Where is the cloud in this silver lining?

THE SUNDAY TIMES

January 9, 2000

"What can possibly go wrong?", I was asked by an interviewer on one of those radio programmes aimed at a half-dozen or so insomniacs who hope that the nattering of an economist will produce much-needed sleep. After all, economic forecasters are agreed that the American economy will continue to grow in 2000, with the consensus forecast being that the growth rate will exceed three percent, with low inflation (around 2.5%) and continued low unemployment (4.1%).

Better still, Alan Greenspan, widely hailed for his sensible management of monetary policy, has been appointed to another four-year term as chairman of the Federal Reserve Board; productivity continues to surprise on the up side; consumers are in their most buoyant mood in decades; jobs are plentiful; inflation is low; venture capital is available in abundance to anyone with an idea and a garage in which to implement it; and all is calm, more or less, on the international front.

All of this good news proves that 2000 is likely to be a good year for Americans, perhaps a very good year. But it doesn't rule out the possibility that something might go terribly wrong. That was brought home to Americans with some force on the first trading day of the new year, when the markets dived as investors cashed in some of their paper profits, and began to wonder whether shares in Internet companies that manage to grow losses faster than sales might be a tad overpriced.

After all, if share prices move sharply downward, it is possible that consumers will pull in their horns. Those with shares will be poorer, and those who are mere observers of stock markets will feel less ebullient as television's 24-hour financial channels begin reporting the downward course of share prices. Perhaps. But perhaps not. After all, we have already seen the red-hot stock market dip by as much as 20%, without provoking consumers to zip their wallets.

But if a drop in share prices doesn't bring the current expansion to an end, might not the recent run-up in oil prices? Remember the 1970s, when a series of oil price shocks led to a long period of stagflation -- low growth with high inflation.

Although the more than doubling of oil prices will leave American consumers poorer by transferring billions of dollars from them to Arab oil sheiks and state-owned oil companies in Mexico and Venezuela, there are reasons to believe that the consequences of higher oil prices will be far less dramatic in 2000 than they were in the 1970s. For one thing, as analysts at Goldman Sachs point out, in the 1970s the trebling of the real price of oil coincided with a "productivity slowdown [that] exacerbated the oil shock. This time around, the productivity acceleration is partly offsetting the oil shock."

Then, too, as the service sector has grown relative to manufacturing, the importance of oil to the economy has fallen. One estimate has it that oil expenditures have fallen from 8.5% of GDP in 1981 to only 3% now. And, thanks to new technologies that facilitate fuel-switching by manufacturers, that figure can fall still further if oil prices continue to rise relative to those of natural gas.

Which leaves us with two things to worry about: policy errors, and what economists call exogenous shocks. The reappointment of Greenspan seems to have reduced fears that the Fed will raise interest rates so fast as to abort the current, record-long expansion, or fail to put on the brakes in time to avert overheating. By this reckoning, the Goldilocks economy should continue during 2000 and beyond. Well, maybe. But monetary policy isn't the only lever that must be pulled with just the right touch to keep the economy moving.

There is also fiscal policy to worry about. At the moment, the economy has remained inflation free in the face of consumer and capital spending booms in part because Greenspan has got monetary policy just right, but in part because the federal government is running a large budget surplus. But 2000 is a presidential election year. And all of the credible candidates are promising to loosen fiscal policy.

On the Democratic side, both Bill Bradley and vice president Al Gore have unveiled a steady stream of plans to spend the surplus. On the Republican side, both front-runner George W. Bush and his principal challenger, war hero John McCain, are promising large tax cuts that will encourage consumers to place even greater demands on an already-tightly stretched economy, and to buy more imported goods, swelling an already-record trade deficit even further.

In the face of a loosening of the federal purse strings, Greenspan would have no choice but to move interest rates sharply up -- not by the mere quarter-point that analysts now see as almost a certainty when the Fed's monetary policy gurus meet next month. Tight monetary policy and loose fiscal policy are not the combination best designed to keep the good times rolling.

Which brings us to exogenous shocks. When asked what he feared most, then-Prime Minister Harold Macmillan said, "Events, dear boy, events." What those might be no one can predict. But that they can turn an economy sour there is no doubt.

Franklin Roosevelt saw the recovery aborted when the Fed inexplicably tightened monetary policy in the mid-1930s (policy error), and did not bring down unemployment until another exogenous event -- World War II (event)-- provided a stimulus. Lyndon Johnson was doing fine until he found that he had to wage not only a war on poverty but a major war on communism in Vietnam (event), chose to do so without raising taxes (policy error), and unleashed inflationary forces. Jimmy Carter could not devise the right policy mix to cope with the oil price shocks (event) that the OPEC cartel threw at him.

Events and policy errors. That is what could go wrong in 2000.