Economic Update: The morning after
The U.S. economy in the late 1990's can best be described
as a "bubble economy." Stock prices increased far beyond levels
justified by economic potential. The "bubble" in prices was,
of course, most spectacular in the technology sector with wealth, on paper,
being created at an astonishing rate. But in a capitalist economy, the
prices of financial assets direct the creation of productive capacity.
When the prices of particular assets, for example, tech
stocks, rise to excessive levels, too large a portion of society's scarce
savings is allocated to expansion of the affected sector. Unwarranted
business creation and growth become the order of the day. Afraid of being
left behind, even established, conservative corporations overinvest in
the "hot" sector. Talk is of a "new economy," within
which the old rules of economics no longer apply.
Eventually, prudence re-emerges, the "bubble"
bursts, and we awaken to the reality that, over a period of years, a significant
quantity of resources has been wasted. Financing opportunities that would
have enhanced society's productive capacity have been bypassed in favor
of the more fashionable "bubble" sector. Human resources have
been devoted to ultimately unproductive pursuits. The consequence is that
society's productive capacity is lower than it could have been, and the
economy must endure a substantive, time-consuming, and painful reallocation
Some businesses fail, others need only to downsize. Also,
to the extent they indulged in fashionable over-investment, companies,
even those businesses with strong ongoing business prospects, find retrenchment
a necessity. This process manifests itself through a dramatic decline
in business investment, 10-15 percent in the current case, resulting in
a decline in the economy's level of production. Of course, it is also
necessary to reallocate workers, which takes time. As this occurs, unemployment
rises above its long-run sustainable level. In a word: recession.
Seven decades ago, commentators would have said that a recession
was necessary to purge the excesses from the system, a reckoning, if you
will. A more modern, less judgmental statement might be that a recession
is a nearly inevitable consequence of the reallocation of resources necessitated
by the deflation of a major "bubble." It is important to understand
that there is little that can, or should, be done to curtail this economic
adjustment. What should be done has been done.
In response to similar episodes in the past, society introduced
economic institutions that prevented temporary disruptions of economic
activity (like the current recession) from escalating into deep depression.
Under normal circumstances, only additional policy actions, designed to
reduce the pain foisted upon individuals as the necessary adjustment occurs,
would be appropriate.
However, the events of September 11th and the emerging war
have the potential to complicate matters. The consumer psychology, partly
responsible for the "bubble economy" of the 90's, can also work
in the reverse direction. Consumers may react to fears of additional terrorist
attacks by dramatically curtailing their spending for a substantial period
of time. This would cause business in some sectors to contract more than
is required by the deflation of the economic "bubble." The ultimate
severity of the recession and timing of the recovery will, therefore,
depend upon how consumer psychology evolves over the next few months.
Consumer psychology can be manipulated. As government leaders
devise policies to assist those affected by the recession, they also are
attempting to identify policies that will restore consumer confidence,
and, presumably, the willingness to spend. These proposals will include
some combination of increased government spending and tax cuts.
As long as the actions taken have only a short-term negative
effect on the government's finances, they likely will be harmless and
may even achieve the desired results, leading to a quicker recovery. However,
if policy-makers implement proposals with negative long-term effects on
the government's finances, future economic performance will be harmed.
Recognizing that the current economic situation is a temporary, albeit painful, period in our history, is the prerequisite for a wise governmental and, more broadly, societal response.