underconsumption undertow?
Source Jim Devine
Date 02/08/25/11:38

August 25, 2002/New York TIMES
Cost-Cutting Can Start a Ruinous Circle

In Alice in Wonderland fashion, we talk of expansion and ignore the
contraction all around us. We convince ourselves that out of cost-cutting
will come prosperity. But while cost-cutting can lift a single company or
two, when practiced widely enough it can pull down an economy. And that is
happening today.

Few economists acknowledge this dynamic. Corporate cost-cutting and
labor-saving layoffs appear in the forecasts as the golden road to greater
productivity and rising profits. Never mind that we have just fired the
workers and extinguished the salaries that would have been spent on the
merchandise and services to fatten the profits. With sales revenue failing
to rise, we cut costs more. The process feeds on itself - until there are
not enough workers and salaries left to generate sales and profits.

There is hyperbole in this description, but not much. As a nation, we are
caught in the strangest and perhaps most perilous recovery since the
Depression - featuring a dynamic that William Dudley, chief domestic
economist at Goldman Sachs, characterizes as "the corporate paradox of

"If everyone tries to cut costs and save more, no one saves more," he said.
"If you and everyone else cut costs, costs do indeed go down, but revenue
also goes down, so profits eventually go down, too. Collectively, we can't
cut our way to prosperity."

Individual companies - defending themselves, not the economy - have good
reason to throw themselves into this behavior. In one profit report after
another this summer, the story has been the same: Sales revenue was flat or
barely rose in the second quarter, but don't worry, profits were up.
Cost-cutting and labor-saving efficiencies fattened the bottom line, and
revenue will soon rise as lower costs allow us to cut prices and take sales
away from competitors.

That is fine, for a while, for the winning company. But consider what
happens in an imaginary country where Burger King and McDonald's are the
entire business sector and the total national output - 100 hamburgers a day,
evenly divided between the companies - matches the demand from this nation's
consumers. Demand and sales revenue, however, stay flat. So Burger King lays
off two workers and uses the saved wages partly to fatten profits and partly
to discount prices by just enough to take sales and revenue away from
McDonald's. And McDonald's responds in kind.

But soon, the four laid-off workers, with little income, buy fewer
hamburgers, and the nation's total consumption drops to 95 hamburgers a day.
That sets off another round of cost-cutting and price discounting, and our
imaginary nation sinks gradually into stagnation or deep recession not
unlike America in the 1930's.

Why isn't that danger uppermost in everyone's mind? Why are forecasters like
James Glassman, a senior economist at J. P. Morgan Chase, so optimistic? In
a nutshell, they expect an infusion of demand from somewhere that will
reverse the cost-cutting and persuade companies to expand investment,
production and hiring. Their main hopes are more tax cuts, more growth in
federal spending and more interest rate cuts by the Federal Reserve. They
also count on people to finance consumption by continuing to extract equity
from their homes, which are still rising in value.

Mainly, though, it is stimulus from Washington that for Mr. Glassman will
save the day. "If Washington cannot get us moving toward full employment
within a year," he said, "then there will be more federal stimulus. We have
learned a lot since the Depression about how to fix the economy."

BUT perhaps not enough. Perhaps we have become too accustomed to the other
post-World War II recoveries, which were so different. There were no
excesses to overcome from a stock market bubble and an insane rush by
business to expand far beyond demand. Instead, when consumption rose, there
was shortage and rising prices. To control inflation, the Fed pushed up
interest rates. In response, consumption subsided, provoking a recession -
until rates came down and pent-up demand reasserted itself. Business stepped
up investment to keep output abreast of demand, and recovery was on its way.

In the current cycle, however, consumption - particularly for cars, housing
and appliances - never tapered off from very high levels during the
nine-month recession that started in January of last year. It has still not
tapered off, but it is not rising, either, and that is a problem. Recovery
requires increased consumption and business investment to make the economy
grow. The danger today is that demand will decline instead, and recession
will return - or there will be prolonged stagnation. Unfortunately, Mr.
Dudley's "corporate paradox of thrift" is pushing hard in that direction.

Copyright 2002 The New York Times Company

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