BUSINESSWEEK ONLINE : NOVEMBER 27, 2000 ISSUE
COVER STORY

The Economy: Passing a Dimmer Torch
The next President will likely have to deal with a fading expansion

Al Gore's Nov. 15 bid to end the rhetoric and squabbling in Florida gave hope that eventually this election will be over. The counts and the recounts, the suits and the countersuits will become yesterday's news. Butterfly ballots will fade into the history books, people will forget about chads, and a new President will take office on Jan. 20. And that's when a new issue will leap to the top of the agenda: the economy. Its performance is taken for granted when times are good but becomes a national fixation when it falters. And such a time might not be far off. In the face of six interest rate hikes by the Federal Reserve, high oil prices, a falling stock market, and a tech boom that seems to be losing some steam, the supercharged U.S. economy may finally shift out of overdrive.

No matter who occupies the White House, there's a good chance he will preside over the sputtering of the longest economic expansion in U.S. history--one that started under the elder George Bush in 1991 and accelerated through two terms of Democrat Bill Clinton. All signs point to slower growth, and a growing number of economists say a recession in 2001 is a distinct possibility.

While a troubled economy is never easy for a President to deal with, let alone a newcomer to the White House, this time may be even trickier. The ebbing of the New Economy boom will occur in a political climate that could remain poisoned by the bitter wrangling over the Presidential election. At the same time, the specter of conflict in the Mideast poses economic and political threats.

Right now, the consensus forecast for next year is for 3% growth, the slowest pace since 1995 and a sharp drop-off from the 5% that 2000 is likely to show. Profit growth will probably slide even more, especially if wage and health-care costs continue to rise. Economists at Morgan Stanley Dean Witter ( MWD), not generally known as a pessimistic bunch, are projecting only a meager 0.9% gain in aftertax corporate profits, compared with a 15% projected increase this year. That translates into a 4% to 5% increase in earnings per share for the Standard & Poor's 500-stock index in 2001, down significantly from the much faster pace of recent years. ''It's a soft landing for the economy, but a hard landing for earnings,'' says Richard Berner, chief U.S. economist for Morgan Stanley.

SKITTISH INVESTORS. Moreover, things could get even worse between now and the midterm election two years hence. In one scenario, the slowdown in corporate profits could send the stock market plummeting as skittish investors pull out. That would drag down consumer spending, greatly reduce capital investment, and choke off investment in the young companies that are an essential part of the New Economy. The first signs of this process are already occurring: The falling Nasdaq is stalling initial public offerings and forcing many dot-coms to close up shop.

Historically high levels of corporate and consumer debt, meanwhile, could become increasingly onerous as growth slows (chart). Add in a slowdown overseas and the possibility of even higher oil prices (page 42), and the downside risks to the economy increase. ''We're headed for a year of 2% or less real gross domestic growth,'' says James W. Paulsen, chief investment officer of Wells Capital Management in San Francisco. Adds Nicholas S. Perna, president of Perna Associates in Ridgefield, Conn.: ''I think the odds now of a recession sometime within the next 12 months are up around 30%.''

Before Election Day, Wall Street was cheering the prospect of a divided government. The theory was that political paralysis would prevent the Republicans from pushing through a dangerously large tax cut while stymieing Democrats' plans for lavish spending. Meanwhile, the Fed would take care of steering the economy.

Now, however, there's a growing fear that residual rancor between the parties could prevent Washington from dealing swiftly with the sorts of problems that can occur when the economy slows: a stock-market crash, a plunge in the dollar, a cascade of corporate bankruptcies, or trouble in the banking system. Such crises as the savings and loan bailout of the '80s or the Asian meltdown require the White House and both parties in Congress to be able to work together.

But this new President can expect neither an economic nor a political honeymoon--or much goodwill on the other side of the congressional aisle. ''It's going to be as difficult as any two years we've seen, from government's point of view,'' says Representative Michael Castle, (R-Del.). ''Whoever is going to be President is going to be vilified by almost 50% of the country.''

SCALING BACK. What could go wrong? While there is still plenty of strength in the tech sector there are signs that the tech boom is beginning to unwind. In the U.S., tech orders seem to be weakening, with the third quarter average barely above the second quarter (chart, page 38). The Nasdaq has lost almost 40% of its value since March as company after company has lowered growth forecasts for the coming year. One dose of pessimism came from Dell Computer Corp. ( DELL), which on Nov. 9 announced a lower-than-expected forecast for sales growth in the coming fiscal year. ''There's no question the economy is slowing,'' says Chief Executive Michael Dell.

That's got many smaller businesses starting to scale back. Marc Ferguson, chairman of Cofiniti, an Austin (Tex.) developer of software for financial planners and managers, isn't optimistic about next year's outlook. His company, which has 148 employees and is in the process of raising a $25 million round of venture capital, has begun pulling back on hiring and capital spending. ''We've cut back on the fringe R&D that was futuristic but wasn't going to end up in a product any time soon,'' says Ferguson.

The story is the same at larger companies. Execs at Cambridge (Mass.)-based Polaroid Corp. ( PRD), for example, say the 2001 budget will be more conservative on spending, expenses, and capital expenditures. ''We're preparing for slower economic growth next year,'' says Gary T. DiCamillo, Polaroid's chairman and CEO. ''We're still investing for the digital future, but at a slower rate.''

Some of the worst news has come in the telecom industry, where big spenders such as AT&T ( T) and WorldCom ( WCOM) have been struggling with lower-than-expected sales. The troubles are hitting smaller players even harder. One sign: On Nov. 14, ICG Communications ( ICG), a once high-flying Colorado-based telecom, filed for Chapter 11 bankruptcy.

Nor have Old Economy industries been exempt from the slowdown. Nontech manufacturing output has fallen at an almost 2% rate in the third quarter, led by a 32% decline in the production of appliances and a 25% decline in truck production. Meanwhile, car sales have been softening. ''Total demand in the American auto market has been declining since September,'' says CEO Takashi Sonobe of Mitsubishi Motors Corp.

Any slowdown is going to be aggravated by historically high levels of corporate and consumer debt. On Nov. 14, Bank of America ( BAC) announced that fourth-quarter losses from bad loans would be more than $870 million, double the third-quarter figure. Corporate debt has been rising by 13% over the past year, far faster than the growth of GDP. Consumer debt has been soaring as well. ''Leverage among low income households is high and rising fast,'' says Mark Zandi, chief economist at Regional Financial Associates.

Signs of a day-to-day squeeze are showing up in retail sales, which rose only 0.1% in October. ''I can see that people are being more frugal with their purchases,'' says Rafael E. Cuellar, CEO and president of Eco & Sons Inc., a privately held holding company for President Supermarket in Passaic, N.J. ''A year ago, they were purchasing more expensive cuts of meat like filet mignon. Now they're buying chuck steaks.''

Increasingly, consumers are finding themselves squeezed by rising fuel or housing prices. ''Rents are skyrocketing to the extent that we can't spend more for the holidays,'' says Lisa M. Gorski, senior research scientist at the U.S. Agriculture Dept. in Albany, Calif. ''Those numbers are tempering all of our spending, including buying a car, going on vacations, or holiday shopping.'' Others are hurt by the stock market. ''The market tanked, and my portfolio went with it,'' said Rick Dunham, a 33-year-old consultant from Atlanta, who is sharply cutting his holiday spending.

WORRIES OVERSEAS. With consumer and business spending slowing in the U.S., economists had hoped that foreign economies would pick up the slack. Instead, projections of European growth in 2001 are being ratcheted down. Signs of weakness abound. West European new-car sales fell by 4% in October compared with a year earlier. Meanwhile, German retail sales fell in September for the fourth time in five months. ''The U.S. remains the lynchpin of the global economy,'' says Peter Hooper, chief U.S. economist for Deutsche Bank ( DTBKY). ''Europe just isn't moving ahead strongly enough to pull the world economy with it.'' In Asia, there are similar signs of weakness. Industrial production fell sharply in September in both Japan and Korea. And the bankruptcy of South Korea's Daewoo Motor may trigger massive layoffs in that country and hamper growth.

Of course, the Federal Reserve has shown itself capable of coping with many economic problems, both domestic and international. Notes Melvyn Bergstein, CEO of e-business consultants Diamond Technology Partners ( DTPI) in Chicago: ''It's hard for me to believe that Greenspan is going to allow the economy to slip into hard times.''

But there are plenty of problems that Greenspan can't address alone or that will require cooperation between Congress and the Administration. If the U.S. is hit by both slow growth and rising inflation, or ''stagflation,'' the appropriate remedy is tight monetary policy combined with fiscal stimulus, as in the early '80s. Similarly, a stock-market crash may send the dollar plunging as foreign investors flee the country, forcing the Fed to raise rates to protect the currency even as the economy slows. Once again, fiscal stimulus would be essential.

Moreover, the Fed can't handle international financial and trade problems by itself. The Asian bailout, for example, required both quick action by the Treasury and congressional approval for funds. And bringing down the huge trade deficit, now at almost 4% of GDP (chart, page 39), needs a government that can negotiate trade agreements.

The expectations of a large surplus next year may make it easier to cut taxes or boost spending if needed. But the problem is that slower growth will also reduce the surplus significantly. That could make it hard to get a consensus for fiscal stimulus. ''We need to continue to pay down the debt,'' says Representative Connie Morella (R-Md.), part of the group of moderate Republicans who could play a critical role in the new Congress. ''We have to be careful how our money is spent.'' In the event of a slowdown, business ''should not look to Washington to act,'' adds Representative Amo Houghton (R-N.Y.), another moderate Republican.

Even if the parties agree on the need for fiscal stimulus, arriving at the exact form may be difficult. ''You could visualize a situation in which, because of partisan conflicts, each side stands on its version of what tax cuts are appropriate, and nothing gets done, or it gets unduly delayed,'' says Albert M. Wojnilower, senior economic adviser at private investment firm Monitor-Clipper Partners.

Political gridlock could slow the response to a financial crisis in a nation like Argentina, which is struggling to meet some $20 billion in debt due next year. An international bailout, if needed, might be difficult to cobble together, if it goes beyond what the IMF can afford. ''This policy is where the hands of the U.S. Treasury could be somewhat tied by the outcome of the election,'' says Renato Grandmont, Latin America equity strategist for Deutsche Bank.

An economic slowdown and rising unemployment might lead to a renewed outcry against imports. In that case, politicians looking for an edge might be tempted to fan protectionist sentiments, rather than pushing for free trade and open markets in other countries. ''There is a protectionist problem that could arise that might be made more difficult because of the closeness of things in Washington,'' says Jim Leach (R-Iowa), chairman of the House Banking & Financial-Services Committee.

And then there are the problems that no one foresaw. Virtually no one expected the collapse of the Mexican peso in 1994 and 1995 or the meltdown of the Asian economies, and the 1998 implosion of Long-Term Capital Management came completely out of the blue. A huge wild card now is the possibility of conflict in the Mideast. ''The one big risk in the economic arena is a disruption of world oil markets at a time when everything is very tight,'' says Barry P. Bosworth, a senior fellow at the Brookings Institution. ''And for that you might need the ability to act quickly and strongly.''

To be sure, in a real crisis, people tend to put away partisan differences. ''Always in the past, America has rallied behind our leader, no matter how small a mandate he had in the election,'' says Neil Flanzraich, vice-chairman and president of IVAX Corp ( IVX), a Miami pharmaceutical company. Still, the enmity generated by the election may linger. Adds Leach: ''The odds are we'll unite around the next President. But if this goes on much longer, that will be much more difficult.'' And it will be much more dangerous for the economy.

By Michael J. Mandel, with Peter Coy, in New York; Lorraine Woellert in Washington; and bureau reports

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