Prepared by Diane C. Swonk
Bank One Corporation
(January 13, 2003) President Bush is in the White House, U.S. and British troops are mounting on the boarders of Iraq, and the economy appears to have just posted its worst performance in over a year. Job growth is negligible, if not negative, and many are worried about the prospects for the year ahead. Pop quiz: is it January 1991 or January 2003? Luckily, it is 2003, and we have learned some lessons from the past. Both Bush and Greenspan are acutely aware of the downside risks to the outlook and willing to go to extremes to avoid a repeat of the recession of 1991. Indeed, the pipeline is already primed to deliver better growth in 2003 and 2004.
Separately, there are the economics of war, which have changed dramatically during the last 12 years. Our smart weapons are smarter and more efficient than they once were, making a conflict in Iraq more likely to be short-lived, while oil production is already slated rise to compensate for any disruptions that may occur as a result of a war.
Risks abound, however, and there is no guarantee that the policy decisions we make today will be as good for our long-term growth prospects as they are for our near-term growth prospects.
Similarly, there is no guarantee that war in Iraq will dampen rather than stoke tensions between the U.S. and the Middle East. Political analysts seem to agree that at least some of today's problems in the region are rooted in the aftermath of failed attempts to take Hussein down following the Gulf War.
The remainder of this report examines how both the economy and policy makers are fundamentally better equipped to deal with the risks that we face today than they were 12 years ago. Not only have the binds of fiscal discipline already been broken, the normally hawkish Fed is (for the moment) more willing to risk inflation over recession.
Stronger Fundamentals
The state of the economy today is a far cry from where we were on the eve of the Gulf War:
- Incomes are in the black rather than the red (See Chart 1);
Real Income Growth: Now And Them
- Consumers have restructured their balance sheets, delinquencies are on the decline, and consumer debt is less of a damper on spending (See Chart 2);
Debt Consolidation Via Cash-Outs
*--Estimated from three quarters of data.
- Corporate cash flow is improving instead of deteriorating (See Chart 3); and,
Corporate Cash Flow Has Recovered
- Oil prices remain fairly well-contained, despite problems in Venezuela. Unlike 1991, Iraq has not invaded Kuwait. Despite some interruptions to oil production, we are not seeing the massive destruction of oil fields that set oil prices soaring in late 1990. Indeed, OPEC plans to boost production to compensate for a potential conflict and the recent loss from Venezuela, despite what could be glut conditions next spring.
A More Balanced 2003
Preliminary data suggest that the fourth quarter barely grew at all, which would be the worst performance in over a year. Manufacturing activity was particularly weak, as disruptions created by the West Coast dock strikes were causing bottlenecks into November. Consumer spending also slowed, although vehicle sales ended the year on a high note. Incentives were sweetened on 2003 vehicles over the course of the quarter. Imports slowed (again, due in part to dock strikes), inventories were further drained, and government spending picked up. The movement of troops to the Middle East started to gain momentum in December.
The stage is set for better growth in the first and second quarters of 2003. Inventories have nowhere to go but up, which will add to momentum from a slowly accelerating rebound in capital spending. Cash flow has picked up, and once the dust settles from a conflict in Iraq, confidence among senior executives is also likely to improve. Government spending is also expected to pick up, with gains at the federal level offsetting a slowdown at the state and local level. Trade will remain a drag on growth, with the U.S. doing more for the rest of the world than the latter does for the former. On net, the economy is expected grow at about a 3% pace in the first half of the year, a modest pick-up from the second half of 2002.
A Sidelined Fed
For the most part, no news will be good news for the Federal Reserve during the first half of the year. The Fed is expected to remain largely on the sidelines, but it would not take much for it to act in either direction if necessary. It has worked too hard to obtain the low inflation/high productivity growth economy we have, and Greenspan is not about to give up his legacy this late in the game. His term expires in the spring of 2004, but will likely be extended through the election cycle.
More Active Policies
Add more growth-oriented monetary and fiscal policies to the mix, and it is a slam dunk that the economy will perform better in 2003 and 2004 than it did in the early 1990's. The Fed has been particularly aggressive in hedging the downside risks to the economy this time around:
- Chairman Greenspan, who once believed that sub-par growth was the best way to achieve price stability, is now more concerned with hedging the downside risks of recession and deflation than he is with inflation; and
- The blame aimed at the Fed after the 1992 election still smolders with another Bush in the White House.
Chart 4
Fed Funds Rate: Now And Then
At the same time, we have a different President Bush, intent on correcting the sins of the father. That means that he will pursue policies that aim to both remove Saddam Hussein from power and stimulate the economy via tax cuts prior to 2004 to ensure reelection.
In a January 7, 2003 speech to the Economic Club of Chicago, Bush laid
out his fiscal stimulus plan, while the Democrats simultaneously announced
theirs. The details of the two plans have been discussed at length in the
press, and are laid out in the table.
| Fiscal Stimulus Plans | ||
| President's Proposal | Democrats' Alternative | |
| Total Cost | $102b in 2003; $674 over 10 years | $136b in 2003; $100b over 10 years, with no spending increases or revenue reductions after first year |
| Tax Cuts | Accelerate 2001 tax cuts, including the cut in marriage tax, and rise in child credit | $300 per person and $600 per couple tax rebates |
| Dividends | Eliminate the double taxation of dividends | No provision |
| Expensing | Increase small business tax exception limits from $25k to $75k | Increase small business tax exception limits from $25k to $50k for investments made in 2003 |
| Bonus Depreciation | No provision | Restructure last year's bonus depreciation so that firms can write off a 50% bonus in 2003 |
| Homeland Security | No provision | $10b in grants in FY2003 for homeland security |
| Transportation | No provision | $5b in highway funding and allow states to postpone their matching of project costs for 2 years |
| Alternative Minimum Tax | Increase Alternative Minimum Tax (AMT) to protect lower-income households from missing out on changes in the rates | No provision |
| Medicaid Cost-Sharing | No provision | One time, $10b increase in federal share of Medicaid payments |
| Unemployment Benefits | Extension of benefits already passed, retroactive to December. The Bush plan includes a $3,000 bonus to aid those seeking work. | |
The President's plan would cost an estimated $670 billion over ten years; the Democrats' would cost a smaller $137 billion. The final word on stimulus will probably be somewhere in between. Whereas the Bush plan appears on the surface to benefit the wealthy more (about half of the cost comes from the elimination of the dividend tax), the Democrat plan is a little light on dealing with issues of capital investment and the efficiency of capital markets.
No matter how the final plan turns out, we are likely to see some stimulus this year and more next year. The Administration is conservatively targeting a July 1 passage of the package, but most believe it will occur much sooner (April or May).
Not to worry, however, because a significant amount of stimulus is already in the pipeline from the $1.35 trillion 2001 tax cuts, increased discretionary spending by Congress (which seems to have lost all its earlier discipline), and the ongoing spending necessary to ready the military for war with Iraq.
Indeed, the best bet is that the largest stimulus for the economy this year comes from the war itself, which is currently estimated at about $60 billion in up front costs, more than double the costs of the Gulf War. Remember that the Gulf War was so cheap and, hence, a drag on the economy because it was fought largely with the inventories of weapons accumulated during the Cold War. This will not be the case this time around.
Moreover, as uncomfortable as the idea of another war is, any conflict we do engage in is likely to be short-lived even less than the five weeks it took in 1991. The hit rate of our "smart" weapons has risen from about 30% during the Gulf war to close to 90% during the conflict in Afghanistan, while the Iraqi army appears to be significantly weaker than it was in 1991.
Finally, there is the commitment to occupy and rebuild Iraq once the war is complete, which could go on for years. There is an underlying goal to bring democracy to the region, and the only way to do that would be to calm highly divided factions with an occupation of some sort. As one member of Congress recently quipped, "What Wall Street needs to understand is that the U.S. military is going to be occupying a country with a positive cash flow for the first time."
Risks
It is almost pointless to list the risks at this stage of the game, as they seem to grow by the day:
- Terrorism remains a real and credible threat to businesses and individuals.
- A "regime change" in Iraq may require a building-by-building move on Baghdad, which would cost more in lives and time than most would like to admit.
- A move to bring a U.S.-led democracy to Iraq is not likely to be welcomed by many countries in the region;
- The Kurds, which represent about two-thirds of Iraq's population, have already made it clear that they would prefer their own separate state, an outcome that Turkey (likely to be a close U.S. ally if a war erupts) would vehemently oppose.
- The situation in North Korea remains unstable, although inside sources in Washington suggest a diplomatic solution is possible.
- Market reforms in Latin America continue to backslide, which is diminishing our ability to tap new markets going forward.
- Both the current account and federal budget deficits are growing, and will continue to grow given the commitment to permanent tax cuts and semi-permanent spending increases. The result is an eventual (five to 10 years out) crowding out of business investment and a sharply lower dollar as we saw in the 1980's.
Conclusions
The most likely outcome for 2003 is a year of more balanced and stable growth. Financial markets begin to reflect those gains, and the recovery begins to transform itself into an expansion. There is substantial upside risk that by the end of 2003 and early 2004, we begin to see more substantial gains in growth than forecast, given the stimulus provided by increased defense spending, reduced taxes, and falling oil prices.
There is legitimate concern, however, that we may be trading later strength for gains today. A world with larger fiscal deficits means little in the near-term, but could curtail growth in the long-term, a fact that has not escaped the American public. Two of three people surveyed feel the government should work to hold deficits in check rather than expand them again.
Separately, there is the risk that efforts to fight terrorism and attack
Iraq backfire, especially in the case of a military operation. But that
seems highly unlikely. We have shown how truly resilient we are as an economy
and a nation.