A few years ago, gurus of the New Economy insisted that the business cycle was dead: Growth could go on forever. "The Long Boom," some called it. It didn't take long for the Nasdaq crash and the 2001 recession to puncture that claim. The New Economy acolytes were right that the pattern of growth is changing—but not as they thought. The current business cycle is notable for having the mildest recession and weakest expansion in modern times.
Normally, the higher the economy soars, the more sharply it falls when the time comes. This time, after growing for 10 uninterrupted years—the last five by more than 4 percent a year—the economy landed fairly gently with three quarters of mildly negative growth, in a year in which the economy still managed to grow 0.3 percent. The secret was that productivity continued to rise through this downturn. It usually doesn't.
The fall was soft, and so is the recovery. In a normal cycle, the first two years of recovery are banner times—rising employment and incomes release pent-up demand, which increases corporate revenues and revives investment. In the seven previous business cycles since 1950, the economy has grown, on average, by 5.6 percent in the first year of expansion and by 4.6 percent in the second. But it's not happening this time: Despite the biggest productivity gain in 50 years—4.6 percent—the economy grew just 2.4 percent in 2002, less than half the average for Year One. The outlook for this year, Year Two, is even worse. The International Monetary Fund's new forecast, for example, has the U.S. growing 2.3 percent this year, and that's probably too optimistic.
The White House knows that no president has been re-elected in the last half-century with less than 3 percent average annual growth in his first term. And a few weeks ago—after February data showed shrinking orders and shipments of manufactured goods, weakening wholesale trade, and flat consumption—advisers privately told President Bush that the economy could be falling off a cliff. So the administration has turned up the heat for more tax cuts: If growth is slow, the tax cuts can at least lift people's post-tax incomes next year. But with or without more tax cuts, don't bet on gross domestic product growing more than about 2 percent this year.
Brace as well for more unemployment, because that's what happens when fast-rising productivity collides with slow growth. Do the math: When workers are producing 4.6 percent more output per hour, and total output grows only 2.4 percent, workers have to be working fewer hours. That's why the number of unemployed is 410,000 higher today than when the recovery began 15 months ago.
Why the economy experiences regular cycles of expansion and contraction has fascinated economists for at least 150 years. A generation ago, business-cycle theory was one of the main struggles between monetarists and Keynesians (a struggle both sides lost). For much longer than that, the debate has pitted market enthusiasts, who see recessions as healthy responses to market changes that should be allowed to run their course, against market skeptics, who see recessions as evidence of market failures that government should address.
Today's market enthusiasts often favor what's called "real business cycle theory." This theory holds that the economy expands and contracts when random fluctuations in the pace of technological progress change relative prices, affecting people's incomes and tastes. In this view, Moore's Law cut the prices of a host of goods and services that depend on information technology, spurring an explosion of demand that defined the 1990s boom. It's a view consistent with the central insight of modern growth theory, that innovation drives underlying growth rates. But it goes a lot further, by casting slow growth or recessions as evidence of a temporary decline in an economy's capacity to innovate and take advantage of the results.
The key premise of the market enthusiasts is that business cycles result from natural market processes: Bad things happen to good economies. The key implication is that government shouldn't interfere.
On the other side are the "New Keynesians," who reject the idea of recession as an efficient market response to changes in technology and taste. They believe that recessions result from large-scale market failures. In a typical case, demand falters for some reason, and markets fail to adjust prices and wages to reflect the change. Such "sticky" prices and wages push up unemployment and push down investment, producing a recession, because real wages are too high for all workers to be profitably employed and firms can't find enough buyers for their products at the prevailing price. The answer to such market failures is not to step aside but to get involved, with government providing stimulus that enables firms to sell their goods and keep their workers employed.
Unfortunately, both the enthusiasts and the New Keynesians face serious empirical problems. On one hand, technological progress occurs much too gradually to account for business cycles, even long ones. On the other, "sticky" wages and prices are much less important than they used to be: Outside of the public sector, organized labor long ago lost its ability to keep wages high when demand falls, and intensified competition from imports, deregulation, and innovation deny most firms the ability to maintain prices when demand wanes.
If not technology shocks or market pricing failures, what's driving the current business cycle? It's not terrorism or war. Terrorism doesn't exact sufficiently large direct costs to drive the economy; and it's hard to argue that its psychological effects have slowed growth, when the economy turned around in the quarter immediately following 9/11 and turned in its best performance in years in the quarter after that. Nor is there hard evidence that the prospect or reality of the war with Iraq punctured business investment and consumer spending.
Whatever the theory, the factors producing today's slow growth are pretty clear. The great boom of the '90s drew on high levels of virtually everything that matters to growth —innovation, credit, consumer demand, business investment, and exports. Today, technological innovation is still cranking along; but nothing else has really recovered. With unemployment rising and consumers carrying record personal debt from the '90s buying binge, consumer confidence has disappeared. Foreign demand is no help either: Exports are down, because the rest of the world is in worse shape than we are. Despite low interest rates, credit is less available as well: With accounting scandals making lenders more skeptical, and government no longer adding to the capital pool with budget surpluses but subtracting from it with deficits, firms with less than AAA credit rating have trouble borrowing funds. To top it off, higher energy prices from lower production in Venezuela has chopped perhaps a half-point off growth.
And perhaps most important, business investment hasn't recovered. With one-fourth of industrial capacity still idle, no one is building new factories or offices, and purchases of industrial and transportation equipment remain flat or nearly so.
The current cycle can teach important lessons about how a modern economy behaves. For starters, recessions can be a lot shorter and milder than we've been used to, if productivity keeps growing. But there's a price: When a short, mild recession follows an extended, productivity-driven boom, there's not enough pent-up demand to drive a strong expansion. The recovery can be even weaker if business, mesmerized by the long expansion, miscalculated by expanding capacity too much, thus discouraging new investment. Another lesson of today's mild cycle is that we have less control over these events than we used to, because the rising share of output involved in trade leaves our growth more vulnerable to global economic conditions.
Don't blame the business-cycle theorists for missing so much. Economic change has been so rapid and far-reaching lately—deep deregulation in sector after sector, great shifts in tax and spending policies, enormous progress in opening foreign markets, the emergence of mature global capital markets, and successive waves of technological and organizational innovation—that no model can hope to take account of it. And if change continues at its recent pace, the next business cycle may well seem just as peculiar as this one does.