THE AMERICAN RECESSION AND ITS IMPLICATIONS FOR BERMUDA

2001-2002

By

Andrew F. Brimmer

The American economy is definitely in a recession - the first in a decade. The previous expansion (the longest on record) reached a peak last March. Subsequently, the pace of economic activity was moderating through the summer.

Suddenly, the terrorist attacks on the World Trade Center in New York City and on the Pentagon in Washington, D.C., in September had a devastating effect on the overall economy. The attacks greatly disrupted economic output across a wide range of industries and geographic areas. In so doing, they assured that the slowdown in the United States would be transformed into a genuine recession. That, too, has happened: gross domestic product adjusted for inflation (real GDP) was stagnant during the spring months and actually decreased over the summer. Consumers kept a tight grip on their wallets. Business outlays for fixed investment continued to fall. Exports declined at an accelerating rate as foreign demand for U.S. products shrank as recessions got under way in several of the Country's most important markets abroad.

The current recession in the United States began in the manufacturing sector where most of the adverse effects were initially confined. However, after the terrorist attacks, cut backs in business activity spread rapidly to virtually every sector - especially to airline transportation, hotels, and other travel-related services. Retail trade was next in line. Finally, over the last month or so, the vast array of diverse services has been hit exceptionally hard.

As production, trade, and services have weakened, unemployment has jumped dramatically. Moreover, while mostly blue collar and lower-paid service workers were laid off initially, an increasing number of skilled technicians, other white-collar workers, and professionals are losing their jobs.

Looking ahead, the recession in the U.S. will most likely last through the early months of next year. When recovery does come about, it will almost certainly be led by the American consumer. The business sector (whose record spending for plant and equipment sparked the previous boom) will not rush to expand investment outlays any time soon.

Because the private sectors will have very limited ability to expand spending, the fiscal stimulus program now being debated by the U.S. Congress will determine whether the economy gets a boost and recovers early next year - or whether it continues to linger in stagnation. As of now, the Congress is expected to approve some form of stimulus measure before the end of the year, but there is no guarantee.

Turning to Bermuda, one should expect the effects of the US recession to spill over to the Island. The principal reason is the sharp reduction in travel from the US Mainland and the related decrease in foreign visitors' spending. These negative effects are already evident, and they are more likely to worsen than to diminish in the months ahead.

The Bermuda Government is fully aware of these prospects, and it has already adjusted its expenditure plans accordingly. In the Ministry of Finance, the unfolding situation is monitored daily. I also understand that the Government is prepared to adopt counter-cyclical measures to ameliorate the effects on Bermuda's economy if the recession becomes more severe than is currently anticipated.

Economic Outlook for the United States

As already noted, The economy in the United States is well into a recession, which most probably will last into next year. The only questions remaining are: (1) How large will the decline be? (2) How long will the recession last? (3) When will the recovery get underway?

The recession began in the spring of this year - specifically in the month of March. The date was established by the Business Cycle Dating Committee of the National Bureau of Economic Research, which - by general agreement - has the responsibility to determine the “official” timing of cyclical turning points in business activity. In a Statement released November 26, 2001, the Committee announced that:

it “…has determined that a peak in business activity occurred in the U.S. economy in March 2001. A peak marks the end of an expansion and the beginning of a recession. The determination of a peak date in March is thus a determination that the expansion that began in March 1991 ended in March 2001 and a recession began. The expansion lasted exactly 10 years, the longest in the NBER's chronology.

“A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.

Because a recession influences the economy broadly and is not confined to one sector, the committee emphasizes economy-wide measures of economic activity. The traditional role of the committee is to maintain a monthly chronology, so the committee refers almost exclusively to monthly indicators. The committee gives relatively little weight to real GDP because it is only measured quarterly and it is subject to continuing, large revisions…”.

Of course, National Bureau economists - along with their other colleagues who study the behavior of the overall economy - are vitally interested in gauging the effects of changes in economic activity on the Nation's welfare. For this purpose, the total output of goods and services corrected for inflation (real GDP) is the best measure. Consequently, as a handy tool, most economists define a recession as a decline in real GDP lasting two quarters (six months) or more. By this definition, it appears that the American economy is set to experience at least a two-quarter recession in the current year. Moreover, if the proposed economic stimulus program now being debated in the U.S. Congress fails to be adopted - or is delayed into 2002, the Country may well see nine months or more of declining economic activity.

The U.S. economy was teetering on the brink of recession before the terrorists' attack on the New York World Trade Center Towers and the Pentagon Building in suburban Washington, D.C., on September 11, 2001. The shock of the attacks and their adverse impact on the economy at large removed any doubt that a recession was underway.

The progressive weakening of the U.S. economy can be traced in Tables 1 (attached). It will be noted that gross domestic product achieved a maximum annual rate of expansion (5.7 per cent) in the second quarter of 2000. A year later, the GDP growth rate was down to 0.3 per cent. Over the 12 months, real GDP rose by 1.3 per cent. The increase in GDP was sustained by the 3.2 per cent expansion in personal consumption expenditures (PCE). The gain was partly offset by a decrease of 7.5 per cent in gross private domestic investment. Within the latter category, fixed investment declined by 1.3 per cent, of which the nonresidential segment decreased by 2.3 per cent. There was a 4.3 per cent cut in outlays for equipment and software.

The slowdown continued through the fall of 2000. For example, gross domestic product adjusted for inflation rose at an annual rate of 1.3 per cent in the third quarter - less than one quarter of the 5.7 per cent recorded in the April-June months. For the final quarter of the year, real GDP rose at an annual rate of 1.9 per cent.

The emerging weakness in the economy was recognized by the Federal Reserve in late December 2000. Following the Federal Open Market Committee's last meeting of the year, the FOMC noted that “…the drag on demand and profits from rising energy costs, as well as eroding consumer confidence, reports of substantial shortfalls in sales and earnings, and stress in some segments of the financial markets suggest that economic growth may be slowing further.” Consequently, “…the [Federal Reserve believes that the risks are weighted mainly toward weakness [rather than inflation in the near future.” Among market observers, this pessimistic assessment was interpreted as an indication that the Federal Reserve was likely to cut interest rates some time in January. The goals would be to stimulate the economy and to forestall a recession.

That expectation was borne out on January 3, 2001. On that date, the FOMC cut the target for the federal funds rate by 50 basis points to 6 per cent. In a parallel action, the Federal Reserve Board reduced the discount rate by 25 basis points to 5_ per cent. It also signaled that a further cut to 5? per cent was highly likely. As the record shows, the Federal Reserve moved vigorously to reduce the risk - and ultimate impact - of a recession. In total, by mid - December, 2001, the U.S. Central Bank had cut the federal funds rate eleven times, from 6.5 per cent to 1.75 per cent. (This compares with seven interest rate cuts by the Bank of England - but only three by the European Central Bank.)

One can also see in Table 1 a summary of the overall economic outlook for the United States in the year ahead - both before and after the terrorist attacks. It was anticipated that the second quarter 2001 would mark the low point in the slowdown. The annual growth rate of real GDP was expected to rise from 0.3 per cent in that quarter to 1.6 per cent in the third and to 2.6 per cent in the final three months. This pattern would have produced a year-over-year increase of 1.6 per cent in 2001 - far below the 4.1 per cent recorded in 2000 but still positive.

Following the 911 attacks, every analyst with any standing revised his forecast. The consensus forecasts of Blue Chips were cut to -0.5 per cent for the third quarter and to -0.7 per cent for the fourth. The result was a downward revision to 0.8 per cent in the real GDP growth rate for 2001. However, the estimate was presented with considerable caution, since there was a high probability that the final figures could be lower. As matters developed, real GDP decreased by 1.1 per cent, at an annual rate, in the third quarter. A further shrinkage at a 2.5 per cent rate is anticipated during the final three months. With two quarters, back-to-back, of negative GDP growth, the U.S. economy would suffer a recession as traditionally defined.

In the current forecast, real GDP increases at a 0.5 per cent rate in the first quarter of 2002. Real growth resumes in the second quarter at 2.2 per cent. The pace then picks up steadily to 3.9 per cent in the final quarter. For the year as a whole, real GDP expands by 1.5 per cent. Again, however, the forecast is surrounded by a great deal of uncertainty. In particular, the first quarter may see real GDP decrease at an annual rate of 1.0 per cent. If so, the country would experience a three-quarter recession in duration. The actual decline in real output would be about 1.14 per cent, compared with 0.89 per cent in a two-quarter recession.

As a by-product of the unfolding recession, the level of unemployment in the United States has risen sharply. For the entire year 2000, the unemployment rate was 4.0 per cent - the lowest full-year rate since 1969. In the first quarter of 2001, the jobless rate averaged 4.2 per cent. It then climbed to 4.5 per cent in the spring and to 4.8 per cent over the summer. For the most part, these increases reflected layoffs in the manufacturing sector where the recession came early and proceeded with full force. However, following the 911 episode, the level of activity in transportation (especially airlines) retail trade, and financial services, also declined appreciably. Over the last few months, the marked slowdown has spread through the economy at large. In its train, unemployment has risen sharply. For example, the unemployment rate was 4.9 per cent in both August and September. It then jumped to 5.4 per cent in October and spurted further to 5.7 per cent in November. Moreover, the way weekly claims for state unemployment benefits have been behaving, another rise in the total unemployment rate seems certain.

In the meantime, there is no clear evidence to show that the recession will end soon. In fact, the information being released suggests that, when the recovery does get under way next year, it may be quite sluggish. In late November, the Federal Reserve Board in Washington reported a mixed picture based on surveys by the 12 Regional Federal Reserve Banks. These results indicated that, in general, economic activity remained weak. In most Districts, the evidence of further slowing outweighed signs of budding recovery in a few areas.

In particular, the manufacturing sector continued to shrink - with cut backs in new orders, production, and employment. Consumer spending was especially mixed. Aggressively easy financing terms were boosting sales of new automobiles and light trucks to exceptional levels. However, a number of dealers thought that they were borrowing from the future and expected the volume of purchases early next year will be correspondingly lower. Retail merchants - particularly those selling soft goods - reported mixed results. Many were already putting on pre-Christmas sales. Discount stores were seeing fairly strong growth while department store chains and higher-priced specialty stores reported sluggish customer traffic.

Only two of the 12 Federal Reserve Districts reported a pick up in tourism. The others stated that business and pleasure travel was still feeling the adverse effects of the September 11 attacks. The shortfall was being compounded as the recession spread.

With respect to investment spending, businesses are planning further reductions in outlays for both structures and industrial equipment. The boom in capital spending over the last few years greatly expanded capacity. Now a recession-induced decrease in demand for output has further dampened the willingness of many businesses to undertake additional investment. The housing market has remained quite strong, spurred mainly by low mortgage rates and the ease of re-financing. On the other hand, climbing unemployment and stagnating or declining personal incomes have resulted in rising delinquencies on home mortgages.

In its most recent meeting on December 11, 2001 the Federal Open Market Committee decided to lower its target for the federal funds rate by 25 basis points to 1-3/4 percent. In taking the action the Committee noted that:

Economic activity remains soft, with underlying inflation likely to edge lower from relatively modest levels. To be sure, weakness in demand shows signs of abating, but those signs are preliminary and tentative. The Committee continues to believe that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that generate economic weakness in the foreseeable future.

In combination, these developments (reinforced by the uncertainties generated by the war on terrorism) have cast a cloud over the prospects for the American economy in the year ahead. Moreover, with the recession spreading among the leading industrial countries nearly simultaneously, both exports and imports are being adversely affected. As a consequence, the American economy is likely to remain sluggish well into 2002.

In the case of the United States itself, how the recession turns out will depend on the scope and magnitude of the economic stimulus the Federal Government finally provides. As it became more evident that the September 11 terrorist attacks would push the economy into recession, support for a sizable dose of fiscal stimulus increased. However, there are also widely differing views among the Administration, Republicans, and Democrats, in both the U.S. Senate and House of Representatives. In the Bush Administration's plan, the $40.0 billion of aid for clean up and rebuilding that has already been provided will help spur growth. They also support an additional $60.0 billion to $75.0 billion of appropriations. While no definitive breakdown has been presented, the Administration clearly prefers tax cuts (especially for business) over increased Federal spending.

The deepest divisions are in the Congress. The Republican-controlled U.S. House of Representatives has gone the farthest. It has adopted a bill that would cost an estimated $100 billion in 2002. If finally passed by the full Congress and signed by the President, it would put the Federal budget in deficit during the current fiscal year (which began October 1). The red ink would likely extend several years into the future.

The House of Representatives adopted its bill despite intense pressure from the White House as well as from Republicans in the Democrat-controlled Senate. The Administration found it far too expensive and would return the Government to a string of budget deficits. Republican Senators though it would delay unnecessarily the adoption of a much-needed economic stimulus package.

The Democrats in the Senate have their own preferences. In general, they want to provide more benefits to individuals and less to companies. They support giving $300 rebates to low-income workers. But their highest priority is increased Federal Government spending for unemployment and health-care benefits. Senate Democrats also favor accelerated depreciation of business' capital equipment, but they would limit the measure to one year. Finally, Senate Democrats want increased Federal outlays for public works - particularly to improve water, power, and transportation facilities. These latter activities would also create jobs.

Although the impact of the different forms of fiscal stimulus on the national economy has not been estimated by either the Bush Administration or the Congress, it is clear that some of them would have considerable short-term, counter-cyclical effect while others would have very little. For example, the little-effect categories would include capital gains tax reduction, and repeal of the

Alternative Minimum Tax and rebate of all taxes paid since the measure was adopted in 1986. The quick-acting category would include tax rebates for low-income workers, unemployment compensation, and health-care benefits.

Congressional action on a fiscal stimulus program is still expected in late December. If this is not done, the current recession is likely to be fairly deep and of a long duration.

From the foregoing review, it is clear that the United States is definitely in the grip of a recession, and economic recovery is not expected to be firmly established until the third and fourth quarters of 2002. When it does come, the consumer sector will lead the U.S. recovery. Business investment (which provided the mainsprings of growth in the previous boom) will remain sluggish. Among the types of consumer expenditures, spending on durable goods (such as automobiles and household appliances) will expand only moderately. Spending for non-durable goods will show somewhat more strength. Expenditures for services will most likely increase at a rate above that for the consumer sector as a whole.

However, within consumer services, those purchases which depend most heavily on improvements in discretionary income will experience only modest growth. Among these, spending on travel is likely to be the last to recover. Since businesses will also be restraining the growth of travel expenses, total travel outlays by Americans will continue to be under considerable pressure during the coming year.

The outlook for the travel industry, which was already clouded, was further negatively impacted by the terrorist attack of September 11. Those events greatly increased consumer anxiety with respect to air travel. For example, recent nationwide polls in the United States indicate that 22 per cent of consumers have revised their leisure travel plans in the wake of the 911 episodes. There has been a shift in destination preferences, and many are opting to stay “closer to home.” That implies a significant cut back in travel outside the mainland United States.

Recession and Recovery in Bermuda

Given Bermuda's close trade links to the United States - of which reciprocal travel is the strongest - the recession there will have a direct and substantial impact on the Country. The overall effect will be a much-reduced level of Bermudian economic activity in the short to medium term. The general outlook for Bermuda's economy during the period 2001-2002 is summarized by the figures in Table 2.

In light of these prospects, the Ministry of Finance recently under took a mid (fiscal) - year assessment of Bermuda's current economic conditions and the outlook for the coming year. As a result, the Ministry revised downward the real GDP growth projection for fiscal 2001/02 from 2.7 per cent to a decrease of 0.4 per cent year-over-year. The major factor underlying the downward revision was the sharper than projected reduction in the volume of visitor expenditure for the year. In the year-to-date, visitor arrivals have been down by about 16 per cent year-over-year. Average spending on accommodation, meals, shopping, and related activities have also declined in comparison to the previous year.

Looking ahead to 2002, the overall Bermudian economy is expected to exhibit continuing weakness. As a by-product, unemployment will rise further. Statistics are not available which would make it possible to measure the level and trend of joblessness with precision. However, one should anticipate a climb in unemployment. In fact, the informal evidence suggests that it is already happening. For instance, as hotel occupancy has declined, some staffs have been cut, while others have been put on short hours. Lighter patronage at restaurants similarly has led to job reductions. Self employed taxi operators and hired drivers are working less. Other examples could be cited, but the general direction is clear: unemployment in Bermuda (as one would expect) has risen, and further increases are on the horizon.

As jobs rise more slowly or actually decline somewhat, aggregate household income will most likely show little improvement. Moreover, the loss of purchasing power will be concentrated primarily among the low-income segment of the population. Since citizens in this group have a high propensity to spend, their loss of earnings will further dampen retail sales.

Taking the Bermudian economy as a whole, real GDP is expected to contract by 1.5 per cent in 2002. This decline would follow an expected decrease of 0.4 per cent in the current year. So, over the two years combined, total output may be reduced by about 2.0 per cent. Since Bermuda's population is growing at an annual rate of roughly 0.8 per cent, real per capita income may shrink by almost 3.0 per cent over the two-year period.

On the other hand, there is a chance of a smaller contraction in the overall economy if those sectors that are growing perform exceptionally well. This would be particularly true of financial services.

In the meantime, the sector outlook is mixed. Industry-specific prospects range from actual declines, to no growth, to fairly robust levels of economic activity.

The tourism-related sector (hotels, restaurants, retail shops, and transport services) has been severely affected by fewer visitors and the reduced levels of visitor spending. The already emerging difficulties in this sector were further compounded by the events of 911. These negative impacts are expected to help shape economic activity during the first six months of 2002. For example, the Bermuda Hotel Association has forecast occupancy levels for the first half of 2002 to be 15 per cent below those for the comparable period in 2001.

In light of this unpromising outlook, the industry is not sitting idly by. Instead, the Bermuda Alliance for Tourism (a public-private partnership) has mapped out a vigorous strategy for 2002 aimed at reducing air access costs from U.S. cities to Bermuda while maintaining the frequency of airlift. The strategy includes increasing the awareness of Bermuda as a vacation destination in the top five origin markets of New York, Boston, Washington, D.C., Philadelphia, and Atlanta. Recent marketing data indicate that, in many of these markets, Bermuda is not included in the decision frame.

For the other traditional sectors of Bermuda's economy, low-to-moderate growth is expected for 2002. The principal areas are construction, utilities, and local manufacturing. Among these, the construction industry will be of particular importance. This sector has been operating at full capacity for the last several years, and a sustained high level of activity is expected in 2002. Major projects like the new world headquarters for ACE group of companies and XL Capital Limited were completed in 2001. However, there are a number of other large projects in progress. Also there are indications that smaller construction jobs that were previously on hold due to capacity constraints are now coming on line. So, activity in construction will help to bolster domestic demand in the economy.

The fastest growing sector of the Bermudian economy is financial services. The field has been buoyant in 2001, and the pace is not only expected to continue in 2002 but may even be accelerated. There has been heightened interest in Bermuda as an insurance domicile in the wake of 911. During the last few months, seven major insurance companies have been incorporated with more than $7.0 billion of new capital. Additional incorporations of major excess liability companies are pending which could bring the new expanded capacity to $9.5 billion. This development will spur the creation of new jobs in the sector, create demand for additional office space and residential accommodation, and give a boost to consumer spending. The banking business also remains strong, and employment levels in this sector are expected to be stable. In overall terms, the upshot is that new jobs will be created in the financial services sector in 2002 with positive contributions toward domestic demand.

In the Government sector, the revenue budget for 2001/02 has been revised downward by some $24.0 million (or by 4.0 per cent) due to the accelerated weakness of the tourism sector in the wake of 911. The projected revenue shortfall will be partly offset by a series of cost-saving measures - including a moratorium on non-essential overtime and non-critical furniture and equipment acquisitions. Government travel has also been cut back, and a funding freeze has been placed on long-standing vacant posts.

On the other hand, even in the face of fiscal stresses, a few types of Government outlays will have to expand. Among these are social assistance expenditures as unemployed workers turn to Government for temporary help. Funding support for a number of high priority projects that are already underway (such as schools) will need to continue on schedule. Moreover, several critical capital projects (which have been planned but not implemented) might be activated during a recession period to take advantage of the greater availability of skilled labor and other resources.

Finally, if the recession in the United States is deep and lasts longer than projected, the adverse impact on Bermuda will also be greater than is now anticipated. Under those circumstances, the Government of Bermuda is positioned to adopt counter-cyclical measures to ameliorate the effects of the recession on Bermuda's economy.