Every time I hear a typical analysis of the U.S. economy in 2001, with its components of global recession, investment collapse, falling profits, record deterioration of household balance sheets, and the rising need for companies to lay off more workers, I wonder when the analysts are going to lower their U.S. growth forecasts for the second half of this year. Notwithstanding a positively awful set of economic conditions, most forecasts from investment firms call for a 1, 2, 3 scenario: 1 percent growth in the second quarter, 2 in the third, 3 in the fourth.

The “easy as 1, 2, 3” recovery outlook is beginning to look like a bad joke. It is based on the simplistic notion that 275 basis points of Federal Reserve easing since the start of this year, together with a combination tax cut–rebate that adds about $40 billion to household income in the third quarter, will boost spending enough to justify the 1, 2, 3 scenario. That reasoning is both unsound and disingenuous. No one really knows how much--if at all--these standard countercyclical measures will boost spending and over what time their effects will appear. The rapid Fed easing has done nothing to arrest the slowdown in investment spending, the most serious problem so far in this atypical U.S. economic slowdown. Rather, rate cuts appear to have helped sustain a high level of household spending on autos and housing, but one result of that sustained spending has been a sharply elevated level of household debt. Interest payments on consumer installment debt are soaking up 3.1 percent of disposable personal income, by far the highest level since 1968, when a continuous data series began. As a result, U.S. consumer installment debt is also at a record high, 22 percent of GDP, while total consumer and corporate debt has reached 135 percent of GDP. With debt-service burdens at record levels relative to incomes, will U.S. households keep spending and running up more debts just because the Fed has pushed short-term interest rates down to “neutral”--that is, neither stimulative nor contractionar--levels and a check for somewhere between $300 and $600 arrives from the Treasury this summer?

Analyzing the Numbers

Much of what we know about economic behavior by households and firms makes me doubt that consumer spending will rise by much more than the 2 or 3 percent annual rate we have seen so far this year and, indeed, leads me to suspect that consumer spending growth may actually turn negative. Investment spending and net exports are still falling rapidly and subtracting 1 or 2 percentage points from GDP growth. Even if 3 percent consumption growth adds 2 percentage points to GDP growth (a generous assumption), the net growth outlook is zero to 1 percent, not the 3 percent blithely assumed to appear in the rosy “1, 2, 3” scenario.

Government spending may contribute something to growth, although the average for this expansion is just 0.2 percentage points, not enough to offset falling contributions from investment and net exports. All-important consumption spending growth is highly vulnerable to the 10 percent reduction in household net worth over the past year and to the rapid loss of confidence that will occur if the rising level of layoffs continues. The rising tide of profit disappointments makes a continued rise in layoffs seem likely.

Economists, who are expected to offer their best estimates of the outlook for growth, had better start to think hard about the throwaway line that the second half will look better because of Fed rate cuts and tax cuts. The second half is already here, and with it has come little sign of the widely touted recovery. If anything, the growth outlook is deteriorating, as indicated by the latest report on employment. Average monthly employment growth for the three months ending in June was negative 90,000, placing June 2001 payrolls just 0.3 percent above June 2002 payrolls, a typical level in the early stages of most postwar recessions. In comparison, average monthly payroll growth over the past five years was 215,000, and even during the slowing growth of last year it averaged 167,000 per month.

Total hours worked actually fell 0.2 percent in June--both during the month and year-over-year--indicating that even as firms laid off workers, they cut the hours worked by those they still employed. This adjustment was underway throughout the second quarter; total hours worked fell at a 1.5 percent annual rate during the three months ending in June, a clear indication that output fell at about the same rate.

It is also important to remember during economic slowdowns that the Labor Department is slow to adjust its “plug factor,” which assumes autonomous job growth through new business formations not captured by initial sampling of the labor force. In June, the Bureau of Labor Statistics assumed that 155,000 jobs were created but not counted, meaning that the actual job loss was 155,000 larger than the 114,000 job loss reported, or 269,000. Often, ex post revisions of the plug factor reveal that the economy was in recession earlier than the numbers initially indicated. This was true of the 1990 recession, and it delayed Fed easing that might have avoided that slowdown.

A second-half recovery would require that firms, having accelerated layoffs during the second quarter in the face of falling profits, will, with unit labor costs rising at more than 6 percent, decide suddenly to start rehiring in the next few months. That is extremely unlikely to happen. Managers knew about the Fed rate cuts and the tax cuts when they accelerated layoffs during the second quarter, but they also knew how awful their profits were going to look as negative second-quarter earnings “surprises” cascaded into markets in June and early July. Meanwhile, job seekers are giving up on finding jobs, as shown by a shrinkage of the U.S. labor force by over 1.1 million below its trend level between January and May. Had the labor force grown normally this year, the unemployment rate would have climbed above 5 percent by now--well above the 4.5 percent rate reported for June.

Not Out of the Woods Yet

Analysts who are optimistic about the economic outlook because the unemployment rate has not risen as fast as it usually does in a recession are basing their hopes on the shaky notion that shrinkage of the labor force portends higher growth. It does not, and the fact that the labor market is even weaker than it looks is another negative insofar as the low unemployment number is contributing to the perception, inside and outside the Federal Reserve, that the Fed has already eased enough to avoid a recession.

It is far more likely that the Fed will need to push the federal funds rate down to 2.5 percent (a drop of another 125 basis points) or lower by year-end as the second-half recovery fails to appear. The need for further rate cuts will be underscored--and expedited--by continued weakness in commodity prices, falling employment and consumption, and attendant accelerating downturns in emerging markets.

It is time for economists to quit touting a second-half recovery. Otherwise they will look as foolish as the equity (sales) “analysts” who, every week, have revised downward their earnings forecasts by 2 percent or more as negative “surprises” about prospective profits have flowed in. The sooner analysts acknowledge that the U.S. and global economic slowdowns are intensifying—not abating—the sooner policymakers, households, and corporations can undertake necessary, realistic adjustments and the sooner the recession will be over. Meanwhile, an unbecoming chorus of denial is only making a bad situation worse.

John H. Makin is a resident scholar at AEI.