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America's millennium hangover

Excess liquidity at the turn of the century has created a Y2K recession, writes David Hale Published: January 23 2001 20:12GMT | Last Updated: January 23 2001 20:16GMT

There is now so much downward momentum in the US economy that it will be difficult to avoid a recession this year. The interesting political issue is whether the pundits and the public will regard the downturn as a Clinton recession or a Bush recession.

If President George W. Bush fails to come up with a policy to end the recession, the Republicans will risk losing control of Congress in the mid-term elections of 2002.

There is no simple way to attribute blame: the downturn has resulted from a convergence of factors. First, the US Federal Reserve raised interest rates by 175 basis points during 1999 and 2000 to prevent robust economic growth from producing inflationary overheating. Second, the sharp rise in oil prices reduced household income by almost $100bn. Third, the stock market rise has pushed the tax share of national income to record levels and produced a budget surplus equal to almost 3 per cent of gross domestic product, compared with large deficits three years ago.

In the past, most economists would have regarded such a dramatic swing in the government's fiscal position as contractionary. Meanwhile, the stock market pushed equity valuations for technology companies to such extraordinary levels during 1999 and early 2000 that it would have been impossible to avoid a big correction if they had experienced any bad news.

The only policy variable that could have altered the performance of the economy decisively during the past two years was monetary policy. Future economic historians may argue that the Fed could have tried to cool the late-1990s boom by introducing a restrictive monetary policy when the stock market rose sharply two years ago and then easing more quickly when the economy showed signs of slowing during the second half of 2000.

The problem with such critiques is that the Fed perceived itself to be highly constrained by external factors. The Fed did raise interest rates in early 1997 but quickly shifted to neutral because of the onset of the Asian financial crisis. The Fed then eased three times in the autumn of 1998 in order to prevent the financial contagion resulting from Russia's default and the near-bankruptcy of Long-Term Capital Management from producing a domestic credit crunch.

One could argue that the Fed eased excessively in 1998 but, in view of the upheavals occurring in the financial markets, there was no way for the central bank to quantify precisely how the economy would behave. The Fed was trying to control the psychology of bankers, bond traders, portfolio managers and other people responsible for the performance of the financial system.

However, the Fed also pursued a highly expansionary monetary policy during the closing months of 1999 because of concern about the risk of Y2K disruptions in the financial markets and the world economy - and here the judgments made in hindsight may not be so forgiving.

In retrospect, the impact of Y2K on monetary policy was probably the factor that helped to set the stage for the final wave of highly speculative behaviour in the equity market and the high-yield bond market. During the closing months of 1999, Nasdaq sky-rocketed while money flowed freely to a number of highly speculative companies in the telecommunications and technology sectors. It was the speculative excesses during late 1999 that greatly increased the risk of a hard landing when the mood of the markets changed during the spring and summer of 2000.

In the end, concerns about Y2K risk were greatly exaggerated because there were scarcely any disruptions in the economy as a consequence of the millennium calendar changes. But the downturn now occurring could be classified as the Y2K recession because of the role it played in causing monetary policy to set the stage for a boom-and-bust cycle in the Nasdaq, telecoms and technology fundraising, venture capital and the other financial variables that drove the boom of the late-1990s.

If we classify the current downturn as the Y2K recession, neither political party will have to worry that the electorate will blame it for rising unemployment later this year. But the business cycle cannot be totally divorced from politics. The other great question looming over Washington is how to label the economic recovery of 2002. Will it be the Greenspan recovery because of falling interest rates, the Bush recovery because of tax cuts, or the Dick Gephardt recovery because of large increases in public spending?

At this point, only one thing is clear. With so many policy options available for reviving the economy, the Y2K recession should not last longer than six to nine months. If the downturn extends beyond 2001 because of partisan conflicts, the downturn should be reclassified as the Washington recession because only political squabbles over tax cuts and public spending can prevent a recovery.

The writer is chief global economist at Zurich Financial Services.

http://markets.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT3G9XK0CIC&live=true

-- Martin Thompson (mthom1927@aol.com), January 25, 2001