Huynh 17

Trung Huynh

Prof. Whalen

Econ 128: Term Paper

03 Dec. 2004

Longest Economic Expansion

In the years between March 1991 and March 2001, the United States experienced

the longest economic expansion in history. With innovations in technology and

weakened trade barriers, the U.S. saw its economy grow by 4 ½ percent per year. The

unemployment rate fell to 4 percent, the lowest since 1969. 20 million additional jobs

were created since January 1993. Budget surpluses increased to $124 billion in

2000 and inflation decreased to the lowest since 1965. Strong corporate profits helped

boost the stock market to levels never seen before, creating substantial wealth for

Americans. The United States continued to have the highest income per capita and the fastest income growth. Overall, the prolific economy was a result of low inflation and unemployment, and high investment and productivity.

The economy in the early 90s started off slowly because of Iraq’s invasion of Kuwait and higher debt loads by households and businesses (Kelly). Although the federal funds rate was reduced to 3 percent in 1992 in an attempt to stimulate the economy, long-term rates remained high. Additionally, the national deficit was set to hit the $300 billion mark. To improve the economy, the new Clinton administration implemented fiscal and monetary policies. The 10-year treasury rate, for instance, was decreased from 7 percent in 1992 to 5.3 percent in 1993. As interest rates lowered, investments increased since financing became cheaper. As a result, companies began to invest in R&D paving the way for the technology boom that drastically altered the economic landscape.

There are many factors that led to the tremendous expansion in the latter part of the 1990s. Probably the most influential factor was the surge in information technology. Like the industrial revolution, the technology boom of the late 1990s transformed the way industries operated. New technologies in computer hardware, networking, and software made companies more efficient by improving the ways goods were produced and delivered. New production methods were implemented, inventory management was improved, supply-chain relationships were streamlined, and relationships with customers were enhanced. The improved efficiency in manufacturing and distribution resulted in improved efficiency, is reflected in productivity growth measurements. Productivity

grew at an average 4.2 percent per year between 1993 and 1999 (Economic report of

President 1999) compared to 1.4 percent for the previous 20 years in the business sector. The manufacturing sector experienced productivity growth of 9.3 percent (Roubini). Because of the increase in productivity, unit labor costs decreased to -0.3 percent in the 90s compared to 2.5 percent in the ‘80s.

As technology became more advanced, prices for technological related goods and services fell with respect to quality. For instance, computers today are far more advanced than ones from a few years ago, but their prices have remained the same. Consumers understood the relationship between quality and price; household ownership of computers increased from 15 percent to 35 percent between 1990 and 1997 (BLS). Additionally, companies invested heavily in equipment and software because of the low costs. Since the demand for technology related goods and services increased, a chain reaction throughout the whole economy commenced. Accounting for almost one-third of GDP between 1995 and 1999, information technology was clearly the leading factor in the economic expansion.

Since companies became more efficient and prices of technology related goods decreased because of technology advancements, the demand for new technology companies intensified. Venture capitalists and other investors expected the technology sector to remain lucrative for years to come and saw the opportunity to reap monetary rewards to fulfill the demand for technology. Therefore, they invested heavily into the information technology sector. In 1991, $3.4 billion in venture capital was invested. By 1996, $10.0 billion was invested (U.S. Small Business Administration). Investments grew 13 percent per year between the first quarter of 1993 and the third quarter of 2002 (Presidential report). With financial backing from investors, the number of information technology firms doubled between 1990 and 1997.

As the unemployment rate dropped to 4.0 percent and the stock market increased due to the expanding technology industry, enough wealth was generated to affect consumption noticeably. Accounting for almost 70 percent of GDP, consumer expenditures reached $5.2 trillion (1992 dollars) while inflation-adjusted GDP was only $2.3 trillion higher at $7.5 trillion. The 3.9 percent growth in the economy in 1998 was fueled mostly by consumer spending. Increases in consumption were driven by low inflation rates, increases in disposable income, decreases in the unemployment rate, the rise in the stock market, and expected future income. The CPI, a measurement of inflation averaged 2.9 percent in the 90s, compared to 5.1 percent in the 1980s, while the average unemployment rate was 5.8 percent for the same time period. Due to the technology bias, the CPI was actually lower than the measured average of 2.9. The average unemployment rate is arguably high by today’s standards, but is low compared to the average unemployment rate of 7.3 percent in the 1980s (Institute of Government and Public Affairs). Although a low unemployment rate could have pushed productivity down due to more unskilled people in the workforce, that was not the case in the ‘90s as seen with the increased productivity growth. Students were hired almost instantly upon graduation.

The increase in wealth had an adverse affect on the savings rate as would be expected. The stock market reacted favorably to the boom in investments. The NYSE Index grew by 9.5 percent in the 90s and the NASDAQ by 20.9% compared to 6.3 and 5.8 percent in the 80s, respectively (Institute of Government and Public Affarirs).

The stock market raised consumption by 1 1/3 percent per year from 1994 to early 2000. Although consumers spent only 3 ½ cents per year for every $1 earned in the stock market, the savings rate fell below 0 percent on many occasions while consumer debt increased to $1.3 trillion in 1998. Consumers purchased durable goods such as automobiles resulting in increases of 12 percent on big-ticket items (University of Alabama). Additionally, homeownership rates increased significantly in the 90’s reaching a historic high of 67.5 percent in 2001 (Housing America). The rise in consumption and homeownership was attributed to the increase in wealth, low interest rates, and reductions of the capital gains tax from 28% to 20% in 1997. Low interest rates made it cheaper for consumers to borrow money for homes and other goods. As mentioned, consumers dipped into their savings because they were confident that the economy would remain at its current level and that future income would be available. Those who owned stock felt wealthier. Therefore, consumption increased, which in turn stimulated firms to raise output, thus increased GDP and lowering unemployment.

Another reason for the strong economic growth during the 90s was the reduction in government spending resulting in a budget surplus of $236 billion or 2.4 of GDP in 2000 (Economic Report of the President 2000). Government expenditures and investments grew slower than GDP since the world was at relative peace. According to the House Policy Committee, annual military spending declined in actual dollars by $61.8 billion since the end of the Gulf War to the early part of 2001. The reduction in the capital gains tax in 1997 caused a 53 percent increase in capital gains revenue. The increase in revenue reduced the amount of borrowed funds and their associated interest payments. Therefore, interest rates on national debt decreased accordingly. 1999 was the first year since 1961 that the cost of interest declined; interest as a share of total expenses decreased by 6%, representing a savings of $10 billion. The reduction in government expenditures and increases in revenue resulted in the largest budget surplus ever in American History, $124 billion by 2001.

The Telecommunications Act of 1996 and Y2K spending further strengthened the economy. The telecommunications industry was deregulated in 1996 to benefit consumers with lower prices and better service through competition. Y2K-related investments played a role by increasing the growth rate of real equipment and software investment by more than 3 ½ percentage points per year in the late 90s (Economic Report of the President, 2004).

Exports were the fastest-growing segment of the economy from 1990 to 1997. Capital goods such as computers, machinery, and telecommunications equipment accounted for nearly 70 of the growth in exports and 30 percent of imports according to the Economic Report of the President. Despite the rise in exports, the rise in imports continued to result in a higher trade deficit as rapid growth in investment, income, and wealth caused higher demands for imported goods and services. The trade deficit was around $270 million in 2000.

The economy during the 1990s and early 2000 was the most robust the country has ever seen. A combination of monetary/fiscal policy and advancements in technology led to lower unemployment rates. Armed with first time income or raises in income, consumers increased expenditures resulting in more capital being put back into businesses. The cycle from increased consumer consumption to increased corporate profits continued throughout the 90s creating substantial wealth for many Americans. However, over speculation of the stock market and the changing global environment put a halt to the longest expansion in history.

The Last Recession (March 2001 to November 2001)

The National Bureau of Economic Research (NBER) declared March 2001 to be the beginning of the latest recession. After the longest expansion in history, the economy began to take a nose dive. There are several factors that contributed to the slowdown of the economy. First, the stock market began to weaken due to over speculation. Investors and households continued to have high expectations for the economy resulting in over-valued stocks in large amounts of debt. Corporate profits reached their peak in 2000 and began declining. The Manufacturing industry saw rates of return for the second quarter slip to 4.5 percent, the lowest since 1992, while the services sector dropped to an eight-year low of 12.4 percent (Tutur2u.com). The drops in rate of returns were attributed to a decline in business investment in equipment/software and exports. Equity in businesses fell from $17.5 trillion to under $13 trillion in the third quarter of 2001. The stock market reflected the decrease. The NASDAQ index fell 67 percent from its peak in March 2000.

Since stock prices fell due to decreases in corporate profits, household wealth was reduced. Consumption fell from $180 billion to $135 billion. Production decreased to match the fall in consumption. Industry capacity utilization, the ratio of actual production to capacity, sank to 75 percent by the end of 2001, compared to the long-term average of 82 percent (Lin and Schmidt). Since future income and wealth became unstable, consumer confidence fell dramatically. The Conference Board calculated the index at 85.5 in October 2001, the lowest since February 1994 (CNN).

Any change in a segment in the economy will directly affect the entire economy. The decrease in consumer confidence, stock market wealth, and production utilization, caused a rise in the unemployment rate. The unemployment increased from 4.2 percent in January 2001 to 5.4 percent in September 2001. 415,000 jobs were cut, the largest since May of 1980. Since consumption accounts for roughly two-thirds of GDP, the rise in the unemployment rate was a significant setback.

The September 11 terrorist attacks and the war on terrorism reinforced the recession. A drop in consumer confidence from 114.0 in August to 97.6 in September caused retail sales and orders for durable goods to drop by $17.6 billion; claims for unemployment insurance rose by 50,000 in September (Wesbury). Stock markets closed for 4 days. Major airlines were grounded and flights were cut by 30 percent when flights resumed. Hotels became vacant. Overall, 408 major layoffs were attributed to the attacks, with 70 percent of them coming from the air transportation and travel industries according to the BLS. Increased security at border crossings decreased the flow of goods into the U.S. by $9.2 billion in September.

The decline in the world economy also contributed to the recession in the U.S. and vice versa. The gross world product (GWP) of the world economy increased by only 1.3 percent, compared to 4 percent in 2000 (U.N. Economic and Social Council). In addition to a rise in oil prices, the world economy suffered from previous monetary tightening. As a result, U.S. exports decreased causing a ripple effect throughout all sectors of the U.S., especially in manufacturing as previously mentioned.

To counteract the declining economy, the Federal Reserve eased restrictions on the money supply by lowering the federal funds rate to 2 percent from 2.5 percent in November 2001, the tenth cut in the year (CNN Money). Normally, cuts in the funds rate would trigger a higher inflation rate. However, inflation hovered only around 2 ¾ percent in 2001. The President also signed the Economic Growth and Taxpayer Relief Reconciliation Act of 2001 (EGTRRA), which gave the typical family with two children $1,600 in tax relief (whitehouse.gov). The relaxed fiscal policies were instituted to induce spending on both the business and consumer sides.