Economy's Legs Teetering, but Not Falling Over

Consumers aren't the only salve that can heal this economy.

Sure, their spending accounts for two-thirds of the nation's output. But that includes outlays that continue no matter what the overall economic situation looks like. People always need to buy toilet paper, heat the house, clothe the kids and eat.

It's consumer spending on discretionary, big-ticket items like cars, as well as the nation's construction spending and business investment in equipment and software, that plunges when the economy falls sharply. People and companies buy these things when they feel good about their finances and about their financial future. And spending in each of these areas is needed to keep the economy in growth mode.

Taken together, these three factors account for 30% of Gross Domestic Product. They are the areas most affected by the cyclical gyrations in the economy. Like legs of a chair, when they break, the economy topples.

All three of these chair legs respond well to lower interest rates, which both consumers and businesses have had access to as a result of a series of interest-rate cuts from the Federal Reserve that began soon after the new year started. They grimace in the face of deteriorating balance sheets. And they are socked, in the case of consumers, by decreased job security.

Right now, the economy is at an inflection point. It's unclear whether lower interest rates will spur enough borrowing to keep businesses afloat and consumers spending, offsetting the existing squeeze on corporate profits and higher debt burdens -- or whether sentiment will change for the worse, despite lower interest rates. Two of those legs are reasonably solid right now; the third, business spending, is not.

Construction Junction, What's Your Function

Of these three areas, construction spending is currently the strongest. Despite the economic slowdown, low interest rates have kept housing starts and building construction running at a brisk pace, though down from the even stronger growth rate of late 1999 and early 2000. Consumer spending on durable goods, which accounts for 10% of overall GDP, has also been reasonably strong. While spending on big-ticket items weakened through the first quarter after a strong January, early word on spending from retailers in April shows it picking up again.

What's keeping people with their hands in their wallets? Interest rates -- which have declined in recent months -- are at reasonably low levels given historic benchmarks. The Federal Reserve has been cutting the fed funds rate to make borrowing easier. Among borrowing terms for consumers, mortgage rates dropped in recent months as Treasury rates declined in response to Fed rate cuts. Consumers have been able to refinance their homes, either decreasing their monthly housing expenses or getting cash out of their home.

For now, people are continuing to borrow, saving little money and boosting their debt burden to the highest level since 1986 -- as of the fourth quarter of 2000, it represented 14.29% of their discretionary spending. Coupled with last year's decline in consumer net worth, the first time in 55 years, consumers' continued spending has been somewhat of a surprise.

With breathless reports of more layoffs on the news every day and a slow but sure rise in the unemployment rate, some economists wonder how consumers are continuing to spend. But lower rates are making it easier for people to borrow. And despite the growing layoffs, consumers' perception of their own job prospects hasn't collapsed.

There is typically a change in sentiment that precedes a recession. It doesn't always happen as a result of people losing their jobs -- it's more a perception that personal finances and job security are no longer as solid as an earlier time.

Declining consumer confidence typically leads to a fall off in spending, which creates a cycle that leads to companies earning less, decreasing their spending on capital expenditures and laying off staff -- causing people to consume less. Consumer confidence hasn't hit that breaking point yet, although the closely watched Conference Board's confidence index shows consumers recently hitting their least confident point since December 1996.

Fed Chairman Alan Greenspan described the phenomenon to Congress in January: "The crucial issue ... is whether [the] marked decline [in production already under way] breaches consumer confidence because there is something different about a recession from other times in the economy. It is not a continuum from slow growth into negative growth. Something happens."

Business Woes

While it's not happening in the consumer arena, something like that has happened in the business sector. Business spending, which accounts for 12% of GDP, dropped sharply in the fourth quarter of last year and worsened in the first quarter of this year. David Orr, chief capital markets economist at First Union, says he foresees another lousy quarter in business spending before any kind of turnaround.

That's because the economy has entered a profits recession, meaning companies are earning less than they did in previous quarters. Like consumers, when companies hit hard times and profits are squeezed, the long-term repercussions involve cutting back on discretionary spending -- including investments in new equipment.

There's nothing yet on the horizon to suggest when a rebound will come for business spending. Many telecommunications companies, for example, took on huge amounts of debt to build out networks for anticipated demand that didn't come to pass. Now their balance sheet looks like the floor of a taxicab. For their part, businesses are starting to recognize this, working down their highly leveraged balance sheets.

In March, manufacturing saw its first increase in industrial production since September, a sign that companies increased production to meet demand. So there is potential improvement there, though auto companies were mostly responsible for the increase.

Right now, the economy, resting on a fence, is leaning in the direction of a sluggish recovery. Businesses seem skeptical. But years of growth have given birth to a resilient faith among consumers in America that the economy will continue to grow. The Fed is enhancing that faith. Whether companies swallow that optimism will determine whether all three legs of the economy can keep standing.