Six Months Later: The Economy That Didn't Crash Won't Boom, Either

With the six-month commemoration of the Sept. 11 attacks, I checked in with Edward Leamer, professor of economics, management and statistics at the UCLA Anderson School of Business.

Shortly after Sept. 11, Leamer made a prescient call here that the attacks should not have a "material [negative] impact on the course of the economy."

If anything, it now seems the terrorist attacks (and of course, the reaction of American policymakers, business leaders and citizens) hastened the end of the recession rather than extending it, as many feared at the time. The latest evidence of recovery was provided by today's 0.2% drop in wholesale inventories, to their lowest level since January 2000, as well as separate reports on manufacturing by Federal Reserve banks in Kansas City and Chicago.

"I think everyone has come to realize Sept. 11 was not a recession-causing event for the reasons we said at the time," Leamer said Monday afternoon. "But I don't share the view we'll have a robust recovery," as so many Wall Street economists are now predicting.

The economics professor expressed concern about "three big question marks" for the rest of the year: business investment, consumer expenditures and housing. "You have to tell a compelling story why any will be a powerful locomotive before you can be optimistic about the growth rate for the rest of this year and 2003," he said, offering instead reasons why each will be weak.

Private investment contracted at an annual rate of 24% in the fourth quarter. Half of that was due to declining inventories, which is ostensibly good news. But the other half of the decline was caused by another drop in nonresidential (i.e., business) investment that approached nearly $43.6 billion on an annualized basis, according to UCLA's Anderson Forecast, which Leamer heads.

Business investment will remain sluggish because of the "disconnect between profits and investments," he said. Yes, big investments in technology have led to higher productivity, as the recent upward revision to fourth-quarter productivity attests. "But we're not going to get [another] big surge in investment without a surge in profitability," Leamer argued.

Low inventories will generate sales and production as the economy improves, and this is a linchpin of Fed Chairman Alan Greenspan's recovery scenario. But "the problem isn't inventories but the ... Internet," Leamer countered.

The "paradoxical aspect" of the Internet is that it limits profitability because of the "intensity of competition" it engenders, as participants around the globe fight for the same clientele, Leamer continued. "I really think the Internet is the biggest disappointment as far as investment opportunity that we've seen for a very long time."

That said, Leamer does not expect an Internet-induced deflationary spiral to take hold. Rather, he believes corporations will be averse to investing in new plant and equipment after having been burned by the excesses of the late 1990s, when then-current growth rates were forecast to continue indefinitely. In conjunction with fewer participants because of bankruptcies and mergers, that suggests "inflation is going to be a problem," he said. Corporations will raise prices as the economy "bumps up against capacity constraints," although he does not foresee that being a problem until 2003.

As for the other two areas, consumer expenditures and housing, Leamer is concerned that what had been pockets of strength during the downturn "risk being terminated because of rising interest rates." Recent weakness in the bond market has shown a tightening of monetary policy by the Federal Reserve is not necessary for mortgage rates to rise, which is going to slow refinancing and new home sales. (The Treasury bond market was mixed Monday, with the price of the benchmark 10-year note rising 4/32, to 96 23/32, its yield declining to 5.30%.)

Leamer expects the housing sector to be weaker in the year ahead but does not believe it has reached an "extreme" bubble phase, similar to the 1970s.

As an aside, the professor mused that the popping of the housing bubble in the 1970s caused a recession while the bursting of the equity bubble of the 1990s had a much less damaging effect. "A housing bubble is something you really have to worry about," he said, suggesting there is some "overheating" in residential real estate in certain geographic regions, but not in the country overall.

Rising interest rates will increase consumers' overall debt burden and restrain spending, he continued. In addition, he observed that with many baby boomers approaching retirement there's a "desperate need for high savings" that should add to the "sluggishness" on the consumer side in the coming years.

[I didn't discuss it with Leamer, but the recent uptick in energy prices continued today, with crude oil futures rising nearly 2% to over $24 and natural gas futures jumping 7.9% to over $3. Further strength in energy prices will also put downward pressure on consumer spending.]

Notably, Leamer is not a gloom-and-doomer and is forecasting GDP growth of 2% to 3% in 2002 and 2003 vs. the 3% to 4% (or higher) expected by many on Wall Street, economists and investors alike.

"Price-to-earnings ratios seem high to me," the economics professor said. "Financial markets are placing a lot of confidence in a strong and robust recovery, and I'm doubtful we're going to have that kind of strength."

Just as the talking heads were wrong about the devastating economic effects of Sept. 11, they're likely to be wrong about the strength of the rebound now unfolding.