In cyclical terms, the past decade was the least volatile in history. Searching for answers, many economists attributed the taming of the cycle to IT-related enterprise resource management systems and enhanced productivity growth at the micro level, and much more skillful management of the economy at the national level. There was, in fact, broad acceptance of the notion that with the cycle thus tamed, the risk of recession had essentially evaporated.
The decline in risk was believed to be permanent because it was attributed largely to controllable factors rather than luck. Yet the ability of the U.S. economy to avert a boom-bust cycle as it enjoyed a sustained period of non-inflationary growth was not simply the result of deliberate choices.
As a paper from the New York Federal Reserve finally acknowledged this year, the credit for this period of non-inflationary growth goes mostly to the U.S. economy’s good fortune, in that the world experienced asynchronous expansions and recessions during most of the 1990s. As a result, there was almost always global over-capacity, resulting, for instance, in the four-year decline in U.S. import prices from 1995 to 1999, keeping a lid on U.S. inflation pressures even as domestic growth rose and unemployment fell.
But it is human nature to take credit for good outcomes and attribute poor outcomes to bad luck or external forces. This is what psychologists call “attribution bias.” What happened in the late 1990s was attribution bias on a national scale, with people coming to believe that because they could now control things better, the level of risk had been permanently reduced, and recessions were a thing of the past.
A consequence of this misperception was the popularity of buying stocks on dips, which was quite rational if you believed that the risk of recession — and bear markets — had essentially disappeared.
The ease of raising money in the stock market and low interest rates helped fuel the capital investment boom, which was directed increasingly towards IT-related investment. It did not hurt that the perceived risk of over-investment was thought to be minimal, given that there would never be any more recessions that would cause a capacity overhang. The consequence was a capital investment boom.
A Darker Near Term Outlook
The U.S. economy was already in a recession when the terrorist attack took place. This is evident from the indicators used to officially date a recession — primarily employment and industrial production — which peaked in March 2001 and September 2000 respectively. Secondarily, the broadest measure of sales, real manufacturing and trade sales, peaked late last year as well. Thus, it is highly likely that the recession started months ago.
While it is clear that the attack made the outlook even worse, it is important to examine what the objective leading indicators now suggest about the future. As shown in the chart, the Weekly Leading Index level (WLI), which is a balance of seven major economic indicators, peaked in early 2000, plunging by 10 points from March 2000 to April 2001, predicting the current recession. Following the Fed’s early interest rate cuts, from April to May the WLI recovered about a third of its earlier slide as investor sentiment improved in the expectation of a quick recovery. However, by early summer the WLI was sliding once again. By August the WLI had erased its entire advance since the April 2001 low, dimming the hopes for a year-end recovery.
In the weeks since the attack the WLI has fallen below its April low. This is significant because as long as April was the cyclical low, it was plausible that the recession could possibly end by this winter. With the WLI searching for a new cyclical trough, the recovery is pushed off until sometime next year. Thus, the fading hopes of a year-end recovery have evaporated, and the end of this recession is no longer in sight.
Having said this, we should consider the perspective offered by our post-war experience. The average U.S. recession is ten months long and our worst recessions, in the mid 1970s and early 1980s, lasted 16 months. If we take March of 2001 as the tentative start date of this recession, then history might suggest that it would end somewhere between January and July 2002. But, to have confidence in the ultimate timing of the recovery, we need to first see the WLI turn up in a convincing manner.
Lakshman Achutan is Managing Director of the Economic Cycle Research Institute (ECRI). si
