The Federal Reserve’s 50-basis-point rate cut yesterday came in response to a flurry of extremely negative economic reports and increasingly widespread pessimism about the economy. As the federal funds rate nears zero, many observers believe that there is little room for further significant interest rate reductions. With the economy still declining and the Fed out of ammunition, additional government stimulus must now be of the fiscal variety.

Corporate tax cuts are a natural fiscal stimulus candidate. The corporate sector has dropped the sharpest this year, and business investment has historically responded impressively to tax cuts. Yet Senate Democrats have staunchly opposed Republican efforts to provide corporate tax relief. “I’m not even enamored any longer with the word stimulus,” said Senate Majority Leader Tom Daschle last week, preferring instead to launch a giant government spending spree. Such measures reflect the emerging Democratic view that the “Bush economy” is nearing depression, and only a new New Deal can save it.

Positive News

But if you look closely, things aren’t that bad. Marginal tax-rate cuts might well have difficulty stimulating business activity if there is significant excess capacity. But the data don’t support such a negative view. Indeed, despite rumors to the contrary, the economy was most likely not in a recession on Sept. 10. The monetary and fiscal stimulus adopted earlier in the year appears to have done its job quite well.

That positive news emerged last week when the Commerce Department reported that the gross domestic product declined 0.4% in the third quarter. Negative GDP growth is a strong sign of a recession, but analysis of the background data suggests that the number would have been comfortably positive absent the attack. First, before the attack, chain-store sales indicated that consumer spending in September was at about the same healthy level posted in August. Second, border closings created turmoil in the auto sector, where just-in-time inventory techniques led to significant production interruptions.

It is a simple adding-up exercise to correct for these two factors, and doing so leads to a surprising conclusion. If September consumption had continued at the pace registered at the start of the month and auto production had not jammed up, the economy would have dodged recession in the third quarter. GDP would have been more than a percentage point higher--safely nestled in positive territory.

Although that did not happen, it does put to rest the view that the terrorist attacks pushed an already devastated Bush economy into a steep downward spiral. The economy was doing better than expected, and this was likely because of well-timed economic policy. Consumer spending has been particularly strong in interest-sensitive sectors.

Another bit of positive news lurking in the third-quarter data confirms the view that business tax cuts in particular could be effective now. The government data available do not explicitly report third-quarter productivity, but it is possible to figure this out by using techniques that are also relied upon by Fed economists (and undoubtedly reported to board members yesterday).

These calculations are striking. Even with the sharp declines in output that occurred at the end of the third quarter, productivity increased by more than two percentage points. As economic data watching goes, that remarkable observation is as good as it gets.

Historically, productivity has almost always declined sharply just before a recession and softened further during a recession. This “procyclical productivity” pattern is so reliable that an entire literature exists exploring its cause. The current consensus appears to be that productivity drops near recessions because firms are reluctant to lay off idle workers when demand shrinks, and the proportion of workers that are not productive increases sharply. Perhaps that describes the past, but it has not happened this time. High-tech investments have allowed firms to adjust on the fly and continue to squeeze more output out of fewer inputs.

In February, Fed Chairman Alan Greenspan marveled at the strong productivity numbers posted in late 2000 when the economy was softening. The increase was, he remarked in a Senate Banking Committee hearing, “at a pace sufficiently impressive to provide strong support for the view that the rate of growth of structural productivity remains well above its pace of a decade ago.” It’s important to note that this high rate of productivity has continued over the past few quarters, even as the economy has softened.

Why is this so important? If productivity were declining, then firms would be faced with many more painful decisions in coming months. Capital investments that were intended to improve the bottom line would have failed. Should plants then be closed? As it is, it looks like the inventory and investment corrections that occurred in the 12 months before Sept. 11 had achieved their desired effects. The “overhangs” that presage sharp economic disruptions were not apparent in the data, and a healthy response to marginal tax-rate reductions is quite plausible.

But, of course, other factors are present. And they help to explain why, despite the good news, economic activity has dropped so sharply.

After years of highly mathematical research in dusty journals, many economists now believe that the root cause lies in the distinction between risk and ambiguity that was first described by University of Chicago economist Frank Knight in the 1920s. Knight argued that there is a difference between a circumstance with known probabilities--like a coin flip--and a situation with high ambiguity, where the probabilities of different outcomes are not known. Subsequently, researchers have confirmed Knight’s observation both in theory and with observation.

There are profound differences in behavior when people face the two different types of uncertainty. Most important, when ambiguity is high, consumers and firms often act as if the worst possible outcome will occur for sure. Thus, after the terrorists attacked, we entered an ambiguous world with many horrible possibilities and no probabilities. Predictably, businesses and consumers assumed that a deep recession would occur with certainty. Their extremely cautious response to the assumption helped make the recession more likely.

Core Fundamentals

So the core fundamentals of the economy remain surprisingly strong. If there is a recession, it will have been caused by the terrorist attacks. Therein lies both the hope and the challenge to policy makers. Absent a rapid and clearly visible victory in the war on terrorism, consumers and firms will only gradually return to normal, and a long and deep recession is possible. Yet the underlying strengths suggest that there is ample opportunity, and that corporate tax cuts could ignite further productivity enhancing investments. The stimulus bill that passed the House took a step in that direction. It’s time that the Senate stop bickering and do the House one better.  

Kevin A. Hassett is a resident scholar at AEI.