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Think of it as a variation on the childhood “Rock, Paper, Scissors” game. Except in this game, not only are the stakes higher, but there is one clear victor that will defeat the other two participants: job cuts will override both rate cuts by the Fed and tax cuts to keep the economy in the doldrums. Fiscal Policy First, let’s examine fiscal stimulus. The Bush administration’s tax cuts – watered down to $1.35 trillion by a reticent Congress – have been hailed as providing much-needed stimulus to consumer spending. The focus is well-placed, as personal consumption accounts for about two-thirds of GDP. But the immediate impact is too benign to generate a resurgence of output, and the long-term impact is uncertain at best. Consider the tax rebates that the U.S. Treasury will mail to taxpayers in the third quarter of 2001. The Treasury anticipates mailing out about 95 million rebate checks for up to $600. The total estimated windfall to taxpayers is around $40 billion, which sounds like a pretty big number. On closer examination, it’s not much in terms of fiscal stimulus. Personal consumption expenditures (PCEs) in the first quarter of 2001 totaled $6.4 trillion. So a boost of $40 billion for the quarter would add about 66 basis points to the growth rate of PCEs. PCEs grew 2.9% in the first quarter, so assuming the third quarter would see about the same growth rate, all else being equal, the tax-stimulated growth rate for PCEs would be about 3.6%, which would be below all but one quarter during the period from 1999-2000. (Note: although the 2.9% growth rate stated above is annualized, the impact of the rebates is not annualized for purposes of this argument, as it is a one-time payment that happens to occur entirely in a single calendar quarter.) The impact on consumption of the tax rebates is almost certainly overstated. The above scenario assumes all taxpayers will spend 100% of their rebate checks. Some undoubtedly will. Some will save their rebates, or use them to reduce already bulging debt balances. (The tax bill also includes sharp increases in IRA and 401(k) contribution limits, so it’s safe to assume that a not insignificant amount of the rebates will flow into retirement savings.) Since the rebates represent a one-time payment, they offer the recipients no opportunity to leverage their windfall into higher spending via credit cards, as would an ongoing cash stream. That leads us to the second near-term impact of the tax bill: the reduction in tax rates. The effect of the tax cuts has been referred to as a 1% “permanent” increase in take-home pay for all taxpayers. How likely is it that this will translate into a resurgence of consumer spending? It would be the equivalent of a worker receiving a 4% pay raise instead of the 3% she expected, and going on a spending binge as a result. It just doesn’t add up, and the net impact of that additional spending power would be minimal. As for the long-term effect of the tax cuts, it’s important to remember that no tax cut is “permanent.” In our lifetimes, marginal tax rates will certainly rise again, and are likely to rise, fall, rise. Having gained control of the Senate through the conversion of Vermont Senator James Jeffords from Republican to Independent, Democratic leaders have already promised to revisit this most recent tax legislation. We’d best not count these chickens before they’re hatched, and the incubation period promises to be a potentially long one. Monetary Policy Now let’s turn our attention to the 250 basis points of rate cuts the Fed has delivered thus far in 2001. Lower short-term rates have done little to stimulate consumer spending. Long-term rates have actually risen as a result of the Fed’s action, as the long end of the curve anticipates higher rates in the distant future. (Long-term rates can be viewed as the market’s long view of future short-term rates.) Thus mortgage rates are higher than they were in the first quarter, providing no stimulus from refinance savings. The lack of stimulus provided by lower short-term rates should come as no surprise. Consumer confidence plays a larger role in willingness to borrow than do consumer loan rates. This is intuitive; if one’s job outlook is bleak, one will be reluctant to assume additional debt. Conversely, if one’s job outlook is strong, that removes an important psychological barrier to borrowing. The Job Market That brings us to the 300-pound gorilla of our original three-part equation: job cuts. The U.S. labor market added just 287,000 jobs in the first quarter – an anemic average of less than 100,000 jobs a month – and has shed 201,000 in the two months since. The unemployment rate did decline 0.1% in May, however, this was due to a contraction in the labor force (the denominator of the unemployment equation) rather than growth in workers (the numerator). The manufacturing sector has been hit particularly hard, losing 470,000 jobs thus far in 2001. The near-term outlook for the labor market isn’t promising. Both initial and continuing unemployment claims increased in the two weeks following the survey cutoff date for the May unemployment report. The growth in continuing claims is particularly troubling, since it indicates laid-off workers are having increasing difficulty finding new jobs. The help-wanted advertising index has plummeted from 89 to 65 in the last 12 months, and is near recessionary levels. The pace of layoff announcements by both U.S. and foreign companies shows no signs of slowing. As those job cut plans are implemented in the coming months, unemployment will continue to rise. In the face of the greatest job uncertainty in a decade, borrowing plans are being put on hold and core saving is increasing. Rate cuts simply aren’t enough to motivate consumers to borrow when they are fearful for their jobs, especially given that the savings rate is already negative, meaning that wage earners have little to sustain them if they lose their incomes. Conclusion The upshot of all this is that monetary and fiscal stimulus won’t be enough in the near-term to arrest the economy’s decline. It should also be noted that Fed policy isn’t as easy now as it was in 1999. Although the Fed wasn’t cutting rates two years ago, it dramatically lowered reserve requirements due to fears of a Y2K-induced run on financial institutions. As a result of those actions, the monetary base expanded by an unprecedented 15.3% – a 50% greater rate of money expansion than the previous high recorded in 1992. After Y2K turned out to be a non-event, the Fed recognized it had made a mistake (albeit one it had little alternative but to make). However, the situation was akin to letting all the cows out of the barn because the farmer smells smoke. Once he determines there’s no fire, it’s too late – the cows are out of the barn, and it will take some time to round them up. Once the Fed had made an unprecedented amount of money available to the credit markets, reining in the resultant overconsumption would take some time. The Fed actually contracted the monetary base in 2000 for the first time ever. That action only began to take hold late in the year, and its effects are still with us. The growth rate in the monetary base thus far this year is just 4%, well below the 7% average of the last decade. So in spite of aggressive rate cutting, there’s a lot less money available to lend than was the case in 1999, or even over most of the past decade. What will it take to return the economy to stable growth? One or more of the following factors: Depletion of excess inventories. Inventory overhang has abated, but there is still room for further inventory cuts, especially given sales projections for the remainder of 2001. This factor alone would prove a slow road to strong growth. Sufficient savings growth to provide skittish workers with the confidence they need to resume robust spending. Some market observers estimate the savings rate must reach approximately 8% before a true “boom” cycle emerges. From today’s -1% rate, that will take some time. Strong export growth. Don’t count on this happening anytime soon, as most industrialized economies are currently in decline. A resurgence of the tech sector. The shakeout in tech is far from over. Dot-coms are finding venture capital scarce, and the IPO market has all but dried up for techs. There will have to be considerable inventory reductions for this sector to recover, and companies will have to actually have a product or service that makes money in order to obtain funding. The days of triple-digit multiples for high-flying tech stocks are behind us. Consider the long-term patterns of economic growth. From 1929 to 1946 – a period of 17 years – the economy was generally in decline or flat at best, as the nation suffered through the Great Depression and a World War. The 20-year postwar period from 1946 to 1966 saw solid growth, with the end of that period marked by what we would now call “irrational exuberance.” From 1966 to 1982 we again faced 16 years of economic decline to stagnation. The most recent boom, from 1982 to 2000, lasted 18 years, and again was marked at the end by a euphoric bubble in equity valuations, confidence and spending. Our economy tends to follow such long-term cycles, in spite of all of the technological advances and changes in macroeconomic policy witnessed over that time. Those that wonder “when this economy will turn” may have a long wait, as we could be in for another lengthy down cycle lasting a decade or more.

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