First, the U.S. slowdown does not exist in a vacuum. Most of the rest of the world has followed the U.S. into recession, with forecasts of world growth below 2% for at least the first half of 2002. Growth outside the U.S. had been driven by overheated U.S. demand in the late nineties, with exports to this country, rather than domestic demand, leading growth. With the U.S. slowing, our imports have declined affecting the growth of trading partners in the rest of the world. There are spotty signs of recovery in some countries, but, for the most part, it seems unlikely that foreign demand, independent of a resurgence in U.S. growth, will act to cushion U.S. economic activity anytime soon.

But even the slowdown has been different from the normal recession. Usually a downturn in business fixed investment follows rather than leads an economic slowdown or a recession. The usual, though simplified, recession timeline goes like this: fast-paced growth strains the economy’s resources raising the potential for rapidly rising inflation. The Fed steps in to return the economy to a more sustainable level of growth and the interest sensitive sectors of the economy begin to slow. Consumer spending on houses and other big ticket items contracts and the rest of the economy follows suit. But, in this recession exactly the opposite has happened-consumer spending has maintained some strength but capital spending has been slowing or declining for over a year.

Over the last several years economic forecasts have often been wrong, sometimes markedly so. In the late ’90s, nearly all underestimated the economy’s potential to grow and overestimated the degree to which inflation might be a problem. Then, just as many were getting the hang of predicting a high growth, low inflation economy, growth started to stall. Last year saw errors on the opposite side, at least as it regards growth, with most forecasts of GDP revised downward with every passing month.

In some ways this is no surprise. Economic forecasting is based on the idea that the future will obey the rules of the past. Thus, forecasting is particularly difficult when economic fortunes change direction, or when the rules of the present truly are different from the past. Last year saw an important economic turning point, so it’s not surprising that after the longest period of economic expansion in U.S. history, a downturn was hard to predict.

Rhode Island Economic Summit

by Cathy E. Minehan, President and Chief Executive Officer, Federal Reserve Bank of Boston
State House, Providence, Rhode Island
February 11, 2002

http://www.bos.frb.org/news/speeches/cem/2002/021102.htm

[ . . .]

**ALSO **
Businesses saw profits eaten away by rising wages paid to ever harder to come by skilled workers, and by increases in energy costs. They began to cut back by trimming workforces and by cutting costs particularly in the area in which they had spent so much in the last half of the nineties—capital goods, especially high-technology-computers, software and anything to do with telecommunications. As businesses stopped spending in the fall of 2000, economic growth slowed suddenly as well—to remind you, in the first half of that year the economy grew by 4%; by fourth quarter it was growing at a pace less than one-half of that. And that pattern of very slow and eventually negative growth continued through 2001.

[ . . .]

When are state governments likely to obtain some fiscal relief? Given the forecast I spoke of earlier, budgetary pressures aren’t likely to ease materially until the early part of calendar year 2003. Although most economic forecasters believe that the economy will be growing at a respectable pace before then, growth in income tax revenues will probably lag since employers are generally reluctant to hire back workers until they’re confident that the recovery has legs. Sales tax revenues might be sluggish for several more quarters, since consumption of durables is not likely to surge as much as it usually does during the early stages of a recovery. Consumers have been buying too much all along, and are too deeply into debt, to spearhead a burst of growth. Nor will spending pressures abate very much; demands for health care, school funding, and homeland security will continue to stiffen resistance to deep spending cuts in these areas. Many previously enacted tax cuts will probably be implemented, further tightening the fiscal noose around the states.

Arkansas Governor Mike Huckabee summed up the fiscal bind of the States colorfully in mid-November. The Governor warned that, unless things improved very quickly for state governments, “we’re going to be…between a dog and a fire hydrant.”

[ . . .]

But the last several years truly have been different as well. The last half of the decade and the first years of the new millennium were unlike any in thirty years or so. During the late nineties, economic growth was fed by rising levels of productivity. This was spurred in part by large business investments in new technology, accommodative financial markets, and rising consumer and business confidence and demand that fed on itself to create even faster growth. And, in spite of periods of oil price increases, inflation never really surged.

Remember the last quarter of 1999, when the economy grew at a 8.3% pace? Even with rising productivity, mature economies with slowly growing labor forces cannot maintain that pace for long without severely straining resources. As Herb Stein said—if something can’t continue, it doesn’t.

Businesses saw profits eaten away by rising wages paid to ever harder to come by skilled workers, and by increases in energy costs. They began to cut back by trimming workforces and by cutting costs particularly in the area in which they had spent so much in the last half of the nineties—capital goods, especially high-technology-computers, software and anything to do with telecommunications. As businesses stopped spending in the fall of 2000, economic growth slowed suddenly as well—to remind you, in the first half of that year the economy grew by 4%; by fourth quarter it was growing at a pace less than one-half of that. And that pattern of very slow and eventually negative growth continued through 2001.

http://www.bos.frb.org/news/speeches/cem/2002/021102.htm

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