In the September/October Ivey Business Journal of last year, I did an article entitled “The New Economy: Preparing for a Slowdown.” I argued that executives should be getting their enterprises ready for economic trouble. I have even more conviction in that regard today. Last year was the best time to start preparing; the next best time is now. Slowdown brutally exposes weak management practice.



In the New Economy of the 1990s, the good news just kept coming: booming real growth, brimming confidence, record job creation, unstoppable consumer and investment spending, soaring equity markets, strong corporate profits, and unprecedented workplace and product technological innovation. Most astonishing of all, perhaps, is the fact that all of this occurred with virtually no inflation. It was the Goldilocks economy: not too hot; not too cold; just perfect.

For forecasters, staying ahead of the good news was a particular challenge of the New Economy. Forecasts of growth in everything from the economy to the stock market were one continual upward revision. Politicians, economists and executives bumped into each other taking credit. The United States was stronger for longer, but by the late 1990s, Canada was on pace.

Increasingly, it all seemed too good to be true. That is what prompted last year’s article. I was optimistic but cautious; prudence said, “enjoy but get ready for trouble.” It particularly concerned me that the “new” in the New Economy was so poorly understood. If the forecasting experts understood the linkages, pressure points and complexities of the New Economy so well, why were they so wrong, so often and over such seemingly short forecasting horizons? Their errors of underestimation were a joy, but they were errors nonetheless. Would the experts miss the downside as much as they missed the upside, only this time the errors would be no fun at all?

It is popular now to believe that some semblance of Goldilocks will return late this fall. Growth and job creation will be accelerating and business will be rebuilding inventories and productive capacity. Cleansed of its excesses, our economy will stand poised for a sustainable and growing prosperity without inflation. The fear-mongers and bears will be in exiled disgrace. Let us hope! Let us even pray! Indeed, it may happen! But think hard before you let this rosy outlook dictate how you run your enterprise! There are too many issues for my comfort.

First, as a general rule, the longer and stronger the expansion, the greater the excesses in the economy. In good times, the excesses help drive the economy to increasingly heady levels; in slower times, the excesses come back to haunt as balance is restored. The stunning expansion of the 1990s in the increasingly integrated Canadian/U.S. economy (over 35 percent of our economy is now U.S. exports) created two particularly alarming excesses. Consumer and corporate debt relative to standard measures of ability to repay, like GDP and income, are in historic territory. Corporations, from telecoms and computer makers to car manufacturers and retailers, are over the gunnels in productive capacity. Consumers are similarly overstocked with durables like cars, appliances and electronics. Productivity-stoking technological innovation had a lot to do with the Goldilocks economy, but do not ignore the effects of an arguably unprecedented borrowing and spending binge. Are tapped-out/overspent/overstocked consumers and corporations likely to drive a quick and sustainable return to anything close to the dizzying growth rates of the late 1990s? Unlikely! Rather, the sensible are rationalizing their spending, restoring their finances and using up what they have bought. Sensible, yes, but this is the stuff of a slowdown, not an expansion.

Most worrisome, perhaps, is the overcapacity that now exists in many industries. An arcane macroeconomic concept called “the accelerator” is at the heart of why overcapacity such as we have today should concern us.

The accelerator relates investment in productive capacity to product demand; it can be a time bomb. For example, say an enterprise needs one machine for every 100,000 units of product demand. Demand is 1,000,000 units, so the enterprise needs 10 machines. Wear and tear requires the enterprise to replace one machine each year. Now, let product demand go up by 10 percent or 100,000 units. A new machine is required, increasing the number of new machines bought by 100 percent, from one to two in that year. A 10 percent increase in product demand has increased investment in productive capacity by 100 percent. Now, suppose instead that product demand had declined by 100,000 units to 900,000 units. Only nine machines are needed, so there is no need to replace the worn-out one. Investment in productive capacity drops by 100 percent from one new machine to zero, even though product demand dropped by only 10 percent. Small changes in product demand magnify themselves many times in their effect on investment.

Huge overcapacity in a slowing economy is a lethal cocktail for investment. To economists, investment has always been special in that the ultimate effect on the economy is many times the initial investment. When things are good, investment makes them multiples better; but when things are bad, look out. Investment exaggerated the economy’s performance on the upside; expect the reverse on the downside. Slowdowns since the Second World War have generally been inventory/consumer-spending-based events triggered by the central banks’ raising of interest rates to counter inflation late in the business cycle. Overcapacity such as we have now adds a whole new dimension to a slowdown. We are in economic territory that few of us have been in before. Declining profits, the bursting of the stock-market bubble, zero private-sector savings and stringent lending conditions do not help investment either.

The second reason executives should be wary about the economy’s immediate prospects is Japan. Together, Japan and the U.S. represent about 40 percent of global economic activity. Since Japan’s emergence as an economic power, we have not experienced a significant slowdown in both Japan and the U.S. at the same time. When business cycles synchronize, there is a reinforcing effect that can produce spectacular upside and downside consequences. It is not a good sign that the Japanese and U.S. business cycles seem so closely aligned at the moment; nor is Europe helping. Diversification across economies provides great comfort for the global economy, but it is not diversification when the two most important players—the U.S. and Japan—are slowing in tandem. The OECD was ominous on Japan in its May 2001 economic report, warning of the “risk of entering a downward spiral.”

Third, in many human activities, speed and risk are exponentially related. Driving a car is a prime example— 100 miles per hour is far more than twice as dangerous as 50 miles per hour. The faster the economy is changing, the greater the likelihood that things will go seriously wrong and stay wrong for a while.

The pace of change in our economy is breathtaking. The likes of just-in-time inventory management, continuous control, Internet ordering, instantaneous communication and minute-to-minute customer, market and financial reporting give executives the capacity to literally turn their enterprises on a dime. Executives have the tools, the incentives and the information to slow their enterprises down faster than many dream possible. At the level of a single enterprise, all of this does not matter much; however, over an entire economy of enterprises, it is an entirely different matter.

The speed of our economy enhanced its performance on the upside; it is likely to accelerate and prolong the slowness on the downside. For proof, note the speed at which major capital spending plans are being shelved. An advantage of the Old Economy was the way its more leisurely pace moderated the business cycle. A fundamental law of physics is that speed increases momentum. Now that the economy has finally turned, expect its speed to give it a downward momentum that will be tough to offset quickly.

Fourth, the wealth effect is the name economists have given to the relationship between the paper value of financial holdings and the willingness to spend. The richer the stock market, in particular, makes us feel, the more freely we spend, and vice versa. Recent stock market losses, especially in the technology sector, have been huge. It would not be surprising if those losses took a bigger bite out of spending, and therefore the economy, than is currently expected. The powerful relationship between the Nasdaq stock index and U.S. consumer spending is particularly unsettling. Spending by individuals and families accounts for well over half of the aggregate economic activity. The Nasdaq lost about 60 percent between spring 2000 and spring 2001.

Fifth, the most astonishing aspect of the New Economy was not its power, but rather that it could be so strong for so long without inflation. Is it possible that price stability on the upside will give way to an even more astonishing scenario—rising prices on the downside? Indeed it is, and that would be real trouble! The month-to-month inflation data, especially in the United States, is troublesome. Energy prices are an ongoing worry and productivity growth is slowing, pressuring margin-pressed enterprises to raise prices if they are to maintain a semblance of profit respectability. To head off imminent recession, central banks are printing money at a blistering pace; sooner or later, an oversupply of money usually shows up in prices. We import over 30 percent of our standard of living from the U.S., and those import prices do not reflect our deeply depressed Canadian dollar. Rising prices in a slowdown are a central banker’s worst nightmare. Do you keep stimulating and so risk increasing inflation? Or do you tighten and so risk deepening the slowdown? A decidedly un-Goldilocks-like choice!

Finally, some are pinning their hopes for quick economic recovery on falling interest rates and tax cuts. Declining interest rates are well suited to turning around an inventory/consumer spending slowdown. However, they are less helpful when the problems are excess production capacity, excess consumer and business debt, low confidence and weak profits. In terms of moving an economy, monetary policy is sometimes like pushing on a string; this may be one of those times. As for tax cuts in both the U.S. and Canada, they are too little too late if the goal is a quick rebound. That the Federal Reserve began moving aggressively in January augurs well for some time next year; no one should forget that the impact of a change in monetary policy is anything but instantaneous. The Federal Reserve may have been acknowledging as much in its April 18, 2001, press release, announcing a surprise 50-point drop in the federal funds rate. “The risks are weighted mainly towards conditions that may generate economic weakness in the foreseeable future.” Very powerful stuff in the rarefied rhetorical world of the central bank!

Slowdown puts a premium on proper management practice. Nothing hides management weakness like booming real growth, unstoppable consumer and investment spending and soaring equity markets. Going forward, the balance of probabilities seems to favour slower for longer than is popularly expected. For executives, the agenda is not complicated:

  • Customers, products, key staff and competitiveness are an enterprise’s lifeblood; do not trade them off in a short-term profitability compromise.
  • Put operating and investment spending under a microscope; if spending does not affect the customer, the product, the key staff or competitiveness, be tough.
  • Force the pace of adjustment and keep in mind that gradualism is a dangerously slippery slope in a downturn.
  • Keep the balance sheet as strong as possible, as rising debt and/or mismatched asset/liability maturities and currencies always exacerbate the effects of slowdown.
  • Solidify important supplier relationships; everything from capital and credit to raw materials and professional services depends on suppliers.
  • Focus on slowdown as opportunity; remember that distracted competitors and their customers may be ripe for the picking.
  • Success usually goes to the flexible and nimble; Rosabeth Moss Kanter’s (author of the splendid book Evolve) notion of strategy as improvisational theatre is apt.
  • Know your business, what is happening in it day to day, how it is affected by business conditions and how business conditions are changing; knowledge is always important, especially when things are turning down.
  • Be relentlessly determined to survive, grow and prosper.

The hope is that the economy does a V, meaning that it soon turns sharply up. For that to happen, consumers have to keep spending in the face of rising unemployment, declining confidence and huge debt loads. Consider me a skeptic! More likely is a U, or worse, a lazy U, where the economy stays stubbornly slow. This scenario is based on the consumer and housing markets not holding up until capital spending turns.

The far more important issue for executives is not whether we get technical recession (two quarters of negative growth) but how long we bump along a slow-growth bottom. Granted, Dell Computer Corporation CEO Michael S. Dell is a standard-bearer for technology, but in the April 9, 2001, BusinessWeek he made a compelling comment, “Somebody says things are going to recover in the second half. Well, why is it going to recover in the second half? Because it’s not the first half? That doesn’t make sense.” John Chambers, CEO of Cisco, was also instructive in a conference call reported on Netscape (April 17, 2001), in the aftermath of his company’s second earnings warning in two months. “The challenges in terms of projecting global business have never been more difficult. Changes that used to occur over quarters are now occurring over months….A hundred-year flood can happen in your lifetime.” Hundred-year floods have special meaning to someone from Manitoba!

Calling turning points has never been easy. The newness of the New Economy only increases the challenge. A crash landing is not in the cas, but the soft-landing scenario is surely getting harder for longer. Alas, the New Economy did not repeal the laws of the business cycle. Executives should respond accordingly. This is unlikely to be a garden variety inventory/consumer-spending business cycle where it’s up, up and away any time soon. Management is the edge, whatever happens!

About the Author

John S. McCallum is Professor of Finance at the I. H. Asper School of Business, University of Manitoba, and former Chairman of Manitoba Hydro. Contact