Goldilocks Gone

By GEORGE J. CHURCH

What's the difference between a business slowdown, a so-called growth recession and a real recession (classically defined as two consecutive quarters or more of negative growth)? Through most of the increasingly boomy 1990s, American businessmen, workers and consumers by and large would have answered, Who cares? None of the three versions of economic contraction registered even as blips on the national radar screen. But brace yourself: it may be time to make those painful distinctions. The consensus of TIME's Board of Economists, which convened recently in Manhattan to assess the outlook through next year, is that the issue is no longer academic. It is practical and even pressing.

The U.S. economy is slowing from its blistering pace of late 1997 and early 1998, when growth rates ranged between 3.0% and 5.5% annually, and the sag is virtually certain to continue into next year. Given the continuing spread of the global financial crisis, from which the U.S. can no longer stay immune, "there must be a big slowdown," says Allen Sinai, chief global economist of Primark Decision Economics, a major forecasting firm. And next year, if the board's majority opinion is correct, the slowdown should cross the line into a growth recession. That is usually defined as a continuing increase in national output of goods and services, but one too puny to keep unemployment from rising.

What about the chances of a genuine recession? None of the economists on TIME's board would flatly predict one, but none would rule it out either. If the "Asian financial flu" infects Latin America and Canada, if a renewed plunge in U.S. stock prices scares consumers into slashing their spending, and if the Federal Reserve Board fails to make deep enough cuts in interest rates--why, then, a growth recession could turn into the real thing.

Noting that the U.S. until now has enjoyed a "Goldilocks economy"--not too hot, not too cold, just right--David Wyss, chief economist of Standard & Poor's DRI, the economic-consulting firm, poses this question: "Will the bears eat Goldilocks?" (As in the fairy tale, there are three bears--the Asian, Russian and Wall Street varieties.) His answer: It's a toss-up. Right now Wyss sees a fifty-fifty chance of an outright recession before the end of the year 2000. Wyss would have shifted the odds to favor recession if the Federal Reserve had continued to hold out against interest-rate cuts. But in late September the Fed did push through a quarter-point reduction in the so-called federal-funds rate, which banks charge one another on overnight loans--the first change since an equally small increase in March 1997.

Wyss, Sinai and other members of TIME's board think the new cut by itself is too small to have much impact. Other rates, on bonds for example, had already been adjusted downward in anticipation of a Fed move. But it is a heartening sign that Greenspan and the other Fed governors have become convinced that a worsening slowdown is now a greater threat than renewed inflation. Since Greenspan has long preferred to move rates in a series of small, repeated steps, the economists on TIME's board devoutly hope that more reductions will follow, late this year or in early 1999.

Should that happen, the TIME board's numerical forecasts are not spectacularly gloomy. Stephen Roach, chief economist of Morgan Stanley Dean Witter, the giant investment firm, foresees the growth in gross domestic product slowing to an annual rate of 3.2% by the end of this year--vs. 3.9% for all 1997--and then to 2.5% by the end of 1999. Sinai expects 1.5% for all 1998, then 1.9% for 1999.

Wyss is more pessimistic. He forecasts a GDP increase for all 1999 of only 1.5% and an unemployment rate rising to around 5% by the end of next year, and then 5.5% by late 2000. (Roach guesses 5% a year from now, and Sinai 5.3% by mid-1999.) Those estimates are all significantly higher than August's 4.5%, not to mention the 28-year low of 4.3% touched last April and May. It would be anything but bad, however, for a period of "growth recession." Even a 5.5% jobless rate would be lower than any the U.S. achieved between August 1990 and November 1994.

The slowdown, or growth recession or whatever, will bite much harder into corporate profits. They are already dwindling, to the grief of investors who saw the Dow Jones industrial average plunge from a July 17 high of 9337 to an Aug. 31 low of 7539, at least partly because it became obvious that earlier expectations of a continued smart rise in profits were wrong. Wyss expects after-tax profits to drop about 2% this year and stay essentially flat in 1999, perhaps rising a nearly invisible 0.3%.

Robert Gordon, who occupies the prestigious Stanley G. Harris chair of economics at Northwestern University, thinks profits may be hit even harder, though he offers no numbers. His explanation: labor shortages caused by the past boom are still severe and likely to remain so even with a slowdown in the growth of output. That condition will push up wages faster than companies will be able to raise either prices or productivity--that is, output per hour. Productivity is in fact already sliding, as it usually does at this late stage of a business expansion, the increasing computerization of the economy notwithstanding. Even such computer enthusiasts as board members Erik Brynjolfsson, professor of management at M.I.T., and Timothy Bresnahan, a Stanford University economics professor, do not expect the machines to transform productivity that quickly.

Gordon, however, points out that if wage increases cut into profits, that is good news for workers, at least those who stay off the unemployment lines. Labor is likely to recapture some of the share of national income it lost to profits in the early '90s. To the extent that wage increases run ahead of price boosts, workers' real incomes will also rise absolutely as well as relatively. And that is likely to happen, despite the fact that most of the economists expect inflation to quicken a bit from its current astonishingly slow pace--an annual rate of less than 1% in each of the first two quarters of 1998. But Roach's estimate of a 2.9% consumer price index rise in 1999 is the highest of the board's guesses, and Greenspan and the Fed might not find that acceptable.

More striking than any of the board members' numerical forecasts, however, is the marked change in the overall tone of some of their comments. Sinai, usually a sturdy optimist, now sees "the greatest risk to good times since 1989-91," the period that included the last outright recession, and though he predicts only a growth recession, he immediately adds that "I can't guarantee there will not be a recession in a traditional sense."

Sinai is most worried by "a very intense and unprecedented global credit crunch and balance-sheet contraction" that seems to be getting steadily worse. He runs down a kind of box score: nine of 13 countries on the Pacific Rim of Asia that once accounted for a third of world output "are in depression or recession, and we're still counting"; Japan, the world's second biggest economy, "is still going down--it looks like a drop of 2% this year"; in Latin America, Venezuela and Colombia are in recession and Brazil is "in a very dicey situation," saddled with an overvalued currency. Argentina also "is at risk because a chunk of its exports goes to Brazil." Even Canada is "slowing down because of Asia"--and Canada and Latin America together account for more than 40% of U.S. exports.

Russia's ruble devaluation and debt default were not especially damaging in broad economic terms; the Russian economy is no bigger, measured by gross domestic product, than that of the Netherlands. But the Russian default and devaluation were devastating financially and psychologically. They reinforced the impulse of global investors to pull their capital out of any country where they sense the slightest risk. Sinai explains that because of Russia's thousands of nuclear weapons, many considered its economy too important to be allowed to fail. Yet it did collapse, and investors drew a bitter lesson: in theory any country could "stiff the creditors" just as Russia did.

The global downward spiral "should serve as a lightning rod to world policymakers--yet it really hasn't," complains Roach. But what can they do? The International Monetary Fund has exhausted its ability to keep acting as a global lender of last resort, in large measure because the U.S. Congress has failed to pass appropriations to refill its coffers. President Clinton has asked Greenspan and Treasury Secretary Robert Rubin to set up a meeting with their counterparts in 22 countries, stirring some hopeful talk of a coordinated cut in global interest rates. But Greenspan promptly denied that any such move was afoot, and the TIME board thinks he is only being realistic. "The main decision makers are focused in totally different directions, and there is no incentive to coordinate," explains Gordon. The German Bundesbank, for example, is preoccupied with smoothing Europe's conversion to a common currency, the euro, and Japanese interest rates are already so close to zero that the Bank of Japan thinks it has no room to maneuver.

At best, Wyss and Sinai expect not even the beginning of significant world recovery before the year 2000--and some wounds will remain unhealed long after that. The era of "everybody investing in everything, everywhere" is finished, at least for a good long time, says Sinai. He thinks economists may even reluctantly stop preaching the gospel of totally free markets globally and accept the idea of a greater degree of government control, though far less than in old-fashioned command economies.

Amid such deep global gloom, why does the U.S. have at least a chance of scraping through with nothing worse than a growth recession, if that? Primarily because consumer spending propels two-thirds of the U.S. economy, and consumers are still, in Wyss's words, "spending their little hearts out." Continued high employment, rising wages, low inflation and a recent lowering of some key interest rates, such as those on home mortgages, even in advance of the cut by the Fed, should encourage consumers to keep spending rapidly too.

Maybe. Even the outlook for consumer spending is fraught with uncertainty. The U.S. savings rate hit a postwar low, 0.6% of income, in this year's second quarter, partly as a result of the GM strike. The savings rate is virtually certain to rise now, and the more of their incomes consumers save, the less, obviously, they spend. An increase to, say, 1% to 1.5% would not be too troublesome. A greater rise would be, though, and it could happen. Many people have felt safe while spending all or nearly all their current income because they thought they could eventually rely on stock-market profits to finance their children's college educations and their own retirement. The nearly 20% drop in the Dow from July high to August low may have convinced many that such a prospect is too risky; a deeper drop could change their attitude sharply.

Wyss has developed a rule of thumb to gauge how much a drop in stock prices might reduce consumer spending. He calculates that the July-August dive wiped away $2 trillion in paper values, which in turn will cut consumer spending $50 billion below what it otherwise would have been. By itself, that is not enough to trigger a recession--not even a growth recession--but it is a reminder of how vulnerable the economy might be to a prolonged bear market.

In the back of some economists' minds lurks another worry. The last time the U.S. confronted the possible impeachment of a President was in 1973 and '74. And that period just happened to witness a severe recession, a galloping inflation and one of the growliest bear markets in Wall Street history, during which the Dow fell no less than 45%. Could history repeat itself?

No way, says Gordon: current circumstances are totally different. In late 1973 Arab states imposed an embargo on oil shipments to the West and followed up with price boosts that quadrupled the cost of crude. Oil shortages pinched production, and the price boosts further fanned the upsurge of inflation that resulted from the lifting in mid-1974 of the price controls that President Nixon had imposed back in 1971.

Today the U.S. economy is so well balanced that it stands a good chance of coming through a global recession with fairly minimal damage. Inflation is well under control. Oil in particular is in such ample supply, thanks in large part to less demand from the financially strapped Asian countries, that its price, relative to the prices of other goods and services, is lower than before the 1973 embargo. There have been no distorting price controls or other straitjackets on the economy recently.

All true, of course--besides which there is no certainty that Bill Clinton will ever be impeached. But if he is, and the proceedings drag on, that is one more uncertainty for a world--and U.S.--economy that needs more uncertainty about as much as it needs--well, a deepening global recession.