Exposing the Fraying Edges in the Fabric of the Economy
New York Times; New York, N.Y.; Dec 18, 2000;

The American economic expansion, already the longest on record, is nearing its 10th birthday, and while growth has slowed, economists generally expect a ''soft landing'' that will avert a recession.

But the fact that things have gone so well for so long does not mean there are no risks. We asked the four people who rotate in writing the Economic Scene column that appears on Thursdays to ponder a simple question: What factors pose the greatest threat to our nation's prosperity in 2001? Their answers varied, ranging from worry over a possible decline in the dollar to concern about the potentially stifling impact that new regulations might have on growth.

Here are their responses:

Hal R. Varian -- Economics professor and dean of the School of Information Management and Systems at the University of California at Berkeley.

Economists aren't known for their optimism. We more often see clouds where others find the silver linings.

On the eve of 2001, I see four economic clouds facing the United States economy: the downward trend of the stock market; signs of less-than-robust retail sales; the overvalued dollar and the resulting current account deficit; and the high personal and corporate debt burden.

None of these is a big problem on its own, but the combination could be deadly. A pessimistic scenario begins with a plunge in the stock market, leading to a significant drop in consumer spending. Foreign investors liquidate their positions, causing a further fall in the stock market and precipitating a run on the dollar. Overextended consumers and corporate borrowers experience financial distress, damping down spending even more, which leads to a full-fledged recession.

That's the nightmare scenario. In truth, each of these risk factors does have a positive side. An optimist could argue that the market is simply coming back to reality after its high-tech binge. And retail sales may not be growing as fast as last year, but their growth is still significantly above long-term averages. The dollar does appear to be unusually strong, but, if it weakens, exports would become more competitive, improving the balance of trade and keeping unemployment down. Finally, some economists argue that the household savings rate is mismeasured since retained capital gains are not counted as part of savings; if you add them in, the private savings rate is quite high by historical standards.

The sole remaining cloud is corporate debt. Capitalist economies have a long history of overinvestment in hot new technologies. In the 1880's, more miles of railroad track were laid than in any other decade of American history. In the 1890's, the resulting excess capacity led to more miles of track in bankruptcy than in any other decade in American history. In the 1990's, we have seen huge investments in information technology, with much of the infrastructure investment being debt-financed. We are already seeing signs of excess capacity in long-haul fiber optics. Will telecommunications infrastructure suffer the same fate as the railroads?

ALAN B. KRUEGER -- Bendheim Professor of Economics and Public Affairs at Princeton University and editor of The Journal of Economic Perspectives.

The United States economy has performed extraordinarily well the last nine years, and the most plausible forecast is for continued growth, albeit at a slower pace. Nevertheless, there are two main potential threats to economic prosperity, one gradual and the other sudden. The gradual threat is a return to the slower productivity growth of the 1970's and 1980's; the sudden one is a loss of foreign investor confidence.

Due to the wonders of compound interest, in the long run productivity growth is virtually everything. The United States economy has boomed because output per hour worked grew 3 percent a year since 1995 -- twice as fast as in the preceding 20 years. Despite claims about oil shocks causing the 1970's slowdown and information technology causing the 1990's boom, no one knows for sure the origins of either. Productivity growth could slow again. If it grows by 1.5 percent a year over the next decade instead of 3 percent, national income will be nearly 20 percent less.

Not only banana republics can suffer sudden losses in investor confidence and sharp swings in exchange rates. The current account deficit -- the net flow of trade and investment income to the United States -- surged past 4 percent of gross domestic product this year, a record level. Foreign investors financed our $400 billion current account deficit. Hardly anyone believes this situation is sustainable.

Economists Maurice Obstfeld of the University of California at Berkeley and Kenneth Rogoff of Harvard sketch out what would happen to the dollar if the current account deficit returned to balance, and the results are not pretty. The dollar could fall by as much as the Mexican peso did in 1995. And in our case, the downside could be even greater because there is no international monetary authority that is large enough to bail us out. Inflation would rise and output contract.

What could precipitate such an event? President-elect George W. Bush could try to unite the country after the divisive election by delivering a large tax cut and expensive prescription drug plan, shattering the budget discipline of the late 1990's.

Although a sudden withdrawal of foreign investment is unlikely, a lesson of the Long-Term Capital Management collapse in 1998 is that nine standard deviation events -- that is, statistical long shots -- do sometimes occur.

VIRGINIA POSTREL Editor at large of Reason magazine and author of ''The Future and Its Enemies: The Growing Conflict Over Creativity, Enterprise and Progress.''

The economy is slowing, with consumer spending, stock prices and new-economy hype all down from their recent highs. The question is whether this slowdown represents an inevitable correction -- a healthy pause before another upward trend -- or the beginning of a serious slump.

Both long-term productivity growth and short-term resilience depend on how creative and adaptable private enterprises are. This is partly an issue of management. Executives shaped by good times have different skills and instincts from those who developed during downturns, and it is often difficult to adapt to new circumstances.

The range of available options also matters, however, and here government policy makes a tremendous difference. Regulatory mandates, often passed in good times, bite more when economic growth slows. And they, in turn, reduce growth-enhancing investment, feeding a vicious cycle.

A $1 minimum wage hike passed when business is booming and labor is short throws few people out of work. But when the time comes for belt-tightening, the extra $40 a week, plus related payroll taxes, will lead to layoffs and aggravate the slowdown.

Similarly, the Occupational Safety and Health Administration's controversial new ergonomics regulations will divert billions of dollars into redesigning work spaces and buying new equipment. The $20 billion that United Parcel Service estimates it will have to spend upfront to comply will not be available for new trucks, planes or tracking systems or for employee raises. If the law requires people to worry about ergonomics instead of sales or service, they will do so, but productivity will inevitably be hurt.

Year-end wrangling between Congress and the White House has blocked the latest minimum wage hike, although several states have passed their own. Opponents are challenging the OSHA standards in court. It's possible, though unlikely, that neither will survive. Economic downturns exercise a powerful check on regulatory overreach.

In a sunnier economic scenario, we will see conflicts between new business models -- representing growth rather than belt-tightening -- and existing or proposed regulations. Already, Internet businesses have collided with state restrictions on competition in businesses from optometry to auto sales. The Federal Trade Commission is under increasing pressure to impose a single regulatory standard on data gathered online. And we can expect continued culture wars over biotechnology.

Whether setting limits on growing new businesses or restricting struggling old ones, regulatory expansion poses the greatest long-term threat to economic prosperity.

JEFF MADRICK -- Editor of Challenge Magazine and adjunct professor of social sciences at Cooper Union.

Despite rapid growth over the past five years, we are often told these days that the American economy is remarkably well balanced. What this usually means is that, in contrast to the 1980's, federal and local government spending has been held well within the nation's means to pay. But such an analysis has an eye cast dangerously to the past.

Odds are still that America will survive 2001 without a recession. But make no mistake about it: there are economic imbalances that could turn a slowdown into a more painful downturn.

There are two related concerns. Because we save so little and borrow so much, America has become dependent on a high value for the dollar in order to attract needed capital. The high dollar also helped keep inflation down by keeping import prices low. A new study by the New York Federal Reserve Bank finds that the subdued level of inflation in the late 1990's, in fact, was largely due to low import prices.

But if the economy slows and stock prices continue to perform poorly, investors may withdraw their capital and sell the dollar. Under such circumstances, the Federal Reserve, fearing that a falling dollar will provoke higher inflation even as the economy is slowing, may keep interest rates higher than it otherwise would in order to attract dollar buyers. Just when we need lower interest rates to stimulate the economy, the Fed might well find its hands tied. The dollar fell by 40 percent in the 1980's.

The second problem is that while the federal government is generating budget surpluses, both individuals and corporations are borrowing in record amounts. This has provided the stimulus to consumer demand and capital investment that has allowed the economy to grow so rapidly. But if personal income and profits grow more slowly, and if interest rates rise, the proportion of funds that must be allocated to debt service will rise. This will leave less to spend and invest.

Given falling stock prices, higher oil prices and tightened credit, a significant slowdown in economic growth is a growing likelihood. At such a point, the economic imbalances, so easily dismissed in a time of prosperity, could take a serious toll. The last five years have provided one pleasant surprise after another, but the economy in 2001 is likely to be highly delicate. Managing it will be more difficult than in the recent past.