(FORTUNE Magazine) – In Greek mythology, Hydra was a many-headed monster, devilishly difficult to kill. Cut off one head, and two grew in its place. Lately the U.S. economy has seemed a bit like Hydra. Consumers are one part of the two-headed economy, and they have been spending freely. Companies, which fill the second head, are laying off workers and slashing budgets of everything from technology to travel. It's almost as if they are flashing back to the recessionary early '90s, while consumers are still living in the go-go late '90s. This can't last, so here's the question: Will consumers spend enough to keep the economy out of recession? Or will companies choke off consumer spending with further layoffs?

Smart economists disagree about which head will prevail. "We'll make our way through this period," says Mark Zandi, chief economist of Economy.com. "The Fed is being aggressive, and tax cuts are on the way. But," he adds, "we still need a good bit of luck. We can't have a spike in gas prices or something like that, which could undo us and send us into recession." David Levy, chief forecaster at the Levy Institute, believes, "We're already in the early part of a recession. There's a broad contraction in the business sector, and we're seeing signs that the consumer is now retreating. The process has begun, and it will take a lot of work by the Fed to stop it."

There is plenty of evidence to support Levy's pessimism. Sales of cars and trucks, a leading indicator of consumer sentiment, fell in April for the second month. Energy prices have been rising. Despite an uptick in early May, consumer confidence remains low and fragile. Layoffs have pushed the unemployment rate from 4.3% to 4.5%.

On the other hand, there are powerful reasons for optimism. Technology executives, whose hubris once rivaled that of the Greek gods, now realize their stocks cannot permanently defy either gravity or the business cycle; they are in the midst of writing off inventory, reducing capital expenditures, and cutting labor costs. Although unemployment is rising, the labor market is still one of the strongest in 30 years. Inflation is low. Finally, since early January the Federal Reserve Bank has lowered short-term interest rates from 6.5% to 4.5%, its most aggressive use of monetary policy since the late 1970s, when Fed Chairman Paul Volcker squeezed inflation out of the economy by raising interest rates even more rapidly than Alan Greenspan is reducing them now.

Greenspan has all but promised to keep cutting rates until the economy gets the boost it needs. But it often takes six to nine months for interest-rate changes to work their way through the economy, a lag that could be longer than usual this time because of all the negative forces from the popping tech bubble. The collapse of the Nasdaq created a credit crunch in financial markets and among venture capital investors at the same time that banks were beginning to tighten credit. "Lenders turned cautious, and suddenly there was just no money available," says Zandi. Business spending that had once helped drive the economy dried up and began dragging it down. Since the mid-1990s, for example, technology spending has added 1% a year, on average, to GDP growth; today tech spending is contracting at an annual rate of 6%.

It's true that the economy grew at a 2% annual rate during the first quarter of 2001, much faster than most forecasters had predicted. (Bush Administration officials caution that the number will almost certainly be revised down in coming weeks.) That's because consumer spending, which accounts for two-thirds of GDP, grew at an annual pace of 3% in the first quarter--down from 6% a year ago but still healthy. If consumer spending continues at that rate, it would be enough to prevent a recession; economists were encouraged that retail sales rose 0.8% in April, the first monthly increase since January. But if layoffs emanating from technology companies spread to other industries, consumers will pull back, and the economy will surely crumble.

Whether consumer spending can hold up during what amounts to a recession in the technology sector "comes down to three things," says Bruce Steinberg, chief economist at Merrill Lynch. "Jobs, jobs, and jobs." Steinberg is correct that jobs are key; it's hard to spend a lot if you've been laid off. But the direction of mortgage rates and changes in real wages affect consumer spending almost as much as employment levels.

The most recent data suggest that all three have deteriorated. In April the number of jobs dropped by 223,000, the largest one-month decline since early 1991, when the last recession was well under way. Although salaries have been rising, a softer job market will put wages under pressure, as will declining corporate profits. And while mortgage rates began dropping last fall in anticipation of the Fed's rate cuts, they have recently been edging up, and the refinancing boom has slowed. All of this may have contributed to the weaker car and truck sales in April, which fell by 7%; ominously, each of the Big Three U.S. automakers had double-digit declines.

Such trends worry traditional manufacturers, which have spent the past nine months working off their inventories. Recent numbers indicate that they have mostly finished that job. Instead of continuing to accumulate, inventories are now being liquidated; they rose by $56 billion in the fourth quarter of 2000 but dropped by $7 billion in the first quarter of 2001.

The technology sector, convinced it was immune to fluctuations in the economy, remained in denial until early this year. But then Cisco announced that it would write off $2.2 billion of inventory; similar adjustments are taking place at other networking companies like RedBack and Extreme. The risk now is that contractions at technology firms will lead companies in related industries, such as financial services, to pull back as well, causing widespread job losses and creating a second wave of problems at traditional manufacturing industries.

Enter the Fed, with its interest-rate medicine. Falling interest rates work on the economy in a number of ways. Consumers almost immediately see lower rates on credit card debt. That can have an outsized effect when debt levels are high, as they are now. Between 1990 and 1999, according to CardWeb.com, average credit card debt per household rose from $2,985 to $7,564. Steinberg of Merrill Lynch calculates that U.S. households will save $50 billion in debt repayment this year as a result of lower interest rates.

For businesses, falling rates usually encourage capital investment by reducing the cost of borrowing money. The Fed's cuts have lowered the costs of short-term capital by about 30% so far this year. But the benefits of lower interest rates may take longer to yield results for companies than for consumers. Some economists believe that technology companies, in particular, are reluctant to make new investments now, less because they can't afford to than because they overspent during the past two years. The binge theory of capital investing goes like this: Companies overindulged in unproductive investments; now they've realized the excesses of their ways and are slashing spending. If that's the case, lower interest rates won't encourage investment until the excess capacity is worked off. Robert Barbera, chief economist at Hoenig, an institutional brokerage firm, says this could take as long as a year or two for some companies. "During that time, industries producing capital goods will find business disappointing," he adds.

Other economists say even companies that want to make further investments will be impeded by tight credit. The credit- crunch theory of capital investing goes like this: Banks and venture capital firms, spooked by the Nasdaq's collapse and the broader slowdown, won't extend credit until the outlook for the economy becomes more clear. "If lenders don't feel confident about the economy, then no amount of interest-rate cuts will help," says Levy. He says that was precisely the situation during the 1990-91 recession, when banks were unwilling to lend to companies that wanted to spend.

A credit crunch is made worse--much worse--by a falling stock market. Until recently, technology companies counted on soaring stock prices to help finance their investment needs. With the Nasdaq down 57% from its March 2000 peak, billions of dollars of potential capital have vaporized. As Barbera wryly notes, lower interest rates won't make that money suddenly reappear. "You can't blow a balloon up once you bust it," he says.

The economy may well get worse before it gets better. In an unsettling reminder of how shaky things are, productivity fell 0.1% in the first quarter--the first decline in six years. If productivity weakness continues, so will doubts about the economy's ability to grow at anywhere near the rate it has in recent years. That's because the higher cost of less productive workers puts pressure on companies to raise prices. Once prices go up, the great fear is that inflation can't be far behind.

What ultimately will kick-start businesses is profitability; companies mired in a profit recession think considerably harder about how to save money than how to spend it. As businesses reduce costs and eke out gains, profits will begin to grow again. When that happens, banks will become more confident and more willing to lend. And as profits rise and the economic cloud lifts, a lot of today's excess capacity won't seem so excess.

Hydra, the multiheaded monster that caused the Greeks such trouble, was eventually killed by Hercules, the mythological hero. (In case you're wondering, Hercules cut off Hydra's heads with his sword, then cauterized the wounds before Hydra could regenerate.) So what will be the fate of the recessionary monster menacing the U.S. economy? We don't presume to know. Maybe it will die the death of a thousand (interest rate) cuts at the hands of Alan Greenspan--a man whom plenty of people have mythologized over the years. Or maybe ordinary American consumers will continue their buying binge and spend the serpent into oblivion. There's also this very real possibility: We may have to live with the monster a while longer.

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