What Could Go Right? It's scary. It's a downer. But the slowdown won't last forever. In fact, it may even be ending now.
By Justin Fox

(FORTUNE Magazine) – The U.S. economy has ground to a halt. That's certainly not news to anyone at this point. What you and the rest of the world are dying to know is just when America--that powerful, high-tech, and usually reliable engine of global growth--will get moving again.

We won't bury the lead: The answer is soon. In fact, the recovery may have started already.

Yeah, yeah, yeah, there are risks and there are uncertainties. The course the economy takes tomorrow depends on choices made today by executives drawing up sales forecasts, investors sorting out portfolios, shoppers rolling carts through the Home Depot. Sudden shifts in business and consumer confidence can wreak havoc with the best-laid economic forecasts.

In other words, a lot can go wrong, especially in a land of heavily indebted consumers, high trade deficits, and a recently collapsed stock market. But the case for what could go right is simply more compelling.

This is partly just a matter of looking at the economic data. To most of us (and that would include most people on Wall Street), the main impression left over from the recent barrage of often contradictory numbers on things like retail sales, inventories, and consumer confidence is one of utter confusion. But to a veteran data-watcher like Mark Zandi at Economy.com, there is a pattern to be discerned--and a fairly encouraging one at that. December may have been a month of contraction, but the economy seems to have grown in January, while the early weeks of February were mixed. Says Zandi: "The economy is struggling, even sputtering, but it's still probably growing."

Another, slightly better known data-watcher, Federal Reserve Chairman Alan Greenspan, gave a similar assessment to Congress in mid-February. While Greenspan's abilities as an economic seer are at times overhyped, he does have one big advantage over everyone else in the forecast business: He actually has the power to make his forecasts come true. The Fed's sudden, sharp rate cuts in January flooded the U.S. economy with money. You can count on your fellow Americans to find ways to spend it. That alone is reason to believe in a comeback.

Finally, there's this: Because the U.S. economy is so big and complicated and so danged hard to grasp, those who attempt to forecast its course often rely on historical parallels to tell their story. While it's easy to find examples of truly frightening past recessions and depressions, it's very hard to find any scary historical parallels that really fit the situation of the U.S. in 2001. That doesn't mean that something bad can't happen this time around; it just means that glib references to Japan in 1989 or the U.S. in 1929 don't really tell us much of anything--especially since the reality of U.S. economic history is that, most of the time, everything has worked out okay.

It all adds up to a cautiously optimistic scenario for the coming months. Maybe an itty-bitty recession, but probably not. Definitely a recovery sooner rather than later.

This sort of sanguinity isn't exactly fashionable just now. Remember how boosters of the 1990s new-economy boom refused to see it as anything but an epochal, paradigm-shifting, rule-breaking golden age? Well, many observers of the 2001 new-economy bust can't seem to accept that we're simply watching the good old business cycle at work. Instead, it's the end of an era, retribution for times of excess, the beginning of the new Dark Ages.

Actually, that kind of rhetoric has been mostly restricted to journalists and other amateurs; few professional economy-watchers are willing to employ quite such purple prose. Instead--and this says something about the enduringly primitive state of business-cycle economics--most of the talk in forecasting circles is about letters: specifically, L's and V's and U's and W's.

An "L" is the scariest scenario, one in which the U.S. economy spends the next few years in a post-boom hangover with little or no economic growth. Sort of like Japan in the 1990s, except that even the grimmest of pessimists don't see the U.S. economy still stuck in a malaise ten years from now. A "V" is the cheeriest scenario, in which growth restarts almost immediately--possibly even averting an official recession, which requires six straight months of economic contraction. A "U" anticipates an ugly recession and a slower comeback. As for the "W," it's good news if you think we're in the second half of the letter (with the first half being the 1998 global financial crisis and subsequent Fed- stimulated comeback) but bad news if you think we're in the first (with the second being the recession brought on by the Federal Reserve when its current easing leads to raging inflation).

Among economic forecasters, the consensus is that we're looking at a "V." That doesn't mean a whole lot, because forecasters tend to have trouble nailing down economic turning points. But a quick look at recent U.S. economic history seems to support the "V" hypothesis. The only prolonged or repeated recessions in the post-World War II era have come in times of sustained high inflation, when the Federal Reserve raised interest rates and kept them up in an attempt to wring that inflation out of the economy. The hints of inflation that the Fed decided to fight last year were mere wisps compared with the inflation of the 1970s and early 1980s; and the Fed's 1999 and 2000 rate hikes were playful pinches compared with the forceful tightenings of earlier days.

That doesn't mean there are no longer any risks. The standard economic problems of the post-war period involved overly expansionist central banks, deficit-racked governments, and an overregulated private sector. And guess what? Those problems have largely been solved. As a result, we'll probably have new problems to deal with. Or very old problems. One way to look at it, as Princeton University economist Paul Krugman put it two years ago in the pages of Foreign Affairs, is as the "Return of Depression Economics."

Krugman's main concern is this: In an era of low inflation, free trade, and deregulated financial markets, a central bank like the Fed might no longer find it so simple to kick-start an economy that has fallen into recession. He isn't the only smart economist talking this talk. In January, former Treasury Secretary (and former Harvard economics professor) Larry Summers scared a few folks at the World Economic Forum in Davos, Switzerland, with his observations that the current U.S. downturn reminded him a lot more of the prewar variety than anything seen since.

If this analysis is correct, it may mean the Fed and other central banks need to shift their focus from inflation fighting to recession fighting. To a certain extent, that appears to be what the Fed under Greenspan has done during the past three or four years. This is less straightforward work than merely hiking rates to keep the consumer price index down, and surely the Fed will make a hash of it one of these days. But to go from there to arguing that the Great Depression or even the Japanese "L" is upon us--something neither Krugman nor Summers has done, but several bearish Wall Street forecasters have--is a misreading of both past and present.

It's a misreading because virtually every U.S. economic downturn before World War II was brought on by some sort of financial breakdown. Not just a stock market crash but a credit crunch in which perfectly solvent businesses and individuals suddenly became insolvent because no one would lend them money anymore. That's what happened in the Great Depression of the 1930s, it's what happened to several Southeast Asian and East Asian economies in 1997, and it's sort of what happened to Japan in the 1990s (the difference being that Japan averted an all-out financial collapse but is nonetheless plagued by banks that won't lend and consumers who won't spend).

That's not going to happen in the U.S. of 2001. It's not just that the Federal Reserve and the federal government have the resources at their disposal to stave off a full-blown financial crisis and know how to use them. It's also that there isn't any sort of financial breakdown under way from which we must be rescued.

The closest thing to a breakdown was what happened to the market for high-yield, high-risk corporate bonds (a.k.a. junk) in December. After a difficult autumn, the market for new issues effectively shut down for the month, the longest drought experienced since 1990, when it shut down for an entire year. If this market freeze-up had lasted much longer, a lot of established but cash-eating cable operators and telecom companies would have been in big trouble. But then the Fed lowered interest rates Jan. 3, and the market came roaring back. In the entire fourth quarter of 2000, corporations sold $4.4 billion in new high-yield debt in the U.S., according to Merrill Lynch. In the third week of January, issuance totaled $5.1 billion; in the fourth week, $5.2 billion. Things have slowed down since, and high-risk startups of the sort that were harvesting money by the bucketload a year ago still can't raise a cent, according to Martin Fridson, chief high-yield strategist at Merrill. But a junk market meltdown clearly has been averted.

As for other debt markets, they're functioning just fine, thank you. The mortgage market is booming, mostly due to refinancings prompted by sinking interest rates. Consumer credit growth has slowed but not stopped. Banks are seeing profits fall, but those profits have been so high for so long that few are in any kind of financial trouble.

So if there's no financial crisis, what exactly has been making the economy so wobbly? Paradoxically, it may have something to do with the very high-tech boom that drove the prosperity of the 1990s. For one thing, emerging technology businesses are by nature volatile: New technologies wipe out old ones; too many companies jump into promising new fields; investors get overexcited and bid up stock prices too high. That has been the case with the semiconductor, software, and PC industries since their inceptions--it's just that in the past their share of economic activity was so tiny that their occasional wipeouts didn't much matter to anybody else. Now they do.

The sheer screeching rapidity of the slowdown (from 5.6% GDP growth in the second quarter of 2000 to 1.4% in the fourth) can also be traced in part to the products that tech companies have been selling to the rest of corporate America. Thanks to their massive investments in ERP (enterprise resource planning), CRM (customer-relationship management), and SCM (supply-chain management) software, and other groovy technological tools with impenetrable acronyms, American companies were able to sense the slowdown and react to it much more quickly than they could have in the past. The problem is that when thousands of companies adjust their expectations downward all at once, the cumulative effect is even worse than what any of their snazzy new technological tools could have predicted, resulting in lots of companies getting stuck with excess inventories precisely because lots of companies were trying to avoid getting stuck with excess inventories. (For more on this, see "Glut Check" in First.) When businesses get stuck with excess inventories, they tend to cut back on production until those inventories go away, which is one of the reasons recessions happen.

Greenspan talked about this in his February testimony to Congress, suggesting that while these new rapid-response techniques have helped bring on the slowdown, they may also lead the way out. And sure enough, the next day new data came out showing that business inventories had virtually stopped growing in December--a sign that the worst of the inventory correction could be behind us.

All of which may well mean that the most important question of the moment may not be whether there will be a recovery soon, but how strong it will be. The answer to that will also decide one of the great debates of the 1990s: Are American businesses, and American workers, really using new information technologies to become significantly more productive? If productivity is on a long-term upswing, then there's room for lots more economic growth and lots more profit growth at American corporations. If, however, the strong productivity gains of the past few years have mostly been the result of cyclical factors and data quirks, we could be looking at a return to the days of 2% GDP growth and tough times for corporate profits.

The debate among economists over productivity has been so drawn out and complicated that it's really not worth getting into here. The Fed's Greenspan is among those who argue that something real is afoot, and he's been winning converts in recent years. If the productivity gains survive this year's downturn, he'll win over a lot more--and the U.S. economy won't have to worry about any U's, W's, or L's.

FEEDBACK: jfox@fortunemail.com