by Cathy E. Minehan, President and Chief Executive Officer, Federal Reserve Bank of Boston
March 31, 2003

The recent recession has been very hard on the technology sector, both in Massachusetts and the nation. And while the worst may be behind us, signs of improvement are scant. However, the historic resilience of the Massachusetts economy plus excellent productivity performance in this period of slack offers reassurance for the longer term. Today, I want to focus on those three themes: 1) the state of the national economy; 2) the problems here in Massachusetts and 3) what insights I might have about the future.

Since the end of 2001, the U.S. economy has been in a mode of slow growth. Relatively vigorous consumption growth and a strong housing market have sustained modest growth in the overall economy despite weakness in business investment. Throughout this period, the central question has been whether business investment will pick up before consumption flags. That question has become even more pressing and more difficult to answer as geo-political concerns weigh on both business and consumer confidence.

Massachusetts’ economic performance has been weaker than that of the nation, reflecting its greater orientation to technology industries and to financial services that are linked to the fortunes of the stock market. These same industries contributed importantly to the state’s superior performance in the late 1990s.

Recap of Recession and "Recovery"

The past two years constitute a very unusual episode. Both the recession, which began in March 2001, and the ensuing recovery were unusually mild. Nationally, the decline in employment was roughly half that in the average post World War II recession. That the recession was so mild is quite remarkable, given the blows the economy has suffered – the plunge in the stock market, the terrorist attack of 9/11 and continuing anxieties over the international political situation. As a policymaker, I believe some credit should be given to the Fed's 12 interest rate cuts over the last two years as an element in this resilience, but I know many other factors contributed as well.

The economy has been supported by consumers and home-buyers, with some help from government spending. In the typical recession, consumption falls. Spending on motor vehicles, furniture and other large-ticket items usually plummets. Residential investment also falls sharply. During the time period from early 2001 on, however, consumption and residential investment have continued to grow. Spending on consumer durables has been quite strong and overall consumption in 2002 averaged 3 percent above the level in 2001. Residential investment was up almost 4 percent. Very low interest rates have been critical in sustaining this spending. The 2001 federal tax cut also provided a timely stimulus. Just as an aside, it is often difficult to use fiscal policy to stabilize the economy. The inevitable – and necessary – political debate may result in the policy moves being delayed, sometimes until after the problem has passed. However, the 2001 tax cut was in the works for other reasons, and gathered support as the economy weakened.

While consumption and housing have held up better than would be expected, we have not enjoyed the bounce back that these sectors have provided in the typical recovery. Not having fallen, they have not exhibited the strong growth rates that are customary in the early stages of recovery. Rather, they have continued to grow as before.

Meanwhile, business investment while not exactly languishing, hasn't been vibrant. The falloff in business investment in the 2000-2001 period was severe. Business investment usually falls in recessions, but largely in response to the slowdown in overall demand. The low point for investment generally occurs after residential investment and spending on consumer durables has started to recover. But in this case, business investment was the primary cause of the slowdown. Over-investment in capital goods, aided and abetted by the bubble atmosphere of the late 1990s and a low cost of capital, led to excess capacity and triggered a collapse in spending. Telecommunications is the extreme example. WorldCom’s recent write-offs provide credence to the many newspaper stories about unutilized cable capacity and the many years that it will take to absorb this excess.

But in other areas as well, firms have found that they can get by with much reduced rates of investment. This has surprised many observers. At the start of the recession, the conventional wisdom was that investment in computers and other technology products would quickly bounce back. It was thought that the rapid depreciation rates of these products would force firms to quickly resume buying as they had before. However, many firms who had been replacing computers and other products almost automatically every two or three years are now giving these expenditures close scrutiny. They are spending--actually investment in computers and software edged up at single digit rates in the last three quarters of 2002. But they are also discovering that two-year old computers work just fine for many purposes. There has been a change in mindset. In the late 1990s, firms upgraded equipment on a regular basis without asking questions; now they look long and hard.

The financial upheaval that accompanied this slowdown and the related highly publicized failures of corporate governance have also engendered increased conservatism upon the part of management and boards of directors. No one is inclined to be venturesome. Adding to the aura of caution are the considerable risks associated with the geopolitical situation.

So where are we now? Roughly where we have been for the past two years: Hoping the consumer will continue to spend while anxiously waiting for business investment to gain traction. If anything, the situation seems to have softened somewhat in recent months. Labor market conditions have deteriorated. The unemployment rate has remained relatively steady, but the sharp decline in employment in February (over 300,000 jobs) was a very unwelcome development. In fact, since the fourth quarter of 2001--a period of so-called recovery--the economy has actually lost 600,000 jobs, clearly securing first place in "jobless recoveries." Initial unemployment insurance claims, at times a precursor of changes in unemployment, have remained at elevated levels in the past two months. Consumer sentiment has fallen and retail sales have been soft. Some of this softness is undoubtedly due to the unfavorable weather, which affected not just the Northeast, but much of the East Coast. As you may remember, the big Presidents’ Day weekend was quite literally a wipe out. Anxieties over prospects of war on Iraq may have also weighed on consumers and businesses as have rising oil and gasoline prices.

Not all is doom and gloom. New orders picked up quite sharply in January; and while they fell in February, the data for the quarter are still consistent with the single digit growth particularly in computers and software that we saw in 2002. An index of new orders from the Institute for Supply Management (ISM) was down in February as well but remained well above recession lows, with more respondents reporting increases in orders than decreases. Housing data have been bouncy, but overall activity remains at high levels reflecting low interest rates and favorable affordability.

One other positive development has been the nation’s strong productivity performance. As you know, productivity growth picked up in the second half of the 1990s. While some hailed this as a long-term upward shift, others attributed the acceleration in productivity growth to the strong economy and predicted that productivity growth would diminish if the economy slowed. Well, the economy has slowed and productivity growth has remained robust. Productivity in the fourth quarter of 2002 was up 4 percent from the prior year. This is a large gain by any standard, but is truly remarkable in light of the sluggish economy. It is true that the other side of the productivity coin is short-term weakness in employment. The current jobless nature of this recovery owes a lot to the desire of businesses to be ever more competitive and cost driven at a time in which the future is particularly cloudy. However, this ability of the nation’s businesses to increase their efficiency in these difficult times is critical to repairing balance sheets and enabling firms to contemplate stepping up their rates of investment. It also tends to confirm the view that we are in an era of higher productivity growth and higher living standards over the long term.

In sum, the national situation remains uncertain. Recent data have suggested that the "soft patch" that began early in 2003 remains, but those data are clouded by weather and geopolitical concerns. It is clearly possible that the summer will bring new economic vibrancy, and most forecasts see a pick-up. But it is also possible that this period of slow recovery from the excess investment of the late '90s will continue. Either way, productivity trends provide a solid underpinning to growth. And, speaking from my own perspective, policymakers will need to be especially vigilant.

Massachusetts Situation

What then of Massachusetts?

This has been a difficult period for Massachusetts. At the state level, the key indicator of economic activity is employment. Recently released revisions to payroll employment for Massachusetts show a decline of almost 5 percent since early 2001. The original figures showed a job decline of about 3 percent. This is a severe recession for the state. Not as severe as the recession of the early 1990s, but comparable in job loss to the 1974-975 recession. By way of comparison, national employment has fallen about 1 ˝ percent.

When this recession began, our expectation was that the impact on Massachusetts would be similar to that on the nation as a whole. In contrast with the late 1980s and early 1990s, when a real estate boom and bust caused the state’s economy to deviate markedly from that of the nation, first on the upside and then on the downside, the Massachusetts economy seemed to be following the national pattern. Some observers expressed concern that the state’s large concentration of mutual funds and asset management activities might make it more vulnerable in light of the decline in the stock market. Financial activities have, indeed, experienced job losses. But the primary problem lies elsewhere. The bulk of the job losses have been in manufacturing, professional and business services, and information.

Since the peak in overall employment early in 2001, manufacturing employment in Massachusetts has fallen 17 percent. As with overall employment, recent revisions have worsened the picture. Data on individual manufacturing industries are not yet available at the state level, but national figures show such Massachusetts’ specialties as electrical and electronic equipment and computers suffering much deeper cuts than manufacturing more generally.

The Bureau of Labor Statistics, along with other agencies, has recently re-done its industry classification. Information is a new industry category, including publishing, telecommunications, and a number of internet- related activities. Massachusetts information employment has fallen 19 percent since the beginning of 2001. Professional and business services is also a new industry group and combines such disparate activities as legal and accounting services, computer systems design, stand-alone corporate headquarters, employment services, and waste management. Employment here has fallen 14 percent. This is a large sector and the total numbers of jobs lost is similar to the job loss in manufacturing. In the early stages of the downturn, the job losses were concentrated in employment services--or temporary help. More recently, employment in computer systems design and related services has been falling. Sizeable cuts are also occurring in accounting, tax preparation and bookkeeping services.

The only major Massachusetts industries that are showing any appreciable growth are education and health services.

In a nutshell, the "new economy" activities that caused Massachusetts to enjoy strong growth and very low unemployment rates in the late 1990s have been severely impacted in the current period. This has turned a prolonged soft spell at the national level into a big problem for the state.

Despite this divergence, Massachusetts’ fortunes continue to remain highly dependent upon the national outlook. In particular, a pickup in investment spending, particularly spending for technology products is key to the state’s recovery. While I expect investment spending to gain strength over the course of year, the uncertainties are large.

Thinking about the longer term

Recessions, especially ones in which Massachusetts fares worse than the nation, inevitably give rise to anxieties over prospects for the long term. People want to know: What will be the next economic driver – the key innovation or industry—that will restore vibrancy to the economy?

My crystal ball is no clearer than yours. I don't have answers to these questions. But they have been asked before. In the early 1970s, with the end of the Vietnam War, cutbacks in aerospace, and intense competition from the sunbelt states, Massachusetts faced a severe crisis. But an industry that was on no one’s radar screen in those anxious times – minicomputers – transformed the Massachusetts economy. Again in the early 1990s, disaster loomed in the form of a real estate crash and the related banking credit crunch. And once again, people asked: " What will propel growth in the future? Where is the next minicomputer industry?"

As it developed, there was no minicomputer industry. Software and communications were important sources of growth during the 1990s, but the story was more complicated. A wide variety of industries took up the slack. Some large companies, like EMC, emerged from almost nowhere; but much of the vitality came from many relatively small, relatively unknown companies that were linked by their innovation and creativity. By 1997, the Massachusetts unemployment rate was a full percentage point below the national rate, and by 2000 it had fallen to 2.6 percent – an all-time low. The biggest problem for most firms, especially most high tech companies, was finding people.

So what does this short history tell us? First, when things look the worst, we won’t see the industry or innovation that will lead it us back to prosperity – but it will already be taking shape. Second, the new economic driver may not be in one area but in several. And most importantly, this history suggests that the underlying strengths of Massachusetts: its highly educated workforce, the excellence of its many colleges and universities, and a culture that has always valued innovation and creativity are the keys to a prosperous future. In this regard, it is important that we not respond to these difficult times and to the difficult fiscal situation in which state government finds itself with actions that undermine that our long run competitive advantage. But that is a speech for another time.

Conclusion

In sum, these are difficult times. Massachusetts is experiencing a prolonged and serious economic downturn. Its concentration in the new economy industries and firms that provided such vitality in the late 1990s has made it especially vulnerable to the deep cuts that have occurred in business investment. While I expect that the national economy will regain momentum in the second half of the year and that investment, particularly in the information technology area, will pick up, the outlook is unusually cloudy. With respect to the longer term, however, I am confident that Massachusetts’ wealth of intellectual capital and its ability to reinvent itself will keep the state on the forefront of innovation and assure its continued prosperity.