A CASE STUDY: THE MYSTERIOUS SLUMP OF THE EARLY 1990’s
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As the United States entered 1990, there was almost universal agreement among economic forecasters, central bankers, the financial press, and financial market participants that the economy would continue to expand. After all, they argued, recessions were generally preceded by rising interest rates or rapid buildups in inventories, and neither had occurred. Moreover, after a weak 1989 was followed by a firm first quarter of 1990 (largely because of unusually mild weather), virtually no one feared a downturn. Yet economic growth almost halted in the second quarter of 1990, and in July a recession began. The recession, widely but incorrectly blamed on the Gulf crisis, officially ended in March 1991, but profits and employment continued to fall through the end of 1991, and public confidence in the economic future hit an extraordinary low. Commercial banks were in their worst financial condition since the 1930s, and desperate attempts to repair balance sheets caused a "credit crunch" that plagued housing, small business, and general economic activity well into 1993. Revisionist history now discounts the trauma of the early 1990s, citing the briefness of the official recession. Yet, until the 2001 recession and its aftermath, the early 1990s contraction was on several measures the worst of the post-World War II era. The period from July 1990 to February 1992 was longer than any preceding episode of declining payrolls in the postwar era (20 months), and reported profits, slashed by falling operating earnings and massive write-offs, suffered their worst decline. The recovery remained sluggish through the 1992 presidential election, and the Federal Reserve was still cutting interest rates to treat economic weakness a year and a half after the recession's official end. The economy staggered again in the first half of 1993. Standard economic models gave no warning in the late 1980s of the impending downturn. However, from the profits perspective, the economy was almost certainly headed towards a drawn-out slump of an unusual nature, with severe weakness in construction and extraordinary financial problems, and by the end of 1989 the downturn appeared likely to arrive during the year ahead. The economy was not weakened by short-term business cycle forces, such as an inventory correction or a disruption of home building caused by rising mortgage rates. Rather, it was beginning to suffer the consequences of years of excesses in business capacity expansion, commercial construction, and real estate speculation—all financed with debt. Indeed, debt had grown faster during the 1980s than ever before. Most economists could see only roaring consumption, construction, and investment, yet the profits perspective showed precisely how the real estate/debt bubble of the 1980s had created the profits boom, why the bubble would have to burst, and how declining fixed investment, normally a lagging part of the business cycle, would lead to a deterioration in profits. The profits perspective enabled the Levys to foresee a kind of recession that no one had witnessed before. Jay and David Levy, writing in Industry Forecast during the late 1980s, warned that the next downturn would be a capital goods recession—unlike any other slump of the postwar era. At the start of 1990 they described the economy as "flirting with recession", and in early February they wrote, "Developments have caused us to raise our probability of recession from 50+% to 60%." In August they wrote, " The probability that a recession is under way or will soon begin has risen to 75%." That recession would be widely unrecognized by others, even the Federal Reserve, for many months to come. The power of the profits approach is not simply that it enabled the Levys to call this recession when virtually no one else believed it could occur, but that it enabled them to understand what was happening and to know what to watch for. In the November 1990 issue they were able to explain to readers why this recession had occurred, how it was different from other recessions—it was what they labeled a "contained depression"—and why it would have a sluggish, uneven recovery. Of Recessions and Depressions From the August 1990 Industry Forecast In general usage, neither "recession" nor "depression" is precisely defined. We offer one useful distinction: recessions are retrenchments necessitated by overproduction; depressions are caused by overinvestment. The primary imbalances in a recession are in inventories; in a depression they are in structures and productive capacity. Inventory imbalances can be corrected quickly; excess structures and capacity take years to absorb. The credit problems in a recession are mostly short term, linked to temporarily excessive inventories, or to a brief bulge in unemployment. In a depression, severe and long-term financial problems emerge when vast amounts of debt secured by long-term assets lose value as asset prices fall and cash flow diminishes. Industry Forecast's readers know that we have described the present situation: a "fixed investment recession." Are we forecasting a depression? Call it a "contained depression." Were it not for widespread government guarantees that will prevent a collapse of the financial system and for the federal government's large, stabilizing role, the 1990s would rival the 1930s for economic devastation. Major bank and thrift insolvencies would have already led to runs, destroying confidence and paralyzing businesses. Highly leveraged corporations, real estate, and other assets would be causing an epidemic of liquidation. Fixed investment would be grinding to a virtual halt, and aggregate corporate income would turn negative. Fortunately, nothing so cataclysmic is in store. Deposit insurance and government guarantees may not protect individual lending institutions, but they will keep the system intact. Moreover, the federal deficit will remain a huge stimulus to the economy. It will partly offset the stimulus lost as a result of falling investments in construction and equipment. By limiting the decreases in profits, sales, employment, and confidence, the fiscal stimulus will contain the drop in fixed investment and the damage to the financial sector. Both a recession and a contained depression are under way. Inventories are rising involuntarily, and liquidation will follow. The end of this liquidation, the swelling of the federal deficit, and a drop in imports will all contribute to the recession's end, probably late in 1991. But no true recovery will follow; the depressionary environment for finance and fixed investment will continue to frustrate growth for several years. Note that this strikingly prescient last paragraph was written in November 1990, before most economists acknowledged that a downturn had occurred. It described almost exactly what was to occur later, and it did so even though nothing like it had ever happened before. Not every important insight leads to a precise forecast or has a direct implication for practical action, but the recognition of the contained depression did. For example, the Levys’ forecasts of interest rates were extraordinary. After calling the major 1989 peak in interest rates within days, the Levys went on to say, when the market was expecting rising rates at the start of 1990, that the T-bill rate would fall from 8% to 6% in 12 months. Their timing was almost perfect; it took 13 1/2 months instead of 12. At the start of 1991 they wrote that the rate would fall to 4% by year-end, another shocking forecast since the market was expecting a sharp rebound. This time their timing was perfect, and T-bills broke 4% late in December.
THE JEROME LEVY FORECASTING CENTER, LLC
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