10/19/00 12:05 p.m.
The Dreaded “R” Word
Is a recession likely?

By Victor A. Canto of La Jolla Economics

he recent stock-market turbulence has raised the specter of the "R" word. Read the financial pages in the paper and you'll notice that an increasing number of people are now talking about the likelihood of a recession. This is an issue worth revisiting, and the first step is to review the likely sources of the slowdown.

The source most people mention is the continued Fed tightening. A second is the rise in oil prices. A third is the Asian meltdown, and a fourth is the apparent European slowdown.

Europe
The international sources are easiest to dismiss. Asian under-performance has not stopped the U.S. economy over the past few years and there's no unique reason why it should now. While it's true that Europe seems to be slowing down, some of this may be attributed to higher energy prices and the price rule.

An additional factor contributing to the European slowdown is that it is short-lived. Germany is going to lower tax rates on January 1, so it makes sense that Germans have an incentive to delay income recognition and corporate capital-gains realizations until the tax-rate reduction becomes effective. When Germany eliminates the capital-gains tax on corporate holdings, German rates of returns should rise.

Insofar as the rest of the EMU member countries match Germany, the surge in the euro will rival that of the yen a few years ago. Europe should bounce back after the first of the year.

Fed Policy
There should be no major changes in domestic economic policy that will affect the real side of the economy. The slowdown we are seeing now has more to do with past actions and the interaction between monetary policy and relative price changes.

The early stages of the millennium bug (i.e., the second half of last year) had a significant effect on aggregate demand; individuals and businesses that had been preparing for the worst had accelerated much of their planned purchases into 1999. This led to stronger-than-expected real GDP growth. The Fed's reaction to the higher-than-expected real GDP growth rate was to try to slow the economy. In addition to contributing to the economic slowdown, the unintended — or perhaps intended — consequences of the Fed tightening has been to affect the credit markets, increase uncertainty, and increase the economy's regulatory burden.

Other variables have also come into play in 2000. In particular, the rise in oil prices has led to speculation there will be a resurgence of inflation or a "hard landing" of the economy. But the situation is much different than in 1974, when the policy response to the hike in oil prices led to a tremendous bout of stagflation. Don't expect a major government response that could degenerate into a policy mistake like price controls or a trade war.

Oil Prices
However, if the Fed sticks to the price rule, the oil-price hike will have an effect on the economy similar to a tax being levied by the oil-producing nations. The effect of the tax will be threefold. First, it will have a negative-wealth impact on the economy. Second, it will alter the relative rates of return between the energy and non-energy sectors. And third, the higher "marginal tax rate" will reduce incentives for Americans to work and produce. Add all these up, and we're looking at slower growth than previously anticipated.

The Election
We are at a delicate point in the economy. This is particularly the case because we have an election fast approaching. As such, there are unusual and temporary circumstances that could elicit a policy mistake.

The election of the new president will create a new economic environment. If Gore gets elected it can be expected that he will tinker with the economy; regulations will increase, and that will favor the smaller-capitalization value stocks. On the other hand, Bush — with his hands-off policies — will create an environment favorable to growth stocks. The final interaction will come in January.

Interest Rates
If Greenspan is indeed following the price rule, and the spirit of Knut Wicksell is alive and well in the hallways of the Federal Reserve, there are a number of implications that are easily derived:

First, the U.S. inflation rate will remain under control. Second, the fluctuations in the interest rate will mirror fluctuations in the real rate of return (i.e., the Wicksell hypothesis). Third, since the Fed is following a price rule, the Fed funds rate will chase the real rate of return, hence an economic slow down will be reflected in lower interest rates. Fourth, changes in relative prices of basic commodities or imports will induce a monetary response that will reduce the pricing power of the rest of the economy.

All these point to a decline in interest rates in the U.S.

The Economy
Viewed this way, the market's vulnerability is of a short-run nature and will depend critically on the interest rate level. Another variable is industrial production. According to La Jolla Economics data, industrial production does not forecast a recession (i.e., two consecutive down quarters), although it does forecast a decline in the first quarter of the year. The chances of having a positive increase in industrial production are 1 in 10 during the first quarter of 2001.

In short, all these criteria point to an economic slowdown, but not a recession.