Increasingly, the biggest German corporations view themselves as working for the
benefit of their stockholders. This is a major change from the traditional approach which
was to work in the interest of many stakeholders, including in particular the interest of
German workers. As a consequence of the change in approach, German stock prices are
soaring at the same time that the German economy remains mired in recession with an
unemployment rate of about 12 percent.
This year, all the European economies hope to meet an ambitious set of previously
agreed upon financial standards in order to qualify for admission to the Economic Monetary
Union, an arrangement that would give them a common currency. One of these standards
requires that the government budget deficit be no larger than 3 percent of GDP. In the
United States, even though the deficit is a source of enormous concern, it is unlikely to
exceed 2 percent of GDP this year. But because of the European recession, most of them are
not expected to meet the 3 percent standard this year, and the future of the single
currency is in doubt. In my view they are not likely to meet this standard unless they
cheat. (An example of cheating would be to sell government real estate.) Europeans are
extremely troubled about the outlook.
Meanwhile, Japan’s problems have proven more intractable than most analysts
anticipated. Hirohito won the recent election, promising reforms which would eliminate
many of the restrictions that keep prices high for consumers. Big corporations who face
international competition also favor these reforms. The reforms would make the Japanese
economy more like the American economy. Opposing the reforms are farmers and small
businesses who benefit from the restrictions, and government bureaucrats who exercise
great power through their administration of these restrictions.
In recent years, the big Japanese corporations have been whipsawed. First they were
told to invest overseas and the yen was allowed to soar. Now the yen has been brought
down, making it profitable once again—but perhaps temporarily—to export from
Japan. Land prices have fallen by 60 percent in recent years, which has substantially
reduced the cost of producing in Japan, but the accompanying decline in stock prices and
the uncertainty over future government policy seem to have paralyzed investment. Both
bankers and their potential customers are afraid of the risks of increased lending.
In contrast to Germany and Japan, the United States sits with both its current
performance and its outlook better than they have been for years. Confidence is high and
the stock market is booming. Physical investment by business is high and home building is
strong. Flows of investment from abroad are increasing. Indeed, a major risk to the United
States is that it may boom a bit too much and run into inflation. This is a legitimate
risk in my view, a risk that is greater than the risk of stagnation.
In response to the sharp contrast between the performance of the U.S. economy and its
major rivals, international investors have driven the value of the dollar up sharply.
Recently, they have been encouraged in this behavior by the governments and central banks
of the major industrial nations who view a higher dollar as a way to transfer strength
from the United States to its ailing competitors. Because of the continuing recessions in
Japan and Germany, and because of the increase in the value of the dollar, the outlook for
U.S. exports is worse now than it was a few months ago. This sector will provide a
convenient safety valve in the event of overheating. At the first sign of overheating in
the United States, Wall Street would drive up American interest rates, which would lead to
a further strengthening of the dollar. The stronger dollar would weaken our international
competitiveness and take some of the steam out of our momentum.
How Long Can the Expansion Continue?
While the present expansion is more vulnerable to a downturn than it was a few years
ago, there is no reason this expansion must end soon. Among the risks that could lead to a
recession are an outbreak of inflation or a collapse in stock values, events which could
occur without a major change in the present direction of the economy. Another risk is a
speculative surge in the value of the dollar to levels that would make many major U.S.
producers uncompetitive.
Because the economy is so close to full employment an upward move is as much of a
threat to the recovery as a downward move. An upward move could lead to inflation with a
quick reponse by the Federal Reserve, and a downward move could be self-reinforcing
through its effect on stock values and consumer spending. Hence the path of stable,
continued growth remains a narrow one, and minor deviations on either side of the path
could lead to a self-perpetuating decline.
While I would not quite characterize the economy as walking a tightrope, the image is a
useful one in suggesting the dangers of deviation to either side. The downside risk is
that consumer spending could peter out and the upside risk is that any surprising strength
will bring higher interest rates quickly. The most likely cause of a downside move would
be a restriction of consumer credit growth by lenders.
The Risk of Inflation
The upside risk for this economy is that growth at too rapid a rate will kick off
inflation. If inflation appears, the Federal Reserve will move quickly to raise interest
rates to cool the economy down.
The Federal Reserve has stated explicitly that it would be concerned primarily by an
upsurge in inflation in non-food, non-energy products. The reason for less concern with
food or energy inflation is that food and energy prices can rise for reasons other than a
general overheating of the economy. We are unlikely to see inflation in non-food,
non-energy products unless the economy overheats and widespread shortages appear. The main
shortage at this time appears to be a shortage of labor. Because of this, the Federal
Reserve is concentrating on wage inflation as its signal of an overheated economy. It will
move quickly to restrain economic growth if wage inflation reappears. The Federal Reserve
has stated that at this date it does not foresee inflation, and hence does not see the
need to raise interest rates immediately, but Alan Greenspan, in testimony before Congress
in late February, warned how thin the margin is between the current level of performance
and one that the Federal Reserve would consider to be inflationary.
Intelligently, in my view, the Fed decided not to try to restrain the food and energy
price increases of 1996 with tight money. These increases did not spread from the food and
energy sectors into the rest of the economy. While food and energy prices remain high at
this date, further increases in these prices will be at slower rates, which means that
food and energy inflation will decline somewhat in 1997.
Interest Rates
Long-term rates will follow the economy as they have in the past. Unexpected strength
in economic activity would lead to increases in long-term rates, and surprising weakness
would lead to decreases. Growth at the forecast rate of a bit more than 2 percent would be
consistent with modestly declining long-term rates over the year, though temporary surges
or declines in activity could make rates quite volatile.
Short-term rates, which are controlled by the Federal Reserve, will only decline in the
face of substantial economic weakness, which is unlikely. Indeed, the Fed has been leaning
toward raising rates, not lowering them. Increases in short-term rates could occur even in
the face of a weakening economy if labor shortages lead to wage rate increases.
Unfortunately, labor shortages are evident in some markets, so acceleration of wages
remains a possibility that could cause the Fed to act. If an increase in wage inflation
occurs, long-term rates would stop declining. Because the odds on this are almost even at
this time, no declines in short-term rates can be expected in the near term.
Mortgage rates declined sharply in late 1996 after a period in which they had stayed
high despite a decline in long-term bond rates. There remains room for a further modest
decline in mortgage rates even if long-term bond rates stabilize at current levels.
Housing
I expect a continued modest decline in residential construction for another quarter,
and then flatness for the rest of 1997. The peak in interest rates of mid-1996 is now well
behind us and the recent decline in mortgage rates will help housing in 1997. Most
observers, myself included, were surprised by the strong showing of housing in early 1996.
It appears that there is more underlying strength in this sector than had been expected.
As a result, 1.4 million has come to seem like a normal year for housing starts rather
than the boom it appeared to be in 1994. Starts near 1.4 million or even a bit above 1.4
million are likely in 1997.
An End to the Business Cycle?
Some analysts suggest that the business cycle is a thing of the past. This was also
claimed in the late 1980s, but then came the recession of 1990-91. Certainly, recoveries
have been longer in recent years than in the 1950s, and recessions have occurred as a
consequence of identifiable shocks rather than simply as a spontaneous occurrence. But the
cycle is not dead, even though we don’t expect to see a decline in the near future.
The risks that could lead to a decline are there, and declines that are accompanied by
stock market crashes can be particularly nasty.
Summary of the National Outlook
Slow growth in 1997 is as good a performance as we can expect. My forecast, which is of
growth at 2 percent or a bit better would be better for the nation than growth at 1
percent or 3 percent. Three percent would lead to inflation and 1 percent would entail
unnecessary unemployment. Hence we should be gratified by the likelihood that growth will
be modest, and we should hope that 1997 remains dull on the economic front.
The Outlook for Wisconsin
Wisconsin continues to underperform the rest of the nation, at least as far as
employment growth is concerned. One of the main reasons for the underperformance is a
shortage of labor. Wisconsin is so close to full employment that further growth is
difficult without substantial in-migration.
Wisconsin’s growth will be hindered in 1997 because many of its major employers
are near full capacity. Furthermore, the market for capital goods will be softer in 1997
as domestic demand slows and as international competition stiffens. The Wisconsin economy
depends strongly on the strength of its capital goods producers. These producers have had
a decade of strong growth. Growth in domestic demand in this sector in 1997 will be softer
than in 1996, which in turn was substantially softer than it was in 1994 and 1995.
International competition for those sales will become stiffer due to the strong dollar.
From a shorter-term perspective, several employers in the Milwaukee area have already
announced major restructurings that will lead to substantial declines in local levels of
employment.
The accompanying charts show that growth of
employment in Wisconsin outpaced the nation as a whole from 1987 to 1993, but performed at
an average rate for 1994 and 1995. In 1996, growth in Wisconsin was less than in the rest
of the country. I expect the gap that opened in 1996 to continue in 1997.
It will become more difficult to gauge the relative strength of the Wisconsin economy
in 1997 because the employment statistics, which are the most reliable guide to economic
trends in the short run, will be affected by new welfare reform programs, both in
Wisconsin and in the United States. These programs will change the typical patterns of
employment growth. Already there is evidence of a strong national and state response to
the “end of welfare as we know it.” The welfare rolls are shrinking across the
country as many past welfare recipients seek work. This response is taking place even
before the new programs go into effect, and even in states that have not yet enacted their
own welfare reform programs. Because of the new welfare policies, it will be difficult for
analysts to separate employment changes that are due to the differential impacts of
welfare reform in each state from changes that are due to differences in the economic
strength of each state.
Overall, the outlook for Wisconsin in 1997 is good. The economy is likely to remain at
a high level of utilization, but growth will take place at a rate that is a bit below the
national average.