Most key economic variables and indicators show that the U.S. economy continued to slow down in 2001. The warning signs started to appear in the last two quarters of 2000 and remained evident throughout the first two quarters of 2001. The evidence is widespread. The effects of the World Trade Center attack in September will only intensify this slowdown in the short run. The economy will almost certainly move into a recession in the near future, although the length and severity are uncertain.
An economy does not fall apart all at once without any early signals from the leading economic indicators. Indeed, there were advance signs of the end of the long economic expansion of the 1990s. The trends of some of these leading indicators are discussed in detail below.
Background Considerations
If the economy had been strong on September 11, the terrorist attack could be considered as a short-term incident in terms of economic impact, with no serious effect on the growth of the economy. However, economic growth was close to zero in the second quarter of 2001, and the effects will therefore be proportionately greater. Among the contributing factors to this scenario is the negative impact of the attack on consumers’ and investors’ confidence as reflected in the significant stock market drop when the markets first re-opened after the attack. This drop will further exacerbate the “reverse wealth effect” which had already been underway for at least a year. It will likely hold back consumption and investment spending. Contraction in some major industries, including airlines, insurance, entertainment, restaurants, tourism, and finance should be expected. These were among the industries that contributed to the growth of the gross domestic product (GDP) during the expansion of the earlier part of the 1990s.
The uncertainty created by the military action taken by the U.S. and its allies against terrorism is likely to make consumers and investors more conservative in their spending throughout the world. Consequently, the volume of international trade will drop. All of these factors may be mitigated, to some degree by the planned government stimulus package and the effects of the interest rate cuts. Additionally, while the stock market’s decline for more than a year now has created a reverse wealth effect, this may have been partially offset by the increased valuation of residential property that has occurred at the same time. At least for those who own their homes, and especially for those who have re-financed and therefore have lower payments, the sense that they still have money that they can spend on other items may help keep consumer spending higher than it would otherwise be.
Understanding where the economy stands with regard to the business cycle is helpful in planning to cope with the uncertainties of this time, both as business managers or owners and as individuals. A consideration of the data presented below shows that the expansion of the 1990s has entered a classic contraction phase.
Key Economic Data
Consumer Spending: In the first quarter of 2001, the index of consumer confidence plunged over 22 points, reaching its lowest level in five years. It was the biggest two-month drop since the 1990-1991 recession. The drop in confidence is a response to the recent stock market performance as well as the news of job cuts. For the first time since the inception of the program, 401(k) accounts had lost an average of $5,000 per household by the end of the second quarter of 2001. This has affected consumer spending. During this period, aggregate spending grew at rate of 2.1%, the lowest rate in four years.
Manufacturing: By the end of the second quarter of 2001, the manufacturing sector had been contracting for three quarters, and manufacturing jobs are still declining sharply. During the first eight months of 2001, the manufacturing sector alone lost 141,000 jobs. The rate of growth of investment spending plunged 13.6% at the end of the second quarter of 2001, while the rate of growth in technology spending on equipment and software was down 14.7%, reaching the lowest level since 1982. Some of this is due to U.S. manufacturers having outsourced some manufacturing to foreign countries in the past few years. Outsourcing has also affected capacity utilization, which went down from an average of 81% in 1990s to 76.4% at the end of second quarter of 2001, the lowest rate since 1983.
Trade Deficit: During the expansion of the 1990s, exports rose 88.95%, while imports increased by 254%, resulting in a trade deficit of $428 billion. This means that more money leaked from the economy than was injected back into it, taking away potential business from the American businesses and limiting demand for domestic products. The U.S. trade imbalance doubled in the past two years to almost 4% of GDP while the dollar increased in strength in terms of other currencies. The rate of growth of exports plunged 9.9% in the second quarter of 2001 compared to 13.5% growth at the end of the second quarter of 2000.
The Purchasing Managers Index: This index is one of the main economic indicators that Federal Reserve Chairman Alan Greenspan and the Board of Governors use to gauge the U.S. economy’s health. An index above 50 is an indication of economic expansion and an index below 50 is a sign of possible future economic slowdown. Any index below 42.7 is an indication of a likely future recession. The index fell below this level in the first quarter of the year 2001, registering 41.2 in January, the lowest level in nearly 10 years, before going up to 44 in June 2001. At that point the index had been below 50 for eleven consecutive months.
Unemployment: The unemployment rate was 4.9% in September, unchanged from the rate reported for August. That is the highest rate in four years. Even that apparent stability is deceptive since 84,000 jobs were eliminated in August and another 199,000 in September. The September job loss was the largest since 1991. The GDP annual growth rate of 0.1% reported for August of 2001 was the lowest since 1993. In short, the evidence of the slowdown has continued to build in 2001.
Investment Spending: Non-residential investment spending, as defined in economics, is one of the most important economic variables that can be used to indicate whether the economy is in recession or expansion. Residential investment is excluded since it tends to have its own cycle that does not coincide with the rest of the business cycle. Investment is the most variable element of aggregate spending, far more volatile than consumer spending. For example, in the long expansion from 1991 through 2000, investment rose by 254% while consumption rose by 41.6%. Also, in the expansion phase of the three business cycles from 1970 through 1991, investment rose 23% while consumption rose 14%, on average, per cycle.
Investment spending is determined by several variables, but available funds, including profits and the expectation of profits, are key. Factors that play a role in profit expectations include tax policies, interest rates, expectations for the economy as a whole, and inventory levels, as well company and industry variables. Businesses invest because they expect to make a profit. When actual profits decline, there is less money for investment. Expectations for profit in the near term often decline as well. Even when expectations improve, there is still a time lag before new investment occurs because of the lag in information, and the time required for planning, theactual purchase of large equipment, and the construction of plant.
Present Economic Situation
The growth of 4.1% in 1999 GDP indicates there was solid growth that year. The first half of 2000 continued strong, with a 5.7% annual growth rate in the second quarter, although the third and fourth quarter growth rate was much slower — 1.3% and 1.9%, respectively. Consumption spending, which constitutes the highest share of total spending, rose sharply in 1999 and continued at a strong pace through the third quarter of 2000. The pace slowed significantly by the first two quarters of 2001.
Similarly, growth in investment spending was strong in 1999, followed by two excellent quarters in 2000. Then investment spending also slowed in the last quarter of 2000 and declined in the first two quarters in 2001. A decline of 13.6% in the rate of growth of investment was reported for the second quarter of 2001– the lowest level of growth since 1982.
The decline in tax revenues and the decreasing rate of growth of employee compensation (wages, salaries and other benefits) for the last four quarters confirm the slowdown of the U.S. economy. In addition, the recent decline of about 5% in capacity utilization of manufacturing plants has added to the cost of production and cut into profits.
Even with the fiscal stimulus package the government is considering and the interest rate cuts, it may take some time for these trends to change. Government spending accounts for 15-20 percent of total spending. Even a $75 billion increase in government spending is not a large increase in terms of total spending. Second, no matter how aggressively the Federal Reserve cuts interest rates, if consumers and investors choose not to spend more and instead use the money to pay down debt or save, the economy may be slow to turn around. The present economic situation did not start suddenly, and it will not improve suddenly. There is a good chance of a recession beginning before the end of the year.
How did the U.S. Economy Get to This Situation?
In the following sections, the behavior of the components of total spending and total cost will be examined for the 1990s expansion (1991-2000) This, in turn, will lead to some conclusions about how we reached the current economic situation.
Investments: Looking at the rate of growth of gross investment, from the second quarter of 1991 to the third quarter of 2000, investment spending grew at an exceptional rate of 254%. There were two main reasons for this unusual growth. First, the rate of growth of profit was 88.7% during this expansion, one of the highest rates in the history of the U.S. economy. Second, investment increased way beyond the growth in profit on the basis of high optimism and speculation by businesses.
As was mentioned earlier, U.S. manufacturers have outsourced some production to foreign countries in recent years. This has led to a significant reduction in domestic investment in plant and equipment in the United States. Additionally, the slowdown in the economies of the rest of the world means that U.S. businesses have not been expanding capacity in order to increase exports. The rate of growth of U.S. exports has been decreasing since the fourth quarter of 2000. At the end of the second quarter of 2001, it was -9.9%, the lowest it had been in years.
Effect of Government Policies: In the expansion of the 1990s, government spending rose by only 19.7%, while tax revenues rose 63.5% even though tax rates did not increase. Another factor contributing to the decline in the deficit was the fiscal restraint shown by the government in its own spending. Since government revenues rose faster than expenditures, the deficit declined. Toward the end of the 1990s, a large surplus had been created. This surplus was the money taken from the income of consumers and businesses. Therefore, it reduced the potential demand for consumer goods and services and for capital goods. Total consumption spending rose 41.6% during that period, but national income rose 42.75%. This means the share of consumption in national income decreased by 1.15%. Since consumption spending is the largest component of the aggregate spending, a decrease of 1.15% cannot be ignored. Added together, at the end of the 1990’s expansion, these resulted in a reduction in production, and consequently, in profits and investment.
Costs: In the 1990’s expansion, the prime interest rate rose to 9.2% as the Federal Reserve moved to slow down the aggressive growth of the economy. The higher interest payments increased costs of production and cut into profits. Higher interest rates also increased the costs of debt for consumers. The price index of raw materials rose 21.75%, potentially creating some pressure on profits, depending on the behavior of final prices. In addition, the decreasing rate of capacity utilization increased costs of production.
During this expansion, tax collections increased 63.5%, while employee compensation increased only by 36.75%, and national income increased by 42.75%. A comparison of these data indicates that aggregate demand was constrained from both sides. The fact that almost all costs rose more rapidly than national income at the end of the 1990s expansion was an important factor contributing to lower profits, lower investment and the economic slowdown that began in the fourth quarter of 2000.
Summary and Conclusions
An economic slowdown, with declines in some key economic variables, began in the last quarter of 2000. But economic problems that became fully apparent in that quarter did not begin suddenly. They were accumulating for some time. During the expansion of 1990s, the ratio of consumption to income fell, which reduced aggregate demand and total revenue. Government tax revenue rose faster than government spending, so government had less and less of a positive impact on aggregate demand and revenues. A high trade deficit did not help the economy and constrained the demand for domestic products. Therefore, there were trends limiting aggregate demand in terms of consumer demand, demand from net export, and government demand. On the supply side, there were rising costs, such as higher interest rates, raw materials prices, and the recent decreasing rate of capacity utilization which increases the cost of overhead.
Lower profits eventually led to lower investment and the recent economic slowdown. Despite massive amounts of liquidity that are expected to be infused into the economy by the government through tax rebates, interest rate cuts, and the spending for projects related to the September 11 tragedy, the economic contraction has been intensified by the catalyst effect of the World Trade Center terrorist attack. Most likely the economy will move into a recession in the near future.
Despite the claims of a “new economy” based on technology advancement, communication enhancement, and the globalization of businesses from a macro-economic view, the business cycle is still with us. Events similar to those in previous business cycles, including pressure from both the demand and supply side, led to a reduction of profits and investment and the economic slowdown in 2001.
Understanding the trends of the key economic variables and leading indicators such as profits and profit expectations over the different phases of the business cycle enables us to predict where the economy is going to be in the future. If a decision maker understands the present state of the economy and the factors that have contributed to its slowdown, he or she will be able to foresee the coming of an economic slowdown, recession, or recovery in the future.
