Market Advisory Features
Economy: Greenspan's Gloom
The Future of Accounts: True and Fair is not Hard and Fast
World Economy: Slow Going
Is the US Economy Still in Recession?
Deflation: How Big is the Danger?
Street Scandal: Day of Reckoning
Sluggish Growth for US Economy
Foreign policy: The Shadow Men
Unfortunately, Mr Greenspan seemed unable to offer the sort of upbeat message many (no doubt including the occupants of the White House) had been looking for. For months before the military action started, Mr Greenspan had put much of the blame for the economy’s sluggish performance on geopolitical uncertainty. So some observers will have been disappointed, therefore, by Mr Greenspan’s continuing caution. Indeed, the tone of his testimony was remarkably downbeat.
The Fed chairman noted that there is, as yet, only limited evidence about the state of the economy now that the war is over—and that what there is remains mixed. Households, he said, are “less apprehensive” about the economic outlook: but that hardly suggests a rush back to the shopping malls, and Mr Greenspan acknowledged that the increase in consumer demand has so far been “tepid”. He certainly did not make much of the rebound in consumer confidence reported by The Conference Board, a private research body, on April 29th.
It seems clear that what really troubles the Fed chairman are the persistent weakness in business confidence and what that implies for business investment. Right from the onset of recession in 2001, Mr Greenspan has consistently argued that a solid and accelerating economic recovery would ultimately depend on a pick-up in business investment. In this respect, there was a small gleam of hope in his latest assessment, the thrust of which was that at least most of the preconditions for such an upturn are now in place. The oil price has fallen back, share prices are up from their mid-March lows, improved profitability is in prospect for many companies and order books are growing.
Many economists criticised the Fed for the decision it made at its March meeting not to offer a judgment on the likely balance of future economic risks. This “bias” judgment is usually followed almost as closely as interest-rate changes themselves: knowing whether the Fed thinks the main risk is from inflation or from further economic weakness, or if the risks are equally balanced, provides Fed-watchers with clues as to the likely future movement in interest rates. But at the March meeting, the Fed, in effect, threw up its hands and admitted it had no idea what the balance of risks was. Mr Greenspan sought to defend this unusual decision in his latest testimony, and said that the Fed had, as a result, stepped up its detailed surveillance of economic developments.
Yet it seems that the Fed chairman remains troubled by the extent of the uncertainty surrounding the economic outlook. And he gave his most candid assessment yet of the dangers of deflation. With inflation so low, Mr Greenspan said, “substantial further disinflation would be an unwelcome development”. The language was coded, but the import of his words seems clear. Mr Greenspan is concerned that any further fall in the inflation rate could bring the risk of deflation that much nearer. Even for inflation to approach zero would, in the chairman’s view, risk undermining profit margins and delay an upturn in business investment—on which the prospects for a broader, sustained economic recovery depend.
Central bankers normally get very nervous when people start to talk about deflation. They do not like to suggest it is a serious risk, lest that influences behaviour and depresses confidence and spending (because people start to hold off purchases in the expectation of a fall in prices). Instead, they prefer to reassure people that they are alert to the dangers and are prepared to respond to the threat in good time. One of Mr Greenspan’s Fed colleagues, Ben Bernanke, gave a lengthy and detailed speech saying just that, last November. For Mr Greenspan to address the subject so directly suggests the extent of his current concern.
Timing is all, of course, and it is not just Mr Greenspan who is hoping that a clearer international picture in the coming weeks will be accompanied by a clearer and more favourable economic outlook. President George Bush recently indicated that he was minded to nominate the 77-year-old Mr Greenspan for a fifth term as Fed chairman when his present stint expires next year; Mr Greenspan promptly made it clear he would accept. By then, the American economy could once again be displaying its more customary buoyancy. For now, though, it looks as if Mr Greenspan is in for a bumpy ride.
Day of reckoning
As Mr Spitzer intended, the evidence and the charges against the banks contained in the settlement should give plenty of ammunition to lawyers wishing to take action against them on behalf of disgruntled investors. The banks have, as usual, admitted no wrongdoing. But with this much compromising evidence now in the public domain, as Mr Spitzer himself ominously said: “It is not the end, it is very much the beginning.”
As the table shows, three banks bear the bulk of the financial cost: Citigroup, for its Salomon Smith Barney unit, Credit Suisse First Boston (CSFB) and Merrill Lynch. The amounts had been known, but it was only when the settlement was published on Monday, apportioning the blame among the participants, that the reasons for the ranking were known. The settlement accuses all three of issuing “fraudulent research reports” and CSFB and Salomon were also found to have engaged in the practice known as spinning—awarding stock in “hot” initial public offerings (IPOs) to executives at client companies who were in a position to steer investment banking business their way.
One of the most notable punishments is that issued against Sandy Weill, chairman of Citigroup. He has been accused of putting pressure on Jack Grubman, Salomon’s star telecoms analyst, to give AT&T a favourable rating, both because Mr Weill was on its board and also because he wanted to attract some lucrative banking business from the company. Mr Weill has been told that he and other senior executives will not be allowed to contact research staff without a monitor. Moreover, Sallie Krawcheck, hired with great fanfare from Sanford Bernstein, a house known for its independent research, to show Citigroup’s good intentions, will have to report to a board committee rather than to Mr Weill.
Some of the star analysts and bankers at the three banks accused of issuing fraudulent research have themselves come under regulatory fire. As part of the settlement, Mr Grubman, and Henry Blodget, formerly Merrill’s star internet analyst, were both fined—$15m in Mr Grubman’s case, and $4m in Mr Blodget’s—and barred from the securities industry for life. Frank Quattrone, who until recently worked at CSFB, where he was a star technology-industry banker, was charged last week with the criminal offence of obstructing a grand-jury investigation. The SEC released details of e-mails showing just how much influence Mr Quattrone, a banker, exerted over the supposedly independent research analysts. One unhappy analyst wrote: “I have ‘learned’ to adapt to a set of rules that have been imposed by Tech Group banking so as to keep our corporate clients appeased.”
The settlement reveals some damning e-mails from Morgan Stanley and Goldman Sachs, hitherto regarded as minor offenders: one Goldman analyst lists his three most important goals for 2000 as “1) Get more investment banking revenue. 2) Get more investment banking revenue. 3) Get more investment banking revenue.” A Morgan Stanley counterpart wrote: “Bottom line, my highest and best use is to help [the bank] win the best internet IPO mandates.” Similarly, at Merrill Lynch, conflicts of interest were not limited to Mr Blodget’s group. One analyst outside the group passed on important, unpublished information about companies to favoured institutional clients. It also appeared to be common practice at Merrill for analysts to send draft research to the companies they covered, seeking feedback on what to write.
All ten banks were judged by the regulators—the SEC; the National Association of Securities Dealers, the self-regulatory body for brokers; Mr Spitzer and the New York Stock Exchange—to have failed to maintain appropriate supervision over their research and investment-banking operations. Bear Stearns, CSFB, Goldman, Lehman, Merrill, Piper Jaffray, Citigroup and UBS are also accused of issuing research reports not based on principles of fair dealing, and which did not provide a sound basis for evaluating facts and which contained exaggerated claims. Thomas Wiesel, which objected to the use of the word “fraud”, and Deutsche Bank, are still negotiating separately with regulators.
Shares in bank stocks rose on April 28th following publication of the settlement, reflecting relief that this phase of the controversy over conflicts of interest was over. But the saga will run and run. For starters, Mr Spitzer has made it clear that he wishes to go after the executives who failed properly to supervise research departments. Investors will seize on the e-mail evidence to take their claims for compensation to arbitration. As part of the settlement, banks have to pay for independent research, which they will have to offer to clients, for five years. Congress will also try to muscle in on banking regulation: at the very least, it will try to ensure that state attorneys-general, like Mr Spitzer, no longer drive a process that they believe to be the preserve of the federal government and federal agencies. In an era of bear markets and little of the lucrative mergers-and-acquisitions activity that sustained banks in the late 1990s, it seems likely that research departments will continue to shrink. Last but not least, the age of analyst as master-of-the-universe seems to have come to an end. We may never see the likes of Grubman and Blodget again.
The future of accounts
Looking further into the future, however, some see the crisis in accounting as an opportunity to change the shape and content of accounts more fundamentally. The growing use of market values for assets and liabilities (instead of the accidental “historic cost” at which they were obtained) is going to make shareholders' equity and profits swing around far more than in the past. Under such circumstances, profits may come to be stated as a range of figures, each of them arrived at by using different accounting assumptions.
This may sound worryingly uncertain, but it might be better than trying to rely on a brittle illusion of accounting exactitude, which is liable to collapse during times of economic strain. For the moment though, the efforts of regulators and standard-setters are focused on five main areas:
•Pro-forma accounts. These are the first sets of results produced by companies in America: they are unaudited and do not follow America's GAAP (Generally Accepted Accounting Principles). In the years of the stockmarket bubble they were shamelessly abused. Companies regularly reported huge profits in their pro-forma earnings statements, only to register even larger losses in their official filings with the Securities and Exchange Commission (SEC). Since the end of March this year, companies have been compelled to show how they reconcile their pro-forma figures with the numbers subsequently produced according to GAAP rules, of which there are hundreds.
•Off-balance-sheet vehicles. These include the “special-purpose entities” made famous by Enron, which gave them the names of suitably fanciful characters in the Star Wars movies. They allowed the Houston oil trader to hide hundreds of millions of dollars of liabilities from investors' eyes. The Financial Accounting Standards Board (FASB), America's private-sector standard-setter, issued guidance on these vehicles in January, which Ford and General Motors say will have a material impact on their profits this year. But some think that the new rules are weak because they allow exemptions for “qualifying” special-purpose entities.
•Stock options. Most significant of all, perhaps, is the attempt to force companies to account for stock options granted to their employees. This week, FASB agreed that the cost of employee stock options should be treated as an expense. The question is, how to value them. The standard-setters may yet have a fight on their hands. In 1994, Congress threatened to take away FASB's standard-setting powers if it did not abandon its attempt to make companies “expense” their stock options. Opposition is gathering once more, although this time recent accounting scandals should lend support to FASB's position.
•Pension funds. Another controversial aim is to make companies change the way they account for their employee pension schemes. Britain's new standard on pensions, FRS17, forces them to measure pension assets at market value. In future, if a company's pension fund owes its members more than it owns in assets, the difference will be shown on the balance sheet. Outside Britain, such gaps can be smoothed out over years, with the result that some companies are still recording profits from their pension schemes despite the fact that the schemes themselves are in deficit. Britain's approach will spread: in March, FASB said it would start examining ways to improve accounting for employee pension plans, with the aim of publishing a new standard on pension accounting in America next year.
•Revenue recognition. This is the vexed issue of when precisely to include revenue in the accounts—for example, when an order is made, when it is shipped, or when payment is received. Revenue recognition has been the main reason for restatements of accounts by American companies in recent years. Sir David Tweedie, chairman of the International Accounting Standards Board (IASB) in London, and his equivalents around the world want to lay down new rules on when a company can recognise revenue. Again, the effect could be far-reaching: companies could be made to look far smaller if they are prevented from pulling revenue forward from future periods, as many do now.
Standard-setters hope that today's mood of financial conservatism will allow them to tighten up other areas of accounting too. For example, Sir David wants all leases—contracts in which a company is committed to pay for the use of an asset over a long period of time—to be recorded on companies' balance sheets as debt. The result would be to make balance sheets larger and debt ratios higher.
Yet another goal is to shift the world's body of accounting standards away from rules (the approach favoured in America) towards principles (more influential in Britain). The hard rules embedded in America's GAAP have helped devious financiers to design structures that obey the letter of the law but ignore the spirit.
But Bob Herz, the new chairman of FASB, is not optimistic about his ability to move GAAP towards principles and away from rules. Because companies and auditors demand certainty in America's litigious market place, the most he can do, he says, is to steer somewhere in between the two approaches.
Standard-setters may find it a struggle to bring in tough new measures. But they have a wider agenda that finance directors will eventually find it hard to resist. They want to stop companies using accounting rules to create the impression that profits rise remorselessly every year—by, in effect, smoothing out their earnings. “We are stripping away management's ability to massage their numbers,” says Sir David.
Peter Holgate, the head technical partner at PricewaterhouseCoopers in London, asks how it is that corporate earnings move upwards in a straight line while the drivers of those results—consumer demand, stockmarkets, interest rates and foreign-exchange rates—bump around much more unevenly.
Clamour for reform began in the 1990s. As share prices soared, people pointed to the growing gap between the book value of companies (what appeared in their accounts) and their market capitalisation (valued on stock exchanges) as evidence of the irrelevance of accounts. The way to make them more relevant (and to stop executives from fiddling them) is, standard-setters believe, to force companies to value more of their assets and liabilities at market prices, to “mark them to market”.
Instead of holding assets and liabilities at historic cost, and depreciating assets by a set amount each year, they maintain that companies should in future be required to mark them to market at the end of each reporting period. Big swings in values will then be passed quickly through the profit-and-loss account or through the shareholders' equity. Inevitably, profits will become far more volatile.
Sir David Tweedie argues that market value is obviously superior to historic cost. When he was an accounting lecturer at the University of Edinburgh in Scotland, he conducted an experiment with a group of 120 18-year-old students. He sent out of the room the few who were already trained in the historic-cost convention, and found that 95% of the remainder, allowed to think from scratch, said that they would value assets and liabilities at their market value, not according to how much a company had paid for them at some arbitrary moment in the past.
Using market value for all assets and liabilities will make some difference to how fixed assets are valued. But by far the largest impact of “fair-value accounting”, as the use of market value is called, will be to bring the volatility of financial markets into companies' results. Fair-value accounting, therefore, will affect banks and insurance companies far more than others, because they have the highest proportion of financial assets.
Under a new rule from the IASB—IAS39—derivatives and all financial instruments held for trading purposes will have to be recorded at fair value from 2005, when the IASB's rules become mandatory for all listed companies in the European Union. Eventually, says Sir David, all assets and liabilities should be recorded at fair value. In the meantime, IAS39's halfway house creates a particular problem for banks, or so they claim.
French banks, together with German and British ones, are fighting it hard. Philippe Bordenave, finance director of BNP Paribas, France's largest bank, says that as a result of having to mark its hedging derivatives to market—but not the underlying assets being hedged—its shareholders' equity will become far more volatile. The bank's equity of euro40 billion ($44 billion), he says, could swing around by as much as euro1 billion from one year to the next, just because of the new rule. “This is artificial volatility with no economic substance,” he argues.
One solution, says Mr Bordenave, would be to use market values for everything, but that might have a graver consequence. Investors may come to have less confidence in accounts because many of the “fair” market values would be unreliable. Indeed, Enron notoriously made use of fair-value accounting to manipulate the worth of its energy contracts. Insurance companies, which are also facing new rules from the IASB forcing them to mark their assets (but not their liabilities) to market, similarly fear that their earnings will become far more volatile and that investors will shun them.
The slow march to market value is probably unstoppable in the long run, because so many accountants now believe that it is the most intellectually valid way to value assets. But nobody knows what will be the consequences of the volatility that would inevitably follow. In the worst case, large numbers of investors could be frightened away from equities.
In future, accounts are likely to become more volatile, more complex and more subjective. Overall, standard-setters admit that people who are not trained in how to read them will have to rely more than ever on experts. But to help readers cope with the complexity of fair value, they intend to introduce a new way of showing companies' income—instead of a single column with turnover and so on, the profit-and-loss statement will be presented in the form of a matrix, in three columns. One column will show gains and losses from changes in fair value, another would show old-fashioned costs and revenues, and the last would show the total of the two.
Standard-setters also hope to make things a bit easier by simplifying the language used in financial statements. Instead of “debtors”, for example, they would like to have “people who owe us money”; instead of “current assets”, “assets we have at the present time”; and instead of “liabilities”, “where the money came from”.
Closing up some obvious loopholes, bringing in more market valuation and taking away some jargon—these are all important changes. Together, though, they amount to patching up the existing system. It is not surprising that accountants have decided to fix what is there already: they are on the whole a conservative bunch and not given to experimentation. Some of them, however, would like to see a far more radical rethink of accounts.
To start with the basics, what are accounts for? Most accountants would probably reply that they are there to give a true picture of a company's performance during a particular period of time. Investors, however, want far more than that: they want a sense of the company's future prospects. In this, though, they are asking accounts to do things that they have never done before, says Robert Merton, a professor at the Harvard Business School. It is a bit like “asking a plough horse to gallop on a racetrack,” he says.
In particular, he believes that users of accounts want them to highlight risks, and he thinks that they should include something similar to banks' value-at-risk (VAR) measures, which show the amount of money that a bank could lose from its trading at any moment in time. VAR systems aim to provide a range of gains and losses under various scenarios. An accounting version would show investors the likelihood of big swings in a company's assets.
Regulators also believe that companies should be obliged to give out new sorts of information. There should be new sections in annual reports on companies' intangible assets and on “key performance indicators”—such as employee turnover, customer acquisition cost or inventory turnover. The single most important thing that regulators could do to improve accounts, says Lynn Turner at Colorado State University and a former chief accountant at the SEC, would be to make companies report audited key performance indicators. Proper insights into a company's business, he says, can highlight accounting shenanigans. Harvey Goldschmid, a commissioner at the SEC, says that the regulator will consider how to get companies to publish key performance indicators “as soon as we realistically can”.
In 2000, at the height of the stockmarket bubble, the SEC asked Jeffrey Garten, dean of the Yale School of Management, to lead a task-force to look into intangible assets and new kinds of performance information for companies. One of the task-force's most provocative ideas was that companies' accounts should include information about their management and founding investors. There could be a record of managers' past successes and failures, and a summary of employment contracts. On founding investors, the report suggests adding details of their track record, the length of time that they have in the past held shares after an initial public offering (IPO), and their current intentions (if any) to sell shares in the company.
None of this, however, will address the deepest flaw in accounts, says Baruch Lev, a professor of accounting and finance at the New York University Stern School of Business. This is the reality that most of the numbers in accounts are not facts but estimates. People are not good at estimating things, he says, and no amount of new accounting rules and auditing will change the fact that estimates are fragile and easy to manipulate.
Mr Lev's remedy is to separate company accounts into two pieces: one “core” and one “satellite”. The core part would have the most reliable numbers, or the ones that rely the least on estimates—cashflow would go here, for instance, and perhaps property. The satellite part would contain fair-value numbers and intangible assets, as well as other items.
The company would then have to state in its annual report what percentage of its numbers derive from estimates and what portion are verifiable facts: analysts might choose to apply a discount, reflecting the increased risk, to companies with a high level of estimates. In subsequent years, the company would be obliged to go back and check how well its estimates had measured up to reality, much as governments go back and revise GDP estimates. Over the long run, says Mr Lev, managers of companies would not be able to get away with repeated big misses.
Although companies and their auditors pretend that they can work out a single profit figure and a single net-assets number, the truth is that accountants do not know exactly how much money a company has made, nor exactly how much it is worth at any one moment. Realistically, the best they can hope for is a range—“X corporation made somewhere between $600m and $800m”—depending on, for instance, what assumption is made about the likelihood that its customers will pay all the money that they owe.
Throughout the history of accounting, some folk have called for accounts to be presented in the form of ranges. Mr Holgate, for instance, a partner of the world's largest accounting firm and by no means a wild-eyed radical, believes that presenting profits in this way would be much more realistic. For understandable reasons, though, the world has clung to the illusion of certainty and exactness.
Mr Lev argues that the 1902 annual report for US Steel gives more useful information to investors—monthly production data, for instance—than do many sets of accounts today. At the start of the last century, of course, there were no accounting rules and no auditors. So companies could respond directly to what their shareholders demanded to know.
Today, the weight of regulation and the ever-present threat of litigation leaves companies with little freedom to experiment with new information and new ways of presenting their numbers. Even though many chief executives say that they would like to show key performance indicators, for instance, they will probably not volunteer any for fear of the consequences. So, although accounts will probably improve over time, do not expect anything radical too soon.
Sluggish growth for US economy
Economistshad expected a 2.4% growth rate in the first three months of this year, but the fact that there was expansion eased fears that the world's largest economy was heading for a double-dip recession.
The strength in the first quarter came from a narrowing of the huge US trade deficit, strong housing construction and consumer purchases of clothing, food and other non-durable items which offset a further drop in sales of cars and other durable goods.
GDP growth turned positive in the final three months of 2001 after three negative quarters of growth in America's first recession after a decade-long expansion. But growth in the past two quarters has been weak - the economy grew at a 1.4% rate during the last three months of 2002.
"It was a lacklustre, disappointing number, below expectations," Alan Ackerman, strategist at Fahnestock in New York, told Reuters. "The economy of late has given us mixed signals, and this number will take some steam out of recent optimism [in the stock market]."
The US economy is still not growing fast enough to prompt businesses to hire, and companies eliminated half a million jobs in February and March alone in what has been dubbed a jobless recovery. The economy needs to grow by at least 3% to reduce unemployment, according to many economists.
As he begins to focus on the economy in advance of next year's reelection campaign, President George Bush has been pushing for tax cuts to boost a limping economy. But many economists have criticised the proposal as it benefits mostly the rich while threatening to increase budget deficits.
A decline in car sales accounted for much of first quarter weakness. Harsh winter weather also kept consumers from the shopping malls in some parts of the country during February and early March.
Business investment in new plants and equipment proved to be surprisingly weak, shrinking by 4.2% in the first quarter following a 2.3% rise in the fourth quarter. Spending on equipment and software fell by 4.4%, the steepest drop since the third quarter of 2001.
The Paris-based economic thinktank, the Organisation of Economic Cooperation and Development, yesterday raised its expectations for the US in 2004, indicating US interest rates - at their lowest for decades - were "well-adapted" to the economy and forecast a gradual investment-led recovery.
But economists warned of threats ahead, especially if a new wave of job cuts leads to a sharp reduction in consumer spending, which accounts for nearly two-thirds of total US economic activity.
Disappointing as they were, growth in the US easily exceeded that in the UK, which grew only 0.2% in the first quarter, its weakest showing for a year.
FINALLY, a tiny bit of good news for the world economy. But it is only a bit. Figures published on April 25th showed that America's economy grew by 1.6% at an annual rate in the first quarter of this year. That is only slightly faster than the sluggish pace of growth at the tail end of 2002, and is lower than many economists had hoped for. It will certainly not be enough to cause anyone to revise their forecasts for the year as a whole. While the evidence on the American economy remains mixed, for the rest of the world there is little comfort in any recent data. Add to that the economic damage which the SARS virus is inflicting, especially in Asia, and it is hard to disagree with the conventional wisdom that global economic recovery is going to be a long, slow haul.
That is essentially the view of the Organisation for Economic Co-operation and Development (OECD), which published its latest assessment of global economic prospects on April 24th. Keen number-crunchers will make much of the fact that the forecasts from the OECD—a rich-country think-tank—are a tad more optimistic than those produced earlier in the month by the International Monetary Fund (IMF). But the underlying message is much the same: there is unlikely to be a sharp rebound in world growth this year, and the outlook for next year, while better, is not heart-stopping.
Several factors have combined to dampen economic confidence this year, forcing most economists to revise their expectations downwards yet again. Geopolitical uncertainty has hampered the previously anticipated upturn in business investment while depressing consumers’ confidence, and spending, in several of the world’s richest economies. And even though the war in Iraq has ended since the IMF issued its forecast, the OECD reckons that the improvement in the international political situation will not, by itself, be sufficient to boost recovery by much. What is needed is an underlying economic momentum, says the OECD.
To the extent that this momentum is absent—worryingly so in some countries—there is a hint in the OECD’s analysis that this reflects chickens coming home to roost. This is especially true of the European predicament. As the OECD points out, the gap between America and Europe is widening, with the euro area as a whole registering significantly poorer performance in the past few years. There is no prospect of an early reversal, at least in part because European economies have left themselves with very little room for manoeuvre—and because what scope they do have remains largely unused.
It does not help that the European Central Bank (ECB) has been slow to reduce interest rates. The OECD reckons that there is leeway to cut rates by another half a percentage point: the IMF also said further cuts should be considered. In Europe, monetary policy is the main instrument of economic stimulus because the European Union's much-derided stability and growth pact has left no scope for fiscal relaxation. The budget-deficit limits set by the pact were intended to underpin monetary union, but they have already been breached. For the euro area as a whole, the budget deficit should have fallen to 0.3% by last year, and be set to disappear altogether in 2003. Instead, the deficit across the zone reached 2.3% in 2002, and is not now expected to return to balance until 2006 or thereabouts. France and Germany are finding it particularly difficult to meet the pact’s targets.
The OECD does not share the view of those who argue that the stability pact is pointless because it is damaging short-term recovery. Instead, it points out that the medium-term outlook makes curbing fiscal deficits necessary—not just to preserve the pact’s credibility “but because of the age-related spending pressures that are about to intensify over the next few years”. Without new measures, the OECD reckons the three biggest euro-area economies—Germany, France and Italy—will make little headway in bringing down their deficits. The report makes little attempt to disguise the OECD’s view that governments have mainly themselves to blame, for squandering the surpluses in the boom years.
It’s a grim message for continental Europe, especially when contrasted with the somewhat better short-term outlook for America, where the OECD expects a modest but steady recovery this year, accelerating in 2004. The latest GDP figures appear to bear this out. But the OECD's view could turn out be optimistic in the light of the Federal Reserve’s latest survey of economic conditions across America, widely known as the “beige book”, published on April 23rd. This slightly more up-to-date evidence shows a “lacklustre” economy, with several parts of America growing even more slowly than earlier in the year.
The Fed has consistently cut interest rates further and faster than the ECB. But the OECD now reckons enough is enough, and warns Alan Greenspan, the Fed’s chairman, that he should be thinking of raising rates as the recovery becomes firmly established next year (a warning issued to the Bank of England as well). If the beige book evidence is backed up by other data, Mr Greenspan might take a different view when he and his colleagues meet again next month: there is already speculation that the Fed will conclude that the risks of economic weakness outweigh those of inflation. Mr Greenspan will not want to make the wrong call at such a sensitive time: President George Bush said this week that he wanted to reappoint the Fed chairman to a fifth term next year. Mr Greenspan responded by saying he would serve if asked.
The OECD has a warning for Mr Bush, too. It shares the widely expressed concern about the impact of the president’s tax-cutting strategy on America’s long-term fiscal position. Already, the swing from surplus to deficit between 2000 and 2002 represents the biggest two-year fiscal expansion in decades, equal to about 3.8% of GDP. Now the president wants to do more, with a $726 billion tax cut he is now trying to get through Congress. The OECD acknowledges that some of Mr Bush’s measures should help boost domestic demand in the short term. In the longer term, though, the OECD is worried about the impact of such large deficits on the rest of the economy, especially now that there is no legally binding cap on the growth of government spending. As the recovery gathers pace, the OECD suspects that higher deficits might mean higher interest rates.
Drawing attention to medium- and long-term problems should certainly concentrate policymakers’ minds. Some are now paying the price for the poor economic discipline of their predecessors, and some, especially in Europe and Japan, continue to postpone difficult but necessary reforms. The OECD suggests it is no coincidence that the countries that worked hardest to reform during the 1990s—Australia, Canada and Spain, for example—are also those that found it easier to withstand the shock from the world economic downturn.
The shadow men
Now the tyrant has gone, and governments around the world are nervously wondering what this much suspected group of men mean to do next. With Baghdad still burning, the neo-cons' most senior official, Paul Wolfowitz, the deputy secretary of defence, popped up to say that “there has got to be change in Syria”. That comment ushered in two weeks of harsh diplomatic pressure from the Bush administration about the other Baath regime, though Mr Wolfowitz quickly added that “change” did not, in this case, mean regime change.
Such talk rattles chancelleries round the world. Those in power try to be diplomatic about their concerns. But Lord Jopling, a former British cabinet minister, spoke for many when he told the House of Lords on March 18th that “neo-conservatives...now have a stranglehold on the Pentagon and seem, as well, to have a compliant armlock on the president himself.”
Robert Kagan, a neo-conservative writer living in Brussels, says “One finds Britain's finest minds propounding...conspiracy theories concerning the ‘neo-conservative' (read: Jewish) hijacking of American foreign policy. In Paris, all the talk is of oil and ‘imperialism’—and Jews.” A member of the French parliament quoted his country's foreign minister, Dominique de Villepin, saying “the hawks in the US administration [are] in the hands of [Ariel] Sharon”—a comment seen in some circles as a coded message about undue pro-Israeli influence exercised by neo-cons, most of whom are Jewish, at the heart of the administration.
So has a cabal taken over the foreign policy of the most powerful country in the world? Is a tiny group of ideologues using undue power to intervene in the internal affairs of other countries, create an empire, trash international law—and damn the consequences?
Not really. To argue that an intellectual clique has usurped American foreign policy is to give them both too much credit, and too little. American foreign policy has not been captured by a tiny, ideological clique that has imposed its narrow views on others. Rather, the neo-cons are part of a broader movement endorsed by the president, and espoused, to different degrees, by almost all the principals involved, from Vice-President Dick Cheney down (Colin Powell, the secretary of state, is a notable exception). Strands of neo-conservatism can even be found among some Democrats, which is why it makes sense to think that a new foreign-policy establishment may be emerging.
For the same reason, the criticism neglects the role of others. Near-consensus is found around the notion that America should use its power vigorously to reshape the world. Yet because parts of the neo-con agenda have been adopted by a president who is a mostly pragmatic decision-maker, and because the neo-cons themselves are politically astute, the neo-cons do not have things all their own way. They are powerful in so far as the president listens to them, rather than in their own right. The result is that American foreign policy is becoming a mixture of neo-conservative ideas, the president's instincts—and the realities of power.
To see how this came about, start with who the neo-cons are. It is understandable that they are seen as a clique, because, to begin with, they were. The group started in the 1960s as a breakaway faction from the Democratic Party. This first generation emerged as critics of the liberal establishment of their day; paradoxically, considering their reputation as ideologues, their main complaint was that Democrats had lost touch with the practical results of their policies. The term “neo” (new) was an insult thrown at them by the left, but it distinguished them from “real” conservatives; one of their founders, Irving Kristol, joked that a neo-conservative was a liberal “mugged by reality”. Foreign policy was only part of the original neo-con agenda: social policy was at least as important.
The second generation of neo-cons is different. Few are Democrats or former Democrats. They are unapologetic Republicans. And while they retain distinctive views on domestic matters (for example, neo-cons were among the fiercest critics of the former Republican Senate leader Trent Lott, who was obliged to step down for making racist remarks), foreign policy is their focus—partly because their main social-policy proposals, such as welfare reform and the dismantling of affirmative action, have become mainstream.
The second generation forms a clique intellectually and socially, but not politically. Most come from similar backgrounds, whether professors (like Mr Wolfowitz and Steve Cambone, also at the Pentagon) or lawyers (like Doug Feith, the Pentagon's number three, Scooter Libby, Mr Cheney's chief of staff, and the State Department's John Bolton). They join the same think-tanks, such as the American Enterprise Institute (AEI) where Richard Perle, perhaps their most flamboyant spokesman, is a fellow. They write for and read the same magazine, the Weekly Standard, edited by Bill Kristol, son of one of the neo-cons' founders. They co-author the same studies (five of the 27 authors of “Rebuilding America's Defences”, a highly influential report published in 2000, are in the administration). They are, in short, Washington talkers and intellectuals.
In most other countries, where foreign policy is made by permanent bureaucracies, it would be unthinkable for a small group of professors and lawyers to take any sort of policymaking role, let alone a dominant one. In America, with its traditions of entrepreneurial policy advocacy and political appointees, it is not so odd.
What is unusual is that the neo-cons are so different from the Texan business establishment gathered around George Bush. They also differ from the corporate chieftains the president hired for top jobs, such as Mr Cheney and Donald Rumsfeld (both former CEOs). Many neo-cons backed John McCain, Mr Bush's Republican rival, in the campaign; a few had even supported Al Gore.
So it was hardly surprising that, at the start, neo-cons were merely one among several groups vying for foreign-policy influence—and without much success. On the campaign trail, Mr Bush talked about a “humble, but strong” policy and was critical of “nation-building”—very un-neo-con stances. The dominant foreign-policy voice in the president's early days was that of Condoleezza Rice, the national security adviser. Ms Rice's main concern was to improve America's ties with other great powers—a policy that, while part of the neo-con agenda, was hardly uppermost in it.
Even Mr Cheney, who was to become the neo-cons' most powerful backer, seemed to differ from them early on. As defence secretary under the first President Bush, he had supported the decision not to overthrow Saddam in 1991 (to Mr Wolfowitz's dismay). And he was on record as being critical of Israel and its settlement policies—anathema to the most pro-Israeli neo-cons. Even in the aftermath of September 11th 2001, when Mr Wolfowitz went to the president to argue his case that the terrorist attacks showed America needed urgently to address the threat of Saddam Hussein, he was fobbed off.
So how did the neo-cons go from being one group among several to the positions of influence they now occupy? By articulating views that came to seem more important after September 11th 2001—but which many conservatives agreed with even before that.
Neo-cons start with the notion that America faces the challenge of managing a “unipolar world” (a phrase coined by a neo-conservative commentator, Charles Krauthammer, in 1991). They see the world in terms of good and evil. They think America should be willing to use military power to defeat the forces of chaos. Admittedly, they go on to advocate democratic transformation in the Middle East, a view that is not shared throughout the administration. (This is an extremely radical policy, so not only are neo-cons not ‘neo', they are not, in the normal sense of the term, conservative either.) But that apart, their views are not so different from others in the administration.
Neo-cons are also energetic in style, preferring moral clarity to diplomatic finesse, and confrontation to the pursuit of incremental advantage. They are sceptical of multilateral institutions that limit American power and effectiveness; they prefer to focus on new threats and opportunities, rather than old alliances.
Again, these views are not unique to neo-cons. The trends have been visible in American policy since the end of the cold war. Indeed, as Walter Russell Mead of the Council on Foreign Relations points out, opinion in the Republican Party has been shifting for longer than that. The movement away from Euro-centric east-coasters towards Sunbelt conservatives more concerned about Asia, Latin America and the Middle East began with Barry Goldwater and Ronald Reagan in the 1970s.
These common intellectual roots made it possible for neo-cons to maintain close ties with traditional conservative politicians such as Messrs Rumsfeld and Cheney. Though neither really counts as a neo-con, Mr Rumsfeld signed a letter to President Bill Clinton in 1998 urging him to make removing Saddam Hussein and his regime “the aim of American foreign policy”, and the founding document of neo-con policy was the Defence Planning Guidance drafted for Mr Cheney in 1992 during his stint as defence secretary. Written by Mr Wolfowitz and Mr Libby, it raised the notion of pre-emptive attacks and called on America to increase military spending to the point where it could not be challenged. Ten years later, both ideas have been enshrined as official policy in the 2002 National Security Strategy.
The event that turned general like-mindedness into specific influence was the terrorist assault of September 11th 2001. “Night fell on a different world,” Mr Bush said. Neo-cons had long been obsessed with the Middle East and with “undeterrable” threats, such as nuclear weapons in the hands of terrorists. Traditional Republican internationalists, who had less to say on either count, offered little intellectual alternative. As the old rule of politics says, “You can't fight something with nothing.” Mr Bush therefore embraced large parts of the neo-con agenda.
But not immediately. The decision to take on Saddam by force seems to have been made sometime between September 2001 and March 2002. In January 2002, in his state-of-the-union address, Mr Bush invoked the infamous “axis of evil”—which could have been lifted from a neo-con handbook. This February, he gave a speech to the AEI about building democracy in Iraq and encouraging political reform in the Middle East.
Some Europeans seem to think the neo-cons' influence is a direct result of Mr Bush's inability to grasp basic foreign-policy ideas. The recent evolution of American policy does not bear out this patronising view. The new policy was adopted in response to a cataclysmic event. It enjoys support at almost every level of government, including Congress (the main exceptions are the State Department and serving officers in the armed forces). Above all, the new policy is defined by the president himself. The neo-con clique depends on Mr Bush, not the other way around.
Fine, you might argue, but this just shifts the focus of concern from the cabal to the consensus. Whoever formulates policy, it is still, say critics, inimical to the interests of (some) Europeans, international law, multilateral institutions and traditional alliances. Moreover, if policy is run by a coalition of people, of whom neo-cons are just the first among equals, then that raises questions about the stability of the coalition, and whether there are internal tensions waiting to erupt between neo-cons and others.
The worries about America's foreign policy are mostly about means and costs, not ends. Neo-cons want to liberate Iraq, spread democracy through the Middle East and improve counter-proliferation measures. Critics can hardly object to any of these, even if they do not care to focus on the aims as relentlessly as neo-cons do.
Europeans often attribute everything they dislike in American policy to the influence of this cabal. Yet to do so is obviously wrong: the administration's—indeed, America's—disengagement from certain international treaties long predated the neo-cons' ascendancy. It is true that neo-cons are more unsparing than most in their disdain for multilateral bodies that they think act against American interests. But their attitude to “entangling alliances” is pragmatic, rather than hostile across the board. Many, though not all, like NATO because of its role in uniting eastern and western Europe after the collapse of communism. When France and Germany held up a Turkish request to NATO for supplies of defensive equipment before the Iraq war, the administration found a way round the obstacle within the organisation, rather than acting outside it. The neo-cons' main ire is reserved for the United Nations and, sometimes, the European Union (see article) .
Clearly there have been big diplomatic ructions in the past year, notably in the Security Council over the second Iraq resolution. But it is hard to blame the neo-cons entirely, or even at all. The French and Russians were responsible for much of the bad blood, while the department largely responsible for American diplomacy in that unhappy hour was the very un-neo-con State.
The one area where neo-conservative influence may really prove inimical to the interests of others is Israel. Neo-cons are among Ariel Sharon's staunchest defenders. Most fear the “road map” will endanger Israel's security, and will do everything they can to stop it.
On the other hand, the map is itself an indication of the limits of their influence. If neo-cons really ran the show, as they are said to, there would almost certainly be no such map. That there is testifies to the other forces acting on Mr Bush: the State Department, the National Security Council, even Tony Blair.
These forces will continue to influence the president and moderate the neo-cons' power. This could be good or bad. Good in that the wildest flights of neo-con fancy will be grounded; bad if the result is policy incoherence. At the moment, the good outcome seems the more likely.
Iraq is the neo-cons' test case. Military victory has increased the group's influence hugely; a serious reversal could undo it. But successful post-war reconstruction would embolden them to press the president to adopt other bits of their agenda. This does not mean sending troops to Damascus (the neo-cons write what they mean: they have always singled out Iraq, and no other country, for military action). Rather, it means putting pressure on Syria to stop supporting Hizbullah and on the Saudis to stop exporting Wahhabi extremism; and it means backing the internal opposition in Iran to the clerical regime.
But there will be constraints on getting this wish-list through. The neo-cons have waited more than ten years to reform Iraq. They will not lose interest in it, as happened in Afghanistan. But they could be distracted by, say, a crisis in North Korea or on the Indian subcontinent. They could be defeated in Congress over the cost of their plans, especially if the economy falters. Or fault lines could re-emerge with mainstream conservatives over how long to keep troops abroad, with the mainstream, backed by the cautious realists in the armed forces, demanding that troops return home as soon as possible.
Lastly, there is Mr Bush himself. His main concern is re-election, and he has already started to switch his attention back to the economy to avoid his father's fate. That may do more than anything to temper the neo-cons' influence.
European and other governments could add their weight to these countervailing trends if they chose. But, with the exception of Britain, they have not, preferring to demonise the neo-cons as a cabal. This is almost certainly a mistake. The neo- cons are not a marginal group. They are providing much of the intellectual framework for America's foreign policy. Barring a serious reversal abroad, that will continue—and demonising them will merely marginalise their critics.
A new world order
How it has changed, and how international relations will evolve in the aftermath of the war in Iraq, is far more difficult to judge. As always with Mr Bush, it is as important to watch what he does as it is to listen to what he says. In the end, America did go ahead and invade Iraq, in the face of considerable international opposition. But the administration in Washington also displayed far more patience in its attempts to secure broad support for its stand at the United Nations than many had expected. The language recently used to warn Syria to behave has led some observers to infer that the regime in Damascus might also face an attempt to overthrow it. But America has said it has no such plans; indeed, on April 20th, Mr Bush softened his tone towards Syria, saying he saw “positive signs” that it was heeding American calls not to shelter fugitive Iraqi officials. In practice, there is little sign that even the Bush administration's most hawkish members are pushing for further military intervention in the Middle East. What happened in Iraq should, for now, be enough to make rogue states very nervous. It may even already have had an effect on the North Korean regime, which has toned down its fiery rhetoric and agreed to discuss its nuclear programme with America and China.
This, of course, is what has become known as the doctrine of pre-emption. America now seems to be ready to strike at any potential threat to its interests, before that threat is realised. As the world's only superpower, it is easy to see why such an approach makes sense in Washington. America has now clearly demonstrated its convincing military superiority. If anyone doubted that America could wage war successfully in more than one place at a time, and do so with a relatively light force, the events of the past few weeks will have forced a rethink.
But being a superpower does not bring complete immunity from attack, as the destruction of the World Trade Centre showed. Nor does it mean that America can act without any regard to the interests and wishes of others. America needs good relations with the rest of the world, and especially with its key strategic allies. The political philosophy which underpins its constitution and its economic success ultimately depends on vigorous interchange with other countries and full participation in the world economy. The fact that some parts of American business, not to mention Congress, are instinctively protectionist does not mean that America would be a more successful economy without free trade. Any one sector in any one country can usually benefit from subsidies and restrictions on foreign competition: that does not mean that the economy as a whole would register similar gains.
For those non-superpowers who are nevertheless accustomed to wielding considerable influence in international affairs—France being the obvious example—the shift in the balance of power that has taken place in the past couple of decades is bound to be frustrating. The days of the cold war made it much easier for America's strategic allies to punch above their weight. In diplomatic terms, Europe benefited enormously from its proximity to the Soviet empire. For America, the continent was an important buffer, worth the great expense. For Europe, this meant influence and, even more important, someone to pick up most of the tab for defence.
Even in those days there were tensions. In principle, America liked the idea of the European Union. For Washington, it should have simplified doing business with a disparate group of countries. In practice, it often made it more complicated—who spoke for Europe was never wholly clear—and America resented European attempts to take an independent line just as much as Europe resented being told what to do. Since 1991, though, with the cold war over, America has perhaps started to mind less what Europe thinks.
This more disdainful mindset perhaps reached its apogee in the painful arguments that took place at the United Nations before the invasion of Iraq. The Bush administration made it clear that while it was prepared to try for agreement on a new UN resolution, it was not prepared to be deflected from its chosen course by France, Germany or Russia. The Bush administration is probably more suspicious of Europe than its predecessors—but that is probably simply a question of degree. Most American policymakers regard the European Union as hidebound, protectionist and, at worst, inclined to appeasement. That is why the support of Britain's prime minister, Tony Blair, was so important in Washington.
American suspicions about Europe will not fade now that the campaign in Iraq is drawing to a close. Nor will European resentment at the all-powerful upstart from the New World be any more subdued, at least in private. Yet efforts are already under way on both sides to ease the tensions. America has gone a long way towards accepting a UN role in post-war Iraq, although the terms of this role remain usefully vague. European opponents of the war have also been at pains in recent days to strike an emollient note.
Transatlantic relations remain at the heart of American and European foreign policy. The two continents are too closely bound together for that to change in the short term. Talk of the “Pacific century”, implying a westward shift of America's focus, turned out to be premature, partly because of the economic mess Japan got into, and partly because relations with China remain prickly. So how America and Europe patch up their differences will largely determine the future shape of international relations.
America wants Europe to face up to its responsibilities: to raise defence spending, to disavow protectionism in favour of free trade, to reform its creaking economic structures, and to recognise that appeasement rarely buys more than time. Europe, in turn, would like to see America play a more co-operative role in world affairs, to be more willing to participate in global efforts to control global warming, to support the International Criminal Court, and so on. The balance of power makes it realistic to assume America will continue to get more of what it wants. Ultimately, Europe may have to take it or leave it.
How big is the danger?
Japan, for instance, is experiencing its fourth successive year of falling prices. It is on the brink of its fourth recession in a decade, share prices are at their lowest levels since the mid-1980s, and the days when the Japanese economic model was the envy of the world seem a very long time ago. The Bank of Japan, under a new governor but confronting the same old problem, seems at a loss as to how to halt the fall in prices.
Deflation alarms economists because it can quickly send the economy into a downward spin. A general fall in prices nearly always occurs because of a fall in demand. If interest rates fall to zero as part of the attempt to avert deflation, the real cost of borrowing rises. If deflation were, say, 5%, then someone who borrowed for a year at a nominal rate of zero would actually be paying 5% in real terms. That would hardly encourage people to borrow for investment or consumption: if prices are falling, any one business or consumer will usually decide it makes sense to wait before spending money. But the more people who postpone purchases, the more sellers will be forced to cut prices.
That Japan’s economy is in a shambles is nothing new. In the past few months, though, the comfortable assumption that the world’s second-biggest economy had problems that were peculiar to itself has been challenged. Economists, and some policymakers, have started to worry that deflation might become a problem in America or Europe. What if America’s economic recovery, already fragile, falters? The war in Iraq has been shorter than many people feared. But it is too soon to be sure that its end will also mark the end of the long period of uncertainty which has seen business investment stall and consumer spending weaken. With American interest rates already down to 1.25%, what if monetary policy fails to revive the economy even as interest rates approach zero?
The Federal Reserve, America’s central bank, has gone out of its way to reassure those asking such difficult questions that it has thought about how to tackle deflation if necessary. The Fed, though, remains convinced that this is not currently a significant risk for the American economy. As things stand, it is probably right. The American economy might be sluggish, but it remains among the fastest-growing of the big industrial economies. There is—as yet, at any rate—little sign of the collapse in demand which usually accompanies, or precedes, deflation.
The same cannot be said of some European countries. Most attention is currently focused on Switzerland and Germany. Switzerland, which is in neither the European Union nor the euro area, has a very low inflation rate—1.3% in March—and has had several years of GDP growth below its long-term trend level, which implies weak demand and surplus economic capacity. It has very low interest rates—close to zero, which leaves the central bank with little scope for further cuts to stimulate the economy using conventional means. And the Swiss franc has appreciated sharply, offsetting much of the impact of the interest-rate cuts already made.
According to Michael Taylor of Merrill Lynch, however, Switzerland does have some weapons in its locker if deflation were to become a serious threat. Most important, in the European context, is that the central bank can respond directly to Switzerland’s needs. The economy is relatively flexible and able to handle economic shocks better than some other countries. Because it is so open (exports are 44% of GDP), the exchange rate is crucial, which in turn gives the authorities more policy options: they could, as they successfully did in the 1970s, seek to drive down the franc and boost the money supply.
The German authorities are in a much less comfortable position. The euro area’s largest economy is in poor shape: at best, growth is going to be well below trend both this year and next; at worst, the economy could slip into another recession. Domestic demand is weak, and the recent appreciation of the euro against the dollar is curbing export demand as well. Most economists agree interest rates are too high for Germany, but the European Central Bank (ECB) is, of course, setting monetary policy in the interests of the euro area as a whole. And while the monetary loosening Germany needs is proving elusive, fiscal policy is providing no relief either. Thanks to the stability and growth pact, which sets strict budget-deficit limits, the government finds itself tightening fiscal policy to try to bring its budget deficit back within the permitted range. If German prices did start to fall, the authorities would have very little room for maneouvre. For now, the ECB continues to worry more about inflation in the euro area as a whole than deflation in Germany. Even in Germany, it is probably true that deflation is still not the most likely outcome.
But preventing deflation is clearly easier than coping with it. There is a case, therefore, for taking a more pre-emptive stand than the ECB has done so far, and relaxing monetary policy in order to stimulate recovery. The D-word is unlikely to be mentioned much in public, but many economists would like to see the ECB cut rates more aggressively.
In its latest economic outlook, published earlier this month, the International Monetary Fund (IMF) agreed with those who reckon there is only a small risk of deflation spreading beyond Japan. But the IMF went on to argue that policymakers should nevertheless do what they can to prevent deflation occurring. That, said the Fund, could mean relaxing monetary policy more than the immediate circumstances might appear to warrant. It also means paying as much attention when inflation undershoots the target as when it overshoots. Kenneth Rogoff, the IMF's chief economist, said on April 9th that the ECB should consider raising its inflation target (currently 0-2%). But on April 12th, the ECB president, Wim Duisenberg, argued that European interest rates were at the right level. If the situation in Germany continues to worsen, such firmness of purpose could begin to look like pigheadedness.
MANILA, PHILIPPINES | Monday, April 21, 2003
J. Bradford DeLong is now professor of Economics at the University of California at Berkeley and a former Assistant US Treasury Secretary.
Given the size and economic importance of the US, the world is watching where the US economy is going.
It peaked -- and the 1990s boom came to an end around March 2001, when America's remarkable economic expansion gave way to the first recession in 10 years.
But did that recession end when output started to grow in December 2001? Or is it still continuing? The National Bureau of Economic Research (NBER) and its Business Cycle Dating Committee, the semi-official arbiter and tracker of the US business cycle, remain silent.
Recent economic and monetary policy changes have exposed a crucial ambiguity that had always been implicit in the way the NBER thought about business cycles.
Since the Great Depression, it was almost always clear when a recession ended: industrial production grew strongly, total sales reversed their decline, and the unemployment rate fell.
All of these trend reversals occurred simultaneously or within a very few months of each other. Thus, it never really mattered how one identified the end of a recession, or even whether one had a definition at all.
As a Supreme Court justice once said of obscenity, "I may not know how to define it, but I know it when I see it."
Recently, however, this rough-and-ready approach has begun to prove inadequate. In retrospect, the first warning sign was the so-called "jobless recovery" of the early 1990s. Production and sales bottomed out in March 1991. But the unemployment rate continued to rise -- by more than a full percentage point before peaking at 7.6% in June 1992.
If, as I believe, the most important business-cycle indicator is workers' justified anxiety about losing a job and the difficulty of finding a new one, then the worst cyclical moment for the American economy came a full 15 months after the recession's semi-formal end.
And things are worse this time. As measured by trends in production, the recession that began in March 2001 was one of the shortest and shallowest ever: over in less than nine months, and amounting to an extremely small decline in gross domestic product. The same appears true when measured by sales.
But, as measured by employment, this is one of the worst, if not the worst, recession since the Great Depression: 2.1 million fewer people are at work in the US today than at the peak of the business cycle two years ago. If one includes normal growth of the labor force, the employment shortfall today relative to what it would have been had the 1990's boom continued amounts to 4.7 million jobs.
So why the breakdown of the old business-cycle indicators? One reason is that the Federal Reserve has acted differently in the past decade and a half. Most earlier recessions were not entirely undesired: higher unemployment helped reduce inflation when it exceeded the Fed's comfort level. When the Fed concluded that inflation was no longer a threat and shifted its primary short-term task from ensuring price stability to boosting production, most earlier recessions ended. Lower interest rates caused all business cycle indicators-production, sales, employment, and the unemployment rate-to turn upward.
A second reason is that roughly from 1970-1995, the underlying trend of productivity growth was relatively slow. When productivity grows slowly, it is extremely unlikely that rising production will be accompanied by falling employment.
Since 1995 or so, however, the productivity growth trend underlying the US economy has been quite rapid: not 0.7% per year -- the average during the preceding 25 years -- but two percent or three percent, perhaps even more. And so far, there is every sign that rapid underlying potential productivity growth persists.
With these two considerations in mind, the NBER's current dilemma becomes obvious. Unlike in previous recessions, this time there was no sudden shift in Fed policy to give all macroeconomic business cycle indicators the same turning point.
Moreover, rapid growth in underlying productivity means that a respectable, if subnormal, recovery in terms of output growth is associated with falling employment and a rising unemployment rate.
The lesson is that if we are to continue to use the word "recession," we finally have to define exactly what one is. Is a recession a period of falling output alone? Or is a recession a period when the labor market becomes worse for a typical worker? Whether the US economy is still in recession depends on how we answer this question.
The most important point is not whether the US economy is in recession, but that the old categories simply do not fit. The US is still in an employment recession; but in the past, employment recessions were accompanied by falling output, which is not the case now. The US is in a production recovery; but in the past (except for 1991-1992), production recoveries were accompanied by improving labor markets, which is not the case now.
Changes in economic policy and in the underlying productivity trend have created a situation in which neither "recession" nor "expansion," as these terms were used in the second half of the 20th century, adequately describes the current situation.
And that, it seems to me, is by far the most important issue to grasp regarding the current phase of the US business cycle.