The U.S. Economic Outlook: Some Thoughts
Let me begin by first noting that while investment has stopped falling, growth in the future is likely to be moderate. We have seen a recovery in corporate profits to their pre-recession levels, but no sign yet of a continuation of the growth rates achieved in the mid 1990s.
This is not only due to short-term jitters about the war. Sluggish investment is not simply the result of war uncertainty, but is also a result of excess capacity in manufacturing (at present we are operating in the mid-70 percent capacity range). Economic weakness in the rest of the world acts as a drag on demand within the United States (U.S. manufacturers produced $1.664 trillion in durable goods, of which thirty percent is exported.) Moreover, the dollar, even with its recent slide against the euro, remains too strong. Thus, the excess capacity cannot be accommodated by increased exports.
The service sector, however, remains strong. Given that services are so important, investment is likely to pick up in the second half of 2003, even as investment in structures stops falling, investment in information technology grows and investment in other areas experiences slight growth. However, a strong surge in investment in the postwar period is unlikely, and even this modest growth assumes that the oil price will stabilize (or even continue to fall) and that war-related uncertainties are eased.
Moreover, the current overcapacity and downward price pressure in a range of industries have weakened stock prices, discouraged investment, made companies reluctant to hire new employees, and slowed the recovery. We have seen that there is no stable competitive equilibrium in industries with high fixed costs and low marginal costs - for example, steel, autos, chemicals, software, computer chips and airlines, among others. Increased global competition has undermined established pricing practices in many industries. Things have been changing for several years, but a weak world economy and a strong U.S. dollar have intensified the effects. The result has been a "loss of pricing power" and downward pressure on a range of goods' prices.
There is, however, a benefit from this downward pressure on prices. It has forced companies to cut costs and increase productivity. Increased global and national competition has been an important driver of improved U.S. productivity growth. Indeed, a recent OECD study found that raising trade exposure by 10 percentage points increased output per employee by 4 percentage points.
Productivity performance is an important positive for the U. S. economy. The current productivity growth trend is about 2.5 percent per year. Despite weak investment, productivity has grown rapidly recently, even though investment and IT spending have slumped. Strong productivity growth is good for employment over the long term-for example, as occurred during the periods 1948-73 and 1995-2000. In the short term, however, strong productivity growth with only modest demand growth will result in a weak labor market-as we have seen throughout 2002 and in the first part of 2003. The weakness in the labor market, combined with higher oil prices prior to the commencement of the war (and the accompanying uncertainty), resulted in a plunge in consumer confidence. Over time, however, rising productivity leads to rising incomes and profits, and these encourage consumption and investment.
What, therefore, can we expect will happen with the American economy in the immediate future? Most forecasters predict that the first half of 2003 will be slow, but that we should see growth of four percent or more in the second half of 2003. A modest pick up in investment, strong growth in federal government spending, low interest rates, and falling oil prices (OPEC is now scrambling to see whether the $25 per barrel ceiling can even be maintained) should be enough to offset areas of weak demand. If there had been significant damage to Iraq's oil fields or to other nearby oil facilities, the chances of a double dip would have been higher (a double dip is when GDP growth slides back to negative after a quarter or two of brief positive growth). That outcome seems to have been avoided, and coalition forces now control about 900 of the 950 or so wells in the southern Rumaila field (Iraq's largest). Additionally, this forecast anticipates continued weakness, but not collapse, in the European and Japanese economies.
All of this, of course, assumes that the war will be over fairly quickly. Despite some statements to the contrary, Iraq cannot sustain an all-out war for much longer. They do not have the firepower to sustain large-scale resistance to coalition forces.
So what could go wrong in the Middle East that might affect the economy? For starters, the current regime in Iraq may cease full-scale military operations and instead retreat to a prolonged guerilla war. Growing resentment against the United States may incite new terrorist attacks or suicide bombers in the U.S. or against U.S. interests. In terms of the war against terror, we have done well at catching Al-Qaeda's leaders and cadres, but rather more poorly at protecting domestic targets. One or more of the countries of the Middle East could destabilize, and, although it is becoming increasingly less likely, Israel could still be attacked or become involved in the conflict.
I believe that the first outcome is more likely than the others, but even a sustained guerilla campaign should not have overly negative consequences for the economy. The others, however, remain possibilities and if they occurred, would have much more severe consequences. Any outcome that results in large oil price increases that would make a double dip much more likely.