A combination of weak growth indicators and tightening financial conditions has increased the risk that economic growth will slow too rapidly during the coming year, preventing the highly anticipated soft landing. How likely is this and what impact for San Diego?

Nationally, growth in Gross Domestic Product appears to have slowed during the second half of 2000 to a level about one-half the blistering pace set during the first half of the year. GDP growth appears to have dropped below 3 percent during the third and fourth quarters of last year. We assume that this is at the borderline of what is acceptable to the Federal Reserve. Or barely acceptable. After all the Fed funds rate remained unchanged at 6.5 percent until early this year.

Slower Growth — Yes
An overwhelming amount of data supports a slowing national economy, which the Fed now is trying to speed. Examples include high oil prices, sagging employment growth and retail sales, higher unemployment insurance claims, declining stock market and home sales through year-end 2000, the rising trade-weighted value of our dollar, tightening credit markets, including the federal funds rate over the past year, and slipping consumer confidence. Locally, we are impacted by many of the same trends, and a few more, such as exceptionally high and rising energy, fuel and housing prices.

Recession — No
In addition to the trends listed above, those betting on a recession most often point to the deterioration of earnings estimates for the many tech companies as the final poke that pushes the economy over the edge and into recession this year. After all, many feel the economy has been led by growth in tech and telecom for the past five years, so the downturn would likely come from the same two sectors. We see weakness here, but disagree that it is suggestive of an imminent recession. Not even close.

Our Competitive Edge — Diversity
In the San Diego region, 16 diverse employment clusters serve as the engines of the local economy. Employment clusters are groups of interrelated sectors that drive wealth creation in a region, primarily through the export of goods and services.

Of course all employment categories contribute to the region’s output of goods and services. However, it is important to distinguish between those sectors that primarily serve the local economy and those that sell their products and services nationally or internationally. Employment clusters that compete nationally and internationally have a far greater potential for growth. Opportunities for growth in these clusters are not constrained by the size of the local market, and can expand far beyond it.

At the forefront of San Diego’s transition into a modern, export-driven economy are our tech and telecom employment clusters. Since 1995, San Diego’s regional economy has grown consistently and impressively. Over the past five years total employment has grown 22 percent — much better than the first half of the decade, when employment declined by about the same amount. Leading the way for the employment growth during the past five years has been a 37 percent rise in jobs within San Diego’s 16 employment clusters. And within these clusters, tech and telecom jobs rose by 40 percent. So, weakness in the tech and telecom sectors also could represent early warning signs of trouble for the local economy.

Yet, one of the key elements of a strong, stable, regional economy like San Diego’s is a diverse employment base. As we bet against a recession, our aces in the hole are our vibrant visitor industry and stabilizing military presence and defense contracts. Together, these two sectors provide San Diego with a benefit few other regional economies have, stability and strength. Economic downturns would be significantly worse without these clusters. So, as the table below shows, we are forecasting slower employment growth during the coming year than the average growth over the past five years.

Takes A Lickin’ But Keeps On Tickin’
The national and local economies seem to be weathering the storm of higher energy prices. Historically, energy and oil shocks have crushed the national, even global economies. Generally, higher inflation and recession followed oil price increases in 1973, 1979 and 1990. So, should we be worried about the recent doubling in the price of oil or the energy shortage in San Diego specifically and the state generally?

The current run-up in prices is not all that different from prior shocks. Currently prices are about 200 percent higher than they were at their trough in early 1999; that is only a little less dramatic than the 300 percent jump in 1973, and only somewhat more than the 150 percent jump in 1979 and the 100 percent gain in 1990.

The discrepancy between the expected impacts from higher energy prices then and now is due to a number of facts:

• Rising productivity has increased our capacity to withstand price shocks.
• A smaller portion of our income is spent on energy today.
• Inflation was much higher during prior oil shocks.
• Panic behavior set in during past price rises, as analysts predicted ever rising oil prices in the future.

These discrepancies have kept today’s higher energy prices from leaking into the core rate of inflation, which would have collateral consequences such as lower consumer confidence, and a rising federal funds rate.

One similar problem we in San Diego can appreciate firsthand is a series of policy blunders that occurred then and now in the regulation of the energy market leading to severe shortages of supply in some regions.

The Perfect Storm
Today, the local and national economies are in much better shape than in any of these earlier periods. Productivity growth is strong, inflation and unemployment are low, consumer confidence and business investments are high. So, what would it take to push the national and local economy into recession? A replay of the disasters of the past will require at least one of the following collateral shocks: 1) a pickup in core inflation and the resulting Fed tightening, 2) a collapse in consumer confidence, or 3) additional policy blunders by the government.

Upside Down? Or Right Side Up?
Another indicator of recession is an inverted yield curve, which is when interest rates for short-term investments are higher than interest rates on long-term investments. This inversion reflects less confidence in the economy in the near term and greater confidence in the long term. Much has been said about the slight inversion of the yield curve on Treasury notes. Indeed, such an indicator is one of 10 components of the index of leading economic indicators published by the Conference Board. In this setting, an inverted yield curve would indicate an economic downturn and possibly a recession.

The problem is that the only curve that is inverted is the Treasury curve; the yield curve for corporate notes continues to be positively sloped. If the corporate yield curve were to become inverted we would be far more worried about the possibility of a recession this year. The shape of the Treasury yield curve (downward sloping) and the corporate yield curve (upward sloping) also result in a widening gap.

It is worth noting that the federal budget surplus may be playing a role in the discrepancy between corporate and Treasury yield curves. The widening spread reflects the pay down of outstanding Treasury debt. To date, that pay down has been greatest in the long end, hence the disproportionate drop in long-term Treasury interest rates and the corresponding inverted yield curve. Thus, our view of the inverted yield curve is the consequence of the budget surplus and not an indicator of substantially weaker growth this year.

Fuzzy Math
While we’re on the subject of the budget surplus, the biggest “head fake” of this past campaign season has been the growing concern that the budget surpluses are already disappearing. Despite the nervous talk, we believe that skeptics are not doing their math right. On the revenue side, skeptics note that the surge in revenues is due to a surge in capital gains and that with the stock market leveling off, this “revenue windfall” is ending. On the outlay side, skeptics argue that the discipline of the 1990s is falling apart. And there certainly is a lot of pork barrel spending going on in Washington, with discretionary spending exceeding self-imposed caps by triple the overspend of 1999. This rise in spending will stop the growth in the surplus, but it will not reverse the surplus. In 1999, a $28 billion violation of the cap did not prevent a $113 billion increase in the budget surplus.

More importantly, on the revenue side, much of the surplus comes not from capital gains, but from two relatively permanent factors: a strong economy has pushed taxpayers into higher tax brackets and income has grown rapidly for people with high marginal tax rates (more new rich people and the rich getting richer).

New Paradigm Revisited
Problems in the financial markets have pushed the discussion of the benefits of productivity growth to the sidelines. Recent productivity growth has been impressive. From less than 1 percent growth in the mid-1990s, productivity has accelerated to nearly 5 percent. Moreover, such acceleration is usually seen at the beginning of a business cycle expansion, not nine years into one. The critical issue here is for the Federal Reserve to arrive at an estimate of trend productivity, which drives estimates of the economy’s long-run potential. Some argue that the surge in productivity is cyclical and will end with the business cycle. We believe that productivity growth can be shifted to a permanently higher trajectory by applying more capital to a fixed amount of labor, often referred to as capital deepening, or improving the quality of capital and/or labor, or improving technology.

As a rough rule of thumb, every 1-percentage point increase in the growth of the capital stock adds about 0.3 percentage point to labor productivity growth. Since 1992, the acceleration in capital stock growth accounted for about a percentage point of higher trend productivity growth. The key to continued capital deepening depends on the pace of investment spending. If spending on new computers and new machinery slows, for example, the beneficial impact on labor productivity could dry up pretty quickly. This could come about if the recent stock market turmoil prevents firms from accessing capital markets necessary to finance their investment schedule.

At times like these, we believe it is important to keep in mind that it is the level of investment that determines the growth in the capital stock, so a slowing in the growth of investment will not stop the strong growth in capital and resulting productivity.

Marney Cox is the chief economist and director of regional economic planning and research for the San Diego Association of Governments.