Herd on the Street

SYNOPSIS: Despite 5.8% growth last quarter, our recovery could be slow and jobless

On Friday the Commerce Department announced that the economy grew 5.8 percent in the first quarter of 2002. The Dow promptly sank below 10,000, making it the stock market's worst week since Sept. 11. And stocks fell again yesterday.

What's going on? Maybe the market is spooked by those orchestrated leaks about attacking Iraq, which everyone agrees are a smoke screen, but nobody is sure for what. Or maybe we should ignore the Dow; an old line says that the stock market has predicted nine of the last five recessions. But the truth is that the numbers, when you look at them closely, are actually quite disappointing. How can 5.8 percent growth be disappointing? Bear with me while I run through a textbook example. This won't hurt (much).

Imagine a company that produces widgets (companies in these examples always produce widgets), normally selling 100 each month. The company tries to keep one month's sales, 100 widgets, in inventory. But for some reason sales drop off, to 90 per month. And it takes a month before the company realizes what has happened.

At the end of that month the company, having produced 100 widgets but sold only 90, finds itself with 110 in inventory, but wants to hold only 90. To eliminate the excess inventory quickly, it might slash production to 70 for the next month, then bump production back up to 90. But unless sales increase again, that's where it ends production never recovers to its original level.

As go the widget-makers, so goeth the economy. When demand drops, inventories build up, then production drops sharply as businesses work off the overhang. Finally, there's an "inventory bounce" when the overhang is gone. But the bounce doesn't necessarily presage a true recovery to get that, you need increased sales to final buyers.

And more than half of that 5.8 percent growth was just inventory bounce. Final sales actually grew only 2.6 percent, slower than in the previous quarter. And even that growth rate may not be sustainable: home construction soared, partly because of unusually warm weather, but there are already signs that the housing market is cooling off. Meanwhile, business investment, weighed down by excess capacity and weak profits, actually declined. In short, there is nothing in the data to suggest that a great boom is imminent.

This shouldn't be cause for surprise, but it is because the great majority of business forecasters have become cheerleaders. As Alan Abelson put it in Barron's: "Where we are today . . . is not where we were supposed to be, according to the received wisdom back at the turn of the year. Economically, the perfect storm was to be followed by the perfect recovery."

I've never quite understood where that received wisdom came from. Wall Street economists assured us that business investment was about to surge, yet corporate leaders who actually make the investment decisions have consistently been much more pessimistic than the forecasters. Hey, what do they know?

Still, there has been intense pressure on business economists to run with the bullish herd. Skeptics about the impending economic miracle haven't just been ridiculed, they have been ostracized. Morgan Stanley's Stephen S. Roach who was a lonely skeptic in the days of Nasdaq 5,000 and is now one of the few business forecasters with the courage to defy the orthodoxy signs his e-mails to me "From the wilderness."

Of course, it's still possible that the prophets of boom will be vindicated. But it's also still possible, and I'd say about equally likely, that the recovery will stall. Right now the best bet for the next few quarters is probably a "jobless recovery," in which G.D.P. grows but unemployment stays high. After all, the economy needs to grow at about 3.5 percent just to prevent the unemployment rate from rising and the odds are at least even that growth will fall short of that mark.

The funny thing is that a slow, jobless (and profitless) recovery is exactly what levelheaded people like economists at the Federal Reserve have been predicting for a long time. So how did a far more bullish view become not just prevalent but more or less mandatory on Wall Street? How, with the business landscape still strewn with rubble from the bubble, did manic optimism so quickly become de rigueur again? It seems that hype springs eternal.

Originally published in The New York Times, 4.30.02