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Talk about the Grinch who stole Christmas. Until recently, it was possible to indulge in some humor about the decline in the stock market and shortfalls in corporate earnings. No longer, it seems. Signs that the economy is weakening are cropping up everywhere: Consumer confidence has tumbled during the holiday season, and government statisticians report that retail sales fell sharply in November. The unemployment rate has ticked up, and housing activity has slumped. So a growing number of Wall Street traders and analysts are convinced (mistakenly, I believe) that the recent decline in the stock market is forecasting a recession for next year.
Some of the downturn simply reflects the normal ebb and flow of economic activity in a highly decentralized, dynamic capitalist system. Higher oil prices are crimping consumer spending and business margins. And companies are cutting back on ambitious capital-spending plans, especially for new high-tech gear.
Government policies are also weighing on the economy. The Federal Reserve sharply hiked the federal funds rate, a short-term interest rate it controls, in a successful campaign to slow the economy. Less appreciated is that fiscal policy is also stingy, resulting in a federal budget surplus at a robust 2.4% share of gross domestic product. "A tight fiscal policy perhaps deserves some of the blame for the current slew of downwardly revised projections of corporate earnings," says Kamalesh Rao, economist at Moody's Investor Services.
RED TIDE. But the fear of an economic collapse seems greatly exaggerated. The economy doesn't appear to have any of the severe imbalances that typically accompany a sudden downturn in the business cycle. What's more, the current tightness in fiscal and monetary policy means both have plenty of room to ease. "For the first time in 30 years, we're in a position where both fiscal and monetary policy could be used to stimulate an economy that is sputtering or heading for a recession," says Mark Zandi, chief economist at Economy.com. Adds James Paulson, chief investment officer at Wells Capital Management: "The very tightness of both means we have a ton of ammo to use."
Investors are already anticipating that the Fed will ease soon, although perhaps not as quickly as the next Federal Open Market Committee meeting on Dec. 19. Indeed, interest rates are coming down, evidence that investors are easing the downward pressure on the economy even before the Fed acts. Long-term interest rates, such as mortgage rates, are down by almost a percentage point since the beginning of 2000. Short-term rates are also down sharply. The current 5.45% yield on a two-year Treasury note is about a percentage point below the 6.5% fed funds rate -- an unusually wide spread (or difference between the two rates).
How about fiscal policy? Should legislators "ease" too? Hardly. The experience of the past several decades suggests that policymakers can't cut taxes or hike spending quick enough to affect the economy in the short-run. What's more, the economic impact of shifts in fiscal policy is highly uncertain. Remember when Clinton's tax hike in 1993 was supposed to send the economy into a recession? Instead, the markets rewarded fiscal discipline, and the economy strengthened.
IT NEVER WORKS. Indeed, interest rates could soar if the government enacts an aggressive tax cut, as investors worry about a tide of red ink. "We shouldn't use fiscal policy to fine-tune the economy," says Mickey Levy, chief economist at Bank of America. "It hasn't worked in the past and won't work now."
In coming weeks, we'll all read and hear commentary about the need for massive tax cuts to avert economic collapse. Vice-President-elect Richard Cheney hinted as much when he called for tax cuts for an economy on "the front edge of a recession." I wouldn't buy the rhetoric. The economy is healthier than the recession-mongering suggests. Even more important, while there's a strong case for federal tax reform, both theory and experience suggest there's no case for tinkering with the economy through fiscal policy.
Farrell is contributing economics editor for Business Week. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online Edited by Beth Belton
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