FRBSF Economic Letter
2003-17; June 20, 2003
Growth in the Post-Bubble Economy
The U.S. economy entered a recession in March 2001. The consensus view
is that the recession ended sometime around December 2001. In the five
quarters since then, real GDP has expanded at an average compound growth
rate of 2.7%. A closer look at the data reveals that the pace of the recovery
has been uneven across sectors. While the consumer and housing sectors
have shown continued strength, the long-awaited rebound in business investment
has yet to occur. This fact highlights the very different nature of the
2001 recession in comparison to previous recessions. This Economic
Letter examines the behavior of some key macroeconomic variables during
the 2001 recession and places them in historical perspective. This exercise
helps shed light on the underlying causes of the recession and identifies
some fundamental factors that can be expected to influence growth in the
years ahead.
A mild recession?
The
2001 recession is often described as being "mild." Figure 1
lends some credence to this idea. The figure compares the trajectory
of
real GDP during the 2001 recession to the average trajectory observed
during the six prior recessions. In each case, the level of real GDP
is
normalized to 100 at the start of the recession, i.e., at the business
cycle peak. The figure shows that the drop in real GDP from peak to trough
in 2001 was significantly less pronounced than the average drop. This
outcome can be largely attributed to the amazing resilience of the U.S.
consumer.
Figure 2 shows that real household spending (defined as real personal consumption
expenditures plus real residential investment) did not decline at all
during the 2001 recession. Since this category of spending accounts for
about three-fourths of U.S.GDP, its continued expansion was crucial in
limiting the severity of the recession. This behavior contrasts sharply
with that observed during previous recessions when household spending
typically slowed prior to the business cycle peak and then declined for
two or three quarters.
Several factors account for the strong performance of household spending
during the past two years. Fiscal stimulus in the form of tax rebates,
cuts in marginal tax rates, and extended unemployment benefits provided
support to consumer disposable income. Attractive financing deals offered
by domestic auto manufacturers gave a significant boost to consumer durables
purchases. Most importantly, low mortgage interest rates spurred record
home sales and set off a refinancing boom that allowed consumers to tap
the equity in their homes to pay for a variety of goods and services.
An investment boom and bust
Figure
3 shows that the decline in business investment during the 2001 recession
was much more severe than average. Interestingly, business investment
peaked two quarters before the start of the 2001 recession in contrast
to the coincident peak observed on average. The seeds for the subsequent
drop in investment were actually sown during the boom years of the late
1990s. From 1996:Q1 until its peak in 2000:Q3, real business fixed investment
expanded at an average compound growth rate of 10% per year-about 2.5
times faster than the growth rate of the U.S. economy as a whole.
Much of the surge in business investment during the late 1990s was linked
to computers and information technology. During these years, measured
productivity growth picked up, inflation remained low, and the unemployment
rate declined. Such observations were often cited as evidence of a permanent
structural change-one that portended faster trend growth in the years
ahead. Widespread belief in the so-called "new economy" caused
investors to bid up stock prices to unprecedented levels relative to earnings
(see Lansing 2002).
It is now clear that the investment boom of the late 1990s was overdone.
Firms vastly overspent in acquiring new technology and in building new
productive capacity—with an attendant increase in employee headcount—in
an effort to satisfy a level of demand for their products that proved
to be unsustainable. A recent study by Gordon (2003) documents the many
transitory factors that boosted the demand for technology products during
the late 1990s.These include: (1) telecom industry deregulation that led
to the creation of new firms, each demanding large amounts of equipment
to build communication networks, (2) the need to replace computers in
order to run a new generation of software starting with Windows 95, (3)
the one-time invention of the world wide web, (4) the surge in equipment
and software demand from the now defunct dot-coms, and (5) a compressed
PC replacement cycle heading into Y2K.
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The
extraordinary burst of investment during the late 1990s coincided with
the emergence of a major speculative bubble in the U.S. stock market—itself
fueled by the very same optimistic projections about the future. In a
recent paper, Caballero and Hammour (2002) present the view that the stock
market bubble and the investment boom were mutually reinforcing phenomena.
In particular, rapidly rising stock prices provided firms with a low-cost
source of funds from which to finance their investment projects. The resulting
surge in capital accumulation served to increase measured productivity
growth which, in turn, appeared to justify the enormous run-up in stock
prices. Figure 4 shows that the trajectory of the S&P 500 stock index,
both before and after the 2001 recession, is strikingly similar to the
trajectory of investment.
About two quarters after the bubble burst in March 2000, firms started
to cut back sharply on new investment as it became clear how much excess
capital had been accumulated. Rather than investing in new technology
or capacity, firms started to make better use of the technology and capacity
they already had. Firms also began to undertake the painful but necessary
steps to bring their cost structures into line with the post-bubble demand
environment. In many cases, the required adjustments have involved large
numbers of employee layoffs, thus contributing to a rise in the unemployment
rate from 3.9% in October 2000 (a 30-year low) to 6.1% in May 2003. Job
losses in the U.S. economy have continued to trend upward for more than
a year after the presumed end date of the 2001 recession—yet another atypical
pattern relative to the average recession.
House prices and the U.S. dollar
In response to three consecutive years of declining stock prices starting
in 2000, households have shifted more of their assets into real estate
(see Marquis 2003). This portfolio rotation effect has contributed to
the strength of the residential housing market. House price appreciation
in recent years has been nearly double the growth rate of per capita disposable
income. In some geographic areas, the ratio of house prices to rents (a
valuation measure analogous to the P/E ratio for stocks) is at an all-time
high, thus raising concerns about the existence of a housing bubble. For
the U.S. economy as a whole, the ratio of house prices to rents is currently
about 16% above its 30-year average (see The Economist 2003 and Krainer
2003).
U.S. imports have grown much faster than exports in recent years. In
the first quarter of 2003, the nominal trade deficit (imports minus exports)
hit a record $484 billion—about 4.5% of nominal GDP. This number implies
that the U.S. economy requires about $1.3 billion per day in foreign capital
inflows to finance our imported goods. During the boom years, foreign
investors were quite willing to purchase U.S. stocks and bonds for their
portfolios. This activity put upward pressure on stock prices, downward
pressure on bond yields, and led to the appreciation of the U.S. dollar
on foreign exchange markets.
From mid-1995 to its peak in early 2002, the trade-weighted nominal dollar
appreciated by nearly 40% against a basket of major currencies. Since
then, the dollar has retraced more than half of the earlier gains. A falling
dollar suggests that foreign investors are unwinding some of their dollar-denominated
portfolio holdings in order to seek higher returns elsewhere. While a
weaker dollar helps stimulate U.S. exports, it can hurt growth in foreign
countries that sell goods to the U.S. If a rapid, disorderly depreciation
of the dollar were to occur, foreign investors would likely demand higher
risk premiums for holding dollar-denominated assets. This development,
in turn, could lead to lower stock prices and higher bond yields, thereby
slowing the growth of domestic demand.
Growth in the years ahead
During the past two years, the consensus economic forecast has consistently
predicted a robust near-term acceleration in business investment, which
has yet to emerge, notwithstanding substantial monetary policy easing
and the enactment of two fiscal stimulus packages (with a third signed
into law on May 28, 2003).
The sluggish nature of the investment recovery may owe partly to several
shocks that have subdued business and investor confidence. These shocks
include the September 11 terrorist attacks, a wave of corporate accounting
scandals, and the recent U.S. invasion of Iraq. Alternatively, in the
aftermath of what many consider to be the greatest speculative bubble
in history, it is quite possible that investment is being restrained by
fundamental factors that will take longer to overcome. Capacity utilization
in the U.S. industrial sector is currently at a 20-year low —only 74.4%
as of April 2003. Large amounts of excess capacity combined with technological
advances that foster market competition in a global economy have created
an environment where many firms lack pricing power. The lack of pricing
power restrains the growth of nominal sales—typically an important factor
in the determination of a firm's capital expenditure plans. It is worth
noting that much of the recent earnings gains of S&P 500 companies
have been achieved not through increases in sales but instead through
cost-cutting measures.
The likelihood of a robust pickup in sales is ultimately linked to the
outlook for household spending. The fact that household spending performed
so well during the 2001 recession means that there is less pent-up demand
going forward. Hence, the upside potential for household spending growth
appears rather limited. On the downside, continued weakness in the labor
market and the eventual slowing of the mortgage refinancing boom poses
the risk that consumers will rein in their spending. So, to the extent
that business capital expenditures are "demand-determined,"
the projected acceleration in investment may prove to be less vigorous
than the consensus forecast expects.
Kevin J. Lansing
Senior Economist
References
Caballero, R. J., and M.L. Hammour. 2002."Speculative
Growth." NBER Working Paper 9381.
http://papers.nber.org/papers/w9381.
Gordon, R.J. 2003."Hi-Tech
Innovation and Productivity Growth: Does Supply Create Its Own Demand?"
NBER Working Paper 9437.
http://papers.nber.org/papers/W9437.
Krainer, J. 2003."House
Price Bubbles." FRBSF Economic Letter 2003-06 (March 7).
http://www.frbsf.org/publications/economics/letter/2003/el2003-06.html.
Lansing, K.J. 2002. "Searching
for Value in the U.S. Stock Market." FRBSF Economic Letter 2002-16
(May 24).
http://www.frbsf.org/publications/economics/letter/2002/el2002-16.html.
Marquis, M.H. 2003. "Shifting
Household Assets in a Bear Market." FRBSF Economic Letter 2003-09
(March 28).
http://www.frbsf.org/publications/economics/letter/2003/el2003-09.html.
The Economist. 2003."Castles
in Hot Air: Is Another Bubble about to Burst?" (May 31-June 6).
http://www.economist.com/displayStory.cfm?Story_id=1794899#Static.
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