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THE REVIVAL OF RISK

The tragic events of September 11 reminded us that we live in a world fraught with risk. That is one reason so much seems to have changed, all the more so because many believed that a variety of risks had receded permanently. To some extent, the reduction in risks was real. For example, the risk of nuclear war probably declined after the cold war ended. But some people went much further, proclaiming "the end of history," with global conflict winding down as the world finally accepted the triumph of the western capitalist democratic model.

In a different arena, the increased use of information technology (IT) systems for supply chain management reduced uncertainty and cut the risk of demand surprises along the supply chain. As a result, firms could afford to carry lower levels of inventory and thus become more efficient without worrying too much about sharp inventory corrections.

The reality was that in cyclical terms, the past decade was the least volatile in history. Searching for answers, many economists attributed the taming of the cycle to IT-related enterprise resource management systems and enhanced productivity growth at the micro level, and much more skillful management of the economy at the national level. There was, in fact, broad acceptance of the notion that with the cycle thus tamed, the risk of recession had essentially evaporated. The decline in risk was believed to be permanent because it was attributed largely to controllable factors rather than luck. Yet the ability of the U.S. economy to avert a boom-bust cycle as it enjoyed a sustained period of non-inflationary growth was not simply the result of deliberate choices.

As a paper from the New York Federal Reserve finally acknowledged this year, the credit for this period of non-inflationary growth goes mostly to the U.S. economy's good fortune in that the world experienced asynchronous expansions and recessions during most of the 1990s. As a result, t here was almost always global overcapacity, resulting, for instance, in the four-year decline in U.S. import prices from 1995 to 1999, keeping a lid on U.S. inflation pressures even as domestic growth rose and unemployment fell.

But it is human nature to take credit for good outcomes and attribute poor outcomes to bad luck or external forces. This is what psychologists call "attribution bias." What happened in the late 1990s was attribution bias on a national scale, with people coming to believe that because they could now control things better, the level of risk had been permanently reduced, and recessions were a thing of the past. A consequence of this misperception was the popularity of buying stocks on dips, which was quite rational if you believed that the risk of recession - and bear markets - had essentially disappeared.

The ease of raising money in the stock market and low interest rates helped fuel the capital investment boom, which was directed increasingly towards IT-related investment. It did not hurt that the perceived risk of overinvestment was thought to be minimal, given that there would never be any more recessions that would cause a capacity overhang. The consequence was a capital investment boom.

A DARKER NEAR-TERM OUTLOOK
The U.S. economy was already in a recession when the terrorist attack took place. This is evident from the indicators used to officially date a recession - primarily employment and industrial production - which peaked in March 2001 and September 2000 respectively. Secondarily, the broadest measure of sales, real manufacturing and trade sales, peaked late last year as well. Thus, it is highly likely that the recession started months ago.

While it is clear that the attack made the outlook even worse, it is important to examine what the objective leading indicators now suggest about the future. This is where ECRI's Weekly Leading Index (WLI) becomes invaluable, since it is very promptly available, and already reflects post-attack data. The WLI sums up the tug of war between the positive and negative influences on the future course of the economy and is updated every Friday afternoon at www.businesscycle.com. As shown in the chart, the WLI level peaked in early 2000, plunging by 10 points from March 2000 to April 2001, correctly predicting the current recession. Following the Fed's early interest rate cuts, from April to May the WLI recovered about a third of its earlier slide as investor sentiment improved in the expectation of a quick recovery. However, by early summer the WLI was sliding once again. By August the WLI had erased its entire advance since the April 2001 low, dimming the hopes for a year-end recovery.

In the weeks since the attack the WLI has fallen below its April low. This is significant because as long as April was the cyclical low, it was plausible that the recession could possibly end by this winter. With the WLI searching for a new cyclical trough the recovery is pushed off until sometime next year. Thus, the fading hopes of a year-end recovery have evaporated, and the end of this recession is no longer in sight.

Having said this, we should consider the perspective offered by our post-war experience. The average U.S. recession is 10 months long and our worst recessions, in the mid 1970s and early 1980s, lasted 16 months long. If we take March of 2001 as the tentative start date of this recession, then history might suggest that it would end somewhere between January and July 2002. But, to have confidence in the ultimate timing of the recovery, we need to first see the WLI turn up in a convincing manner.

Lakshman Achuthan
Managing Director
Economic Cycle Research Institute (ECRI)

http://www.businesscycle.com

18 October 2001