June 12, 2002
Canadian economist Stephen J. Turnovsky has argued that "internal dynamics" was as important as economic policy in explaining the short run performance of an economy.
The idea of a predetermined path of business fluctuations was a major factor in business cycle theory. Recently, however, rational behavior and efficient markets have supplanted the traditional theory of business cycles. Indeed, few economics departments spend much time on such fluctuations.
Fortunately, Turnovsky has not abandoned the assumption that economies fluctuate around growth paths. Also, those fluctuations have identifiable characteristics. Most economic forecasting models have adjustment mechanisms embedded in their equations, even if few students have taken graduate courses that explain them.
I certainly do not wish to understate the significance of economic policy. Stimulative monetary policy along with substantial government spending and tax incentives clearly should prevent this recovery from suffering a relapse late this year or early in 2003.
However, those "internal dynamics" also are improving the prospects for significant growth in the next eighteen months.
When the speculative bubble burst, consumers and corporations wound down their spending programs. Production lagged the change in spending programs. As a result, inventories swelled. This inventory adjustment mechanism is a significant component of most recessions.
Before production cutbacks could realign inventories with lower sales growth, other forces added to the economic weakness. Fear of job loss slowed the growth of consumer spending further.
As production declined, previous capital spending programs could not be sustained. In the past year, spending on non-residential fixed investment plunged more than 10 percent.
Production and employment were falling while capital accumulation was merely slowing. As unused capital continued to grow, orders for new plant and equipment were cut back further.
At the same time, the excess inventory and idle equipment encouraged some producers to try to sell their way out of their redundancies by slashing prices. Inflation slowed, gradually encouraging consumers to increase their spending. However, a lag in response to price reductions led to collapsing profits first.
Again, none of this is surprising, except to the extent that it no longer is discussed in many economics departments.
Just as these "internal dynamics" along with stimulative policies were about to turn the economy upward, terrorist attacks upset the adjustment process. The economy froze like a deer in the headlights of a car.
As a result, inventory reductions plunged relative to sales. About two-thirds of the strong first quarter economic growth were caused by substituting production for some warehouse sales. Production growth will continue through the summer until the warehouses get to levels needed to meet sales in a timely fashion.
Unfortunately, capital appropriations also were being decided when the terrorists struck. As a result, capital accumulation, which had been growing as much as 5 percent two years ago, fell to only slightly over 1 percent early this year.
Low profits and accounting concerns about corporate debt have encouraged corporations to continue with their very conservative capital spending programs. However, as production begins to rebound, capacity utilization is beginning to grow.
Historically, orders for capital equipment remain anemic until utilization exceeds 77 percent of measured capacity. This time, rising production should push utilization levels above that level before the fall.
Also, new technologies and more equipment exhaustion from increased production will require some growth in capital spending to prevent actual reductions in capital adjusted for depreciation in 2003. Only in 1932 has our nation suffered an actual decline in net capital available for production.
In short, the "internal dynamics" are working with favorable policies to assure that this recovery will not stall, even if most economists no longer are learning what those "internal dynamics" are.