the baby boom and on the dis-saving of the retired generation (and its heirs.) Net new saving can occur only if new assets are introduced into the financial system that represent new investment. In the United States in 1998, no new shares were issued because mergers and buyouts took shares off the market. (Of course, existing shares increased in real value through retained earnings.) Furthermore, there was a substantial inflow of capital from abroad seeking U.S. investments though there were no new shares to be had. Some of the sales of the retired generation were to foreign investors. In the classroom model, the dis-saving of retirees would exceed the saving of the working generations if there were no new shares to buy and if on net some of the sales of existing shares were made to investors abroad.
The bottom line to this saving and investment equilibrium is that the saving rate in the United States has been driven to zero by soaring stock prices. It is possible for the saving rate to stay at that level or even to fall further for at least the next few years. Because we are in uncharted territory, however, there is no guarantee that the system won't come unwound by a collapse of stock prices. But the sensible forecast for 1999 is that the collapse won't come in that year. Indeed, there is less reason to expect a collapse in 1999 than there was to expect a collapse in 1998.
Can 1999 repeat 1998's performance?
While the trade deficit may worsen in 1999, it is unlikely to worsen by another $100 billion. Hence the drag from abroad will increase by less in 1999 than it did in 1998.
Saving rates, on the other hand, which have already fallen to lows not seen since the Great Depression, can continue their decline, though there is little basis for any confidence in this saving rate prediction. If the decline in saving rates continues, the boom could continue. A conservative forecast, again with little basis, is that the saving rate will stop falling. Hence the outlook for 1999 is that these factors may remain at the unusual levels they reached in 1998, but that there is no need to expect them to move by as much in 1999 as they did in 1998.
While there is little basis on which to predict an extension of these unusual factors into 1999, the most likely outcome appears to be one of continued growth, albeit with a modest acceleration of inflation.
Wisconsin is a manufacturing state. The major difference between the composition of its employment by industry and that of the nation as a whole is its concentration of employment in durable goods manufacturing and especially in machinery and instruments.
In 1998, Wisconsins manufacturing employment fared a bit better than average in terms of growth, though the whole sector slowed down substantially, as anticipated. Where Wisconsin performed more poorly than the rest of the nation in 1998 was in the growth of employment in service industries. Services have never been a strong point for Wisconsin. The switch away from exports and toward consumption is a really toward services and away from manufacturing. Furthermore, Wisconsins exports have been concentrated in the capital goods sector, and this sector suffered the most in the decline in exports on a nationwide basis.
Instruments have fared better. High tech medical instruments, for example, continue to be bought by the Japanese medical sector, which is an industry that is partly financed by government. But private sector purchases of capital goods in Japan have fallen sharply.
Basic materials, such as paper, have been hit very hard by the worldwide recession. Paper also suffers from over capacity, a problem that might have existed even without a recession. Farm equipment manufacturers have been hurt by the low prices of grain worldwide. These have hurt American farmers and restricted their demand for new equipment.
The forces that became evident in 1998 are expected to continue in 1999, though on a somewhat reduced basis. That is, the tilt away from manufacturing and toward servicesand away from exports and toward consumptionwill continue. Furthermore, I expect increased spending by retirees. This bodes well for Florida and Arizona, but not for Wisconsin.
Wisconsin is benefiting more than most states from the decline in oil prices because we import all of our energy. In 1998 Wisconsin benefited form the high level of dairy prices, but these prices have fallen substantially in 1999, indicating that rural areas will not be as buoyant in the future as they have been in the recent past.
Construction was extremely strong in Wisconsin in 1998, and I expect this industry to continue to be strong in 1999. The industry heads into 1999 with a full head of steam and with strong fundamentals.
Consumer confidence is high, the stock market is high, interest rates are low, and the prospects for continued growth in income is good. While further growth from existing high levels may not occur, it is likely that the existing high level of activity can be sustained.