Calling the Bottom

Sunday, Oct. 07, 2001 By DAREN FONDA

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The brave souls who try to forecast the U.S. economy spend much of their time looking backward for data and precedents. So when TIME's Board of Economists gathered in New York City, its members referred often to the last time the nation was steeling itself for war: 1990-91, between the invasion of Kuwait and Operation Desert Storm. Back then, a relatively quick military victory helped spark the longest economic expansion in U.S. history. In today's protracted campaign against terrorism, few expect a decisive win that could trigger a quick rebound.

But in many ways, our panelists agree, the economy is healthier today than it was 11 years ago. Real oil prices and inflation are lower. There's no thrift crisis to stymie lending and no budget deficit to discourage policymakers from stimulating demand. Unless there is another catastrophe, our economists believe, economic growth and employment should begin to recover in the first half of 2002, with more robust growth in the latter part of the year.

For the next few months, to be sure, the nation's prospects aren't promising. John Ryding, senior economist at Bear Stearns, contends that for all practical purposes, the economy fell into recession a year ago, largely as a result of the Federal Reserve Board's "assault on the equity markets" through interest-rate hikes. And since May, the message of the markets has been that economists "were essentially wrong" in forecasting a third-quarter recovery, says Hugh Johnson, chief investment strategist at First Albany Corp. The terror attacks of Sept. 11, our panelists agree, will trigger at least two quarters of economic decline--the classic definition of recession. "It's hard to scare American consumers out of spending, but this event did it," says Diane Swonk, chief economist at Bank One. Adds Mark Zandi, chief economist at Economy.com: "A bunker mentality is settling in among consumers, investors and businesses."

Neither the markets nor the economy is likely to rally until Americans feel more confident that they're safe from further terror attacks. "I'm not sure we're going to get bin Laden, and that may be unsatisfying," says Andrew Hodge, chief U.S. economist for the forecasting firm DRI-WEFA. "You may not have the sort of immediate, decisive action that makes people feel that good."

That's the bad news. On the plus side, our panelists agree, the prospects for a V-shaped recovery--in which a contraction is followed by a sharp rebound--are now significantly better. With energy prices having stabilized (at least for now) and inflation in check, "policymakers have lots of room to maneuver," says Johnson. The banking system also appears healthy. "Go back 10 years," says Zandi, "and the system was in disarray. Thrifts were at death's door. It wasn't a question of whether banks would make a loan. They didn't have the capital." That's not a problem today, with the Fed pumping cash into the system.

Except in the airline and travel industries, businesses faced with declining revenues are taking a hit in their profits while "holding up employment and compensation more than we would have thought," notes Hodge. He agrees with Swonk, who says we're "well through an inventory cycle," and purchases of parts and equipment will soon pick up. Companies will also be spending to fortify against disasters, paying for redundant telecom gear and back-office operations. Although that kind of spending won't necessarily enhance productivity, it should help the battered tech sector.

The government's attempts to stimulate growth through tax cuts, interest-rate reductions and spending hikes should kick in by early next year. The attacks make it likely that by the end of 2001, the Federal Funds rate will fall to 2%, our economists say, making the short-term cost of borrowing money lower than the inflation rate. Swonk calls the Fed's aggressive policy a good "umbrella in a hailstorm."

The Bush Administration and Congress are also trying to curtail the recession with some old-fashioned stimulus, spending on everything from defense to airline bailouts and cutting taxes. "You might describe it as a 'guns, butter and pork' fiscal policy," says Hodge. And there's evidence we will get it. Congress is thinking of supplementing last spring's tax cuts with additional reductions in corporate and payroll taxes. Stocks of defense contractors like Raytheon have surged in anticipation of a boom in orders. Meanwhile, lobbyists for industries from travel to insurance underwriting are jockeying for emergency aid. Says Zandi: "So far, the outlays total $55 billion. Given the talk in Washington, the final figure could be triple that."

Whatever surplus the government was counting on will probably vanish, though Ryding thinks we will be better off without it. "The policy of running a surplus at least the size of the increase in the Social Security 'trust fund' was absurd," he says. "The attacks eliminated the constraint and opened the door to more spending and tax cuts." One risk, says Zandi, is that higher defense spending could drag down the economy. "If military outlays rise as a share of the nation's economic resources, that takes some of the shine off the New Economy going forward. It's a deadweight loss, devoting resources to something that adds nothing to productivity." The same effect is already being felt in the cargo industry, with shippers planning to pass on "security surcharges" to customers. But other panelists point out that if smarter spending on national defense and private security prevent further terror attacks, it will be money well invested.