TCS Daily

What Would A New Economy Recession Look Like?

By Kevin Hassett - December 4, 2000 12:00 AM

We have mostly focused in this space on the difference between the new and old economy views when times are good. It is time to look at the other side.

There was a lot more bad economic news last week. Third quarter GDP increased at its lowest rate since 1996. Durable goods orders were way down. Personal income growth was negative. The stock market dropped and dropped. Where is it all headed? How bad will things get before they start to get better?

To answer this question we first need to think about how soft landings in the past have turned into flaming nosedives.

In the past, firms were very unsophisticated in their operations and product management. Firms never really knew how much product they would be able to sell, and changes in production capacity took months to undertake. In that world, a slowing in demand attributable to Fed action could start a negative cascade.

Firms had to keep large inventories around on the chance their products would be big hits. When demand slowed, firms would suddenly have large inventories to liquidate, and a factory chugging out output to meet a high demand. Since demand adjusted faster than the factory could, the inventory situation would become almost obscene. With six months to a year of inventory sitting around, firms could lay off workers with little fear that they would be caught shorthanded by their customers, so layoffs would follow.

Those layoffs would set off a second wave of lower demand. Then, with all the bad news happening at once, firms without cash would have trouble paying their bills. In past episodes, like the recession of 1982, many banks would then tighten or remove credit lines, and bankruptcies would take off. Finally, a full blown recession would be declared the National Bureau of Economic Research's board of business cycle experts, the men and women who have made the official recession call ever since the big one.

The New Economy has likely changed things so much that such a spiral cannot happen. The key difference today is the ability of our highly computerized factories to adjust output knobs on the fly, and maintain profitability even when demand is getting lower. That is a great line of defense right at the first step of the recessionary spiral. That does not mean, however, that we need to have no fear. Indeed, something else has changed as well, that may increase the risk of a bad scenario occurring.

In the past, financiers were extremely shortsighted and unwilling to sink their money into businesses that were not delivering immediate profits. Indeed, in the 1980s there was a cottage industry of academics working to explain the "myopia" of our firms. The upside of this myopia, however, was that most firms in the economy made money (in good times at least) and had a cushion to rest on even if credit lines dried up.

Think about how much things have changed. Now we have big, famous, established firms like who have market capitalizations in the billions of dollars but no profits. These market capitalizations may be justified if the long-run business plans are sound, and may even be a healthy sign that we are no longer so myopic. However, a sound long-run business plan does not guarantee that you will survive. If you run out of cash, you run out of cash.

So a new economy recession is, in my view, possible, but it will look quite different from previous recessions at the outset. It would be set off by a wave of high tech bankruptcies.

But will it happen? The superstitious part of me worries that it can. Indeed, I experienced a weird sense of déjà vu last week as I looked at the data coming in, and thought about all of the mistakes the Phillips-curvers at the Fed have made this year. George Bush senior, after all, likely lost his reelection bid because the Fed tightened us into a recession at exactly the wrong time. Junior might take office just as the Fed is doing it again.

But the rational side of me suspects that a recession will not happen. Despite all of the bad news (the oil shock, the Fed rate hikes, the Nasdaq drop, the chad fiasco) we are still sitting on a fundamentally healthy economy. While output growth is the lowest it has been since 1996, it is still three to four percentage points higher than it tends to be near the start of a typical recession. And finally, hardly a conference call goes by without reference to profitability.

Our high tech managers seem to be waking up to the fact that their survival depends on their ability to make money, and fast.

TCS Daily Archives