The U.S. economy is working nicely, with low unemployment, low interest rates, low inflation, moderate growth and moderate investment despite this winters financial crisis in Asia. We may yet see the Asian flu spread to the U.S. economy, but the chances of a severe large-scale impact in this country are declining. While researching this quarters report, I could not help but notice a research project being conducted under the auspices of the U.S. Commerce Department. The title of the project is Is This Expansion Different? This is a superb question, for despite severe shocks to the world economy, the U.S. economy has, over the past ten years, performed like a juggernaut - constantly rolling forward with little heed to the obstacles in its path. The mildness of the plateaus in this expansion is remarkable. Can we attribute the current lack of boom-and-bust cyclicality to anything in particular? Lets examine a few possibilities.
First, management has improved. This is especially true in areas relating to working capital, such as inventories, which can cause the greatest hardships during a lean year. The effect of this improvement can be felt in your own company. For example, when a customer goes belly up today, you are less likely to be left sitting on a large pile of inventory and substantial receivables. The risk may still be there, but improved management - especially practices like JIT manufacturing - has diminished the impact. That effect multiplied by many thousands of companies has a moderating effect on the whole U.S. economy. It can be seen in the decline of the Inventory to Sales ratio over the past two decades.
Secondly, the money supply is being much more closely managed. At times, this management has been mystifying, and certainly frustrating. In our opinion, tight control of the money supply over the past two years has been a serious impediment to economic growth. But lets look at the result - sure, the economy has only grown three or four percent a year, rather than five or six, but inflation has been consistently low, as well, and there are very few sectors of the U.S. economy that can be said to be overbuilt. Overbuilding - specifically, building that leads to excess capacity in a broad range of industries - is the primary cause of the boom-and-bust cycle. If the constantly moderate economic growth is the best way to avoid this problem, we can certainly live with it. We have, in effect, sacrificed the booms to get rid of busts.
The third possible reason why the recent expansion has continued for so long is continuing real increases in productivity. In the 1970s, computerization was a boon to productivity only in large, technically savvy companies. In the 1980s, it was a boon to most large companies, and technically savvy medium-sized companies. In the 1990s, computers and automation technology are beneficial to everyone, because the level of technical capability in the workforce finally exceeds the capability required to improve productivity with automation. Notice that there are two factors here, workforce capability and capability required. Workforce capability has moved up simply because people are exposed to computer technology in greater numbers, and with greater intensity, than ever before. The required capability has declined because the design of the technology itself has improved, driven by the simple (but revolutionary) concept of user-friendliness. The movement of user-friendly technology into the small and medium-sized business has created extremely agile companies that are tremendous engines of productivity and job creation.
We still think long-term economic growth is limited by the number of workers entering the workforce.
The fourth possible reason for the long expansion is increasing globalization. In the world economic system, markets outside of the U.S. can act as buffers on both the upside and the downside. On the upside, we may purchase tooling, raw materials, or, lately, labor from other countries when their supply becomes tight in the U.S. On the downside, global markets can absorb excess capacity when demand for our products or services are soft in the U.S. The trend of the past twenty years - indeed, of the latter half of this century - has been toward greater speed and efficiency in cross-border transactions. While this will cause difficulties for some, the overall effect has been to dampen the effect of shocks to the domestic economy.
The big question for us, of course, is how does this affect our planning for the next few years? First, we can see that there are key items to watch for signals that the expansion may end. These would include decreasing quality of management, which may be spotted through measures like the Ratio of Inventory to Sales, over-rapid growth in the money supply, decreasing effectiveness of technology - admittedly tough to measure - and increased protectionism and barriers to trade. All of these things are vital to the current recipe for a robust economy. Secondly, we should be aware that the recipe might cease to work for some reason. There are two great threats to the current model: first, a shock so big that the system cannot absorb it, such as a large-scale war, and second, collapse of some industries brought on by deflation. This second threat is real simply because the current model for expansion succeeds by limiting inflation, but not by defending against deflation. This is reasonable, as deflation hasnt been a problem for sixty years, but the threat is real and must not be ignored.
Now, lets take a look at the domestic picture as of the end of January. Disposable income really heated up in the fourth quarter. Some of this increase went into greater savings, which should help to increase liquidity in financial markets. Interestingly, consumption was also up fairly strongly - although less than income.
Orders for Plant and Equipment show yet another strong increase, but again, the increase was lower than the previous quarter. (see graph below) This may be good news for the economy as a whole, since overbuilding can lead to recession. Still, industrial equipment manufacturers and those in construction should watch closely for a further decrease in growth. The Ratio of Inventories to Sales is very low, which we take as an indicator of economic strength. This number continues to bear watching over the next six to nine months, as the U.S. economy absorbs the impact of Asias economic woes. The dollar exchange rates pick up from a third quarter decline to deliver a super 10.4% increase for the year. We predicted this fourth quarter increase in our last commentary, but we cannot continue to predict strength for the dollar over the coming year, as ever cheaper Asian goods will become quite tempting to American consumers and businesses alike.
Employment growth, while slow, picked up nicely in the fourth quarter. We still think long-term economic growth is limited by the number of workers entering the workforce. As long as GDP growth exceeds growth in the labor force, you can expect employment to drive two things: first, inflationary pressure, as more dollars chase fewer workers, and second, a decrease in pressure for continued growth, as companies struggle to cope with extremely high labor utilization. Unemployment is low and continues to drop. One wonders how low it could get - probably not much lower. Manufacturing hours, at 42.1, are approaching the post WWII high of 42.2 set in 1995. We expect this high to be exceeded if the economy stays on its present course. The rate of growth of Private Housing Starts slowed down to a more sustainable level, but we expect first quarter 1998 to show a surge due to mild weather in much of the U.S.
U.S. Productivity is beginning to bore us, with continually record-setting performance. Not that we are complaining - far better to have the tedium of strong productivity results than suffer the bashing that has beset the Japanese economy. The Asian financial crisis could not have come at a worse time for Japan, as the Japanese economy was just beginning to creep out of a recession when it hit. We predicted further deterioration in Q4, and here it is. Capacity utilization remains strong. We had some fear last quarter that this number might weaken due to the Asian economic crisis, but that problem hasnít materialized. This is not to say that it wonít - it is possible that there is going to be a delayed reaction in the U.S. economy - but our assessment of the probability of this threat having great magnitude in the U.S. is lower than it was last quarter.
The money supply showed a second strong increase in as many quarters, but this was well warranted. The intent of this increase was likely to help the U.S. economy sail over the morass of Asian economic turmoil, and it appears to have done its job well. The difficult problem now is, how much is enough? If the money supply overexpands, the tight labor market will gobble up any excess in a way that can only lead to increased inflation. Watch out for this - while prices are declining now, we must remember that the pressures for higher inflation are always present when employment and capacity utilization are high. Interest rates remained steady despite the run-up in the money supply. This is a good sign that the expansion of the money supply has not exceeded the levels required to support further moderate expansion in the economy.
Crude Materials Prices plummeted this quarter. Producer prices lost quite a bit as well. While our main concern in the past has been inflationary pressures coming to light in these numbers, we should remember that declining prices represent a threat as well. Consumer prices managed to increase, but the rate of increase has dropped considerably. Overall, inflation appears to be in check, but we still need to be wary about the strong labor market. Also, we must watch for the paralyzing effects that deflation can have on investment and growth.
Finally, the leading indicators increased slightly, which once again suggests we have six months to a year before we need to start worrying about recession. However, be aware that tight labor markets and increased price competition from Asian competitors could lead to diminished profitability for many U.S. firms. Also, we should remember that profitability in some sectors may be hurt as spending on Y2K problems peaks over the next 12 months. Overall, the domestic outlook looks moderately good, but not great.