How Big Is This Soft Patch, Mr. Greenspan?

When Alan Greenspan testified before the House Budget Committee on Sept. 8, 2004, he could not bring himself to say that the economic "soft patch" that supposedly started in the spring was over. He may have known something that the rest of us learned only later in the day. The same afternoon, the Fed released its periodical review of economic conditions around the country, the so-called Beige Book. In it, the regional Federal Reserve banks describe an economic "soft patch" that has stretched well beyond the summer and that will likely continue for some time.

The recovery is now more than two-and-half years old. Last year at this time, the recovery – well into its second year – showed signs of strong growth. However, since then, growth has slowed. It fell from an annualized rate of 7.4 percent in the third quarter of 2003 to 2.8 percent in the second quarter of 2004 – a deceleration of 62 percent.

This slowdown in economic growth was not surprising. Much of the strong growth in the third quarter of 2003 was driven by factors that were unlikely to recur. Specifically, households cashed out their home equity at a rate of $246 billion in the first nine months of 2003, reflecting the peak of the home refinancing boom, fuelled by declining interest rates and rising home values. Much of the additional funds were spent on consumption items, such as cars and electronics, as well as on home renovations.

However, even low interest rate loans secured by rising home values are not free money. Servicing the additional debt is especially painful if household incomes are not growing, as has been the case for the past three years. Since the beginning of the year, inflation-adjusted earnings have declined, while employment growth has recently seemed to have lost its footing.

Much of the weakness in the economy is concentrated in consumer spending on consumption items and homes, which also makes up the vast majority of the economy. For instance, in the second quarter of 2004, consumer spending grew at its lowest rate in three years. For the months of July and August, consumer spending softened in many parts of the country, according to the Fed's Beige Book. The culprits could equally be found among "lackluster retail sales" and "cooling in new and existing home sales." The combination of record debt levels and slow income growth is obviously taking a toll on households' ability to spend, especially in the face of rising costs for health care, education, housing and energy.

In the near term, this "soft patch" of consumer spending will likely continue. The Fed reported in its Beige Book that there was a drop off in mortgage lending across the country, which will mean fewer home equity cash-outs and thus less debt-driven consumption. And there is little in the Beige Book to suggest that the labor market is poised for a strong surge in hiring. In fact, the Fed describes a labor market characterized by "some unevenness of [employment gains] across sectors in regions." This follows the Bureau of Labor Statistics report last week that employment grew in August, but that it fell short of population growth and that it declined in the retail sector.

Without the continued strength of the refinancing boom and a surge in labor incomes, household spending is likely to continue to be slow in the coming months. For growth to accelerate again, other sectors – exports, government, and investment – need to grow faster. On the trade front, U.S. exports are struggling with lackluster overseas demand. Government spending, in light of record deficits, is likely to be subdued for some time, putting much of the burden of accelerated growth on business investment. The Beige Book indicated that manufacturing activity in a number of investment goods was solid in July and August. The problem is that investment growth has already been strong over the past year, but not strong enough to halt the slow down in overall growth.

For business investment to become the new engine of accelerated growth, a number of things have to fall into place. For one, investment gains have to spread beyond information technology-related spending, where much of the investment gains have been concentrated in the past year. Businesses will also have to have enough incentives to invest more, despite slowing consumer demand and large overcapacities. That also means that businesses will have to hire more people at better wages and with more benefits than has been the case in recent years to boost incomes and create the customers of the not-so-distant future. These are a lot of "ifs" before investment can be a generator of stronger growth.

The fact that the recovery has been largely debt-driven has taken a toll in the form of slower economic growth. Originally dubbed an economic "soft patch" by Fed Chairman Alan Greenspan, it is becoming clear that this weakness was not limited to the spring of 2004. Given the Fed's latest report, it seems that strong growth will not resurface any time soon. But then again, "soft patch" is a term imprecise enough to cover multiple quarters of disappointing economic performance, and there is no need yet for Greenspan to change his tune.

Christian Weller is senior economist at the Center for American Progress.