Daily Fix: How might Y2K bite the economy

Editor's note: This is the second in a series of articles examining programmer Ed Yourdon's predictions that the Y2K problem will cause a ten-year recession. (Read part 1.)

Ed Yourdon, in his recent article, "My Y2K Outlook: A Year of Disruptions, a Decade of Depression," provides readers with disconcerting images of America after Y2K to drive home his argument that the economy could topple with a push from a computer problem. Is Yourdon right, is the economy as fragile as that?

Economics is a dismal and inexact science, but the people who practice it do understand how a very complex system, the global economy, functions. That's not to say that economists can predict the future with complete confidence, but they can explain, given a set of inputs to the system the likelihood that various events will come to pass. Big events, like a recession, an increase in unemployment of more than one percent, and significant changes in interest rates or the money supply. And, today, the signs that Y2K is bringing on a depression just aren't there.

To support his depression argument, Yourdon doesn't use facts. Instead, he engages hyperbolic images of the third world and Japan's long economic woes for which he says "it's hard to imagine a term more accurate than depression." His picture of the economy, as a thing buoyed by consumer confidence, is only partially correct. In addition to confidence, economies are sustained by very real mechanisms that can be measured and managed - the money supply, interest rates, and government fiscal policy. In a word, his economics are simplistic.

Is Japan in a recession or a depression? Yourdon explicitly states that Japan's economic problems have "lasted nearly as long as the Great Depression lasted, and in many ways (e.g. stock market averages), it's almost as severe." While the problems in Japan have been difficult, the downturn is merely a long recession, more similar to what the US experienced in the 1970s than the 1930s. Japanese stock prices, while they have declined dramatically and, at times, precipitously, have never approached the percentage lows that marked the Depression.

Today, unemployment in Japan is at a record high, of 4.3 percent - just about our record low for unemployment. During the Depression, US unemployment ran in the high teens and as high as 50 percent in some areas. Too, because of the Japanese propensity for saving, which has increased over the past decade, senior citizens and families are not finding themselves without a penny, as Depression-era families around the world did. In fact, the government continues to try to spur spending with tax cuts and subsidies to no avail. So, it's absolutely incorrect to say that Japan has experienced a depression.

Japan has endured a long recession during which growth has slowed substantially brought on by poor banking practices. Consumers there have refrained from spending and continued to save in conservatively-oriented ways, like bank accounts. Investment activity or spending, both needed to re-ignite economic growth, are proving very difficult to stimulate, indeed, because of long-established cultural habits. At this writing, overnight interest for bank loans have fallen to less than .01 percent in Japan, and still consumers are not spending more.

So, when Yourdon writes that depression is possible because "If it can happen in Japan, I believe it can happen in the U.S. and Europe as well," he's merely tossing brickbats.

Yes, folks, a recession can and will happen in the US. Y2K may not bring it on. But, are a combination of factors that could lead to a depression present today?

Changing behavior

Yourdon argues that Y2K will work a total transformation in consumer attitudes, writing "we may be forced to adjust to this [reduced productivity and efficiency caused by Y2K] by accepting the manana attitude that citizens in many developing nations take for granted." It's hard to imagine the US simply giving into a change this dramatic. Would it not be more reasonable to conclude that, even in trying circumstances, people would work to solve problems, possibly by coming up with new services or companies in the meantime? Though it may seem to Yourdon that people are subject to nationwide transformations in behavior and values, this is an opinion that is not borne out by any social research.

This argument, though, cuts to the central point in Yourdon's message about Y2K. He predicts a loss of confidence in technology, which may or may not come to pass due to problems with hardware and software. While I don't think that the widespread failures he foresees will come to pass for reasons covered in many other articles and columns, this is a concern with regard to stock prices, which are primarily driven by enthusiasm about technology companies and the increasing productivity technology delivers in older industries.

Believe it or not, we've been through major failure of infrastructures in the past, though the circumstances are always different enough to warrant skepticism about conclusions drawn based on two far-flung economic or historic events. However, for argument's sake, world trade has collapsed many times in the past. During the late middle ages and early Renaissance disease, particularly plague, interrupted trade at intervals. When plague struck, fewer traders would take to the horse-powered highways of Europe and Asia, substantially reducing imports and exports. Since the early 19th century global conflicts have interfered with shipping and trade relationships.

The question to ask about those events challenges Yourdon's assertion that Y2K will change business and consumer values, forcing society backward: Did any of those global trade interruptions of the past change values to the extent that they permanently reduced the pursuit of trade and profit? The answer is, of course, "no."

Confidence man

Underlying the entire article is Yourdon's claim, in the final section, that "the entire economy relies on confidence; that alone is the major reason why Japan is in a state of depression, and we're in an economic boom."

Yourdon, like many programmers, seems to think that systems not reduced to computer code, are phantasms that people can brush away with a change of mind. But they are not. According to Gail Foster, chief economist for the Conference Board, the reasons that recessions begin are almost entirely mechanical. The mechanic is the Federal Reserve, which can adjust key factors in the economy. "[T]ests using the [Leading Economic Indicators (LEI)] indicate that the yield curve would have to be inverted by at least 300 basis points [three percent] to qualify as a possible signal of recession," Foster wrote in the Conference Board's February, 1999, StraightTalk newsletter. "In short, the economy is not likely to experience a recession without significant tightening [of the money supply] by the Fed."

Note that Foster says that a three percent change in yields would be necessary to indicate a possible recession, not to ensure one. These indicators have turned down before every one of the last six recessions in the US, but they have also turned down seven time in the past 14 years, with only one recession having actually come to pass in their wake. All the other indicators in the LEI, including consumer confidence, labor, and manufacturing are at or near all-time highs. For example, consumer confidence historically averages a rating of 100, but in January, 1999, consumers ranked their present situation at 172.1.

According Deutsche Bank Chief Economist Edward Yardeni, the leading Y2K bear on Wall Street: "In a Y2K scenario, corporate earnings are likely to fall dramatically, but so are interest rates on US Treasury securities. I expect that both the federal funds rate and the 30-year Treasury yield could fall to three percent in 2000." Yardeni's forecast calls for far less severe changes in the yield curve than thought necessary to create the conditions that lead to a recession.

"[G]rowth is and will be driven by favorable financial factors," Foster wrote, pointing to the yield curve, money supply and stock prices. Only stock prices have anything directly to do with public sentiment. Federal Reserve officials have repeatedly expressed their commitment to keeping interest rates low and increasing the money supply through the beginning of 2000, to ensure that banks have cash available for depositors who want to withdraw funds and business customers that need loans. Except for stock markets, there is no key indicator that may be driven down by fear in the coming year.

And there's a powerful force that can be brought to bear against economic impacts of Y2K that, in the face of declining consumer and manufacturing indicators, buttresses the LEI against recession: productivity.

What about the upside?

According to some surveys, as much as 50 percent of information technology budgets in many companies has been diverted to Y2K repairs. The Fortune 500, which is represented by the Dow Jones Index, and the S&P 500, which covers many NASDAQ companies, are making good progress on Y2K.

If these companies enter late 1999 with their IT budgets newly freed up to invest in productive projects (remember, Y2K is basically an "invest to stay where you are" project), they may ignite a burst of technology buying at a time when many Y2K pessimists expect technology stocks to be suffering. Likewise, large manufacturing and distribution firms will be turning resources to increased efficiency. The effect on stock prices, as firms make optimistic statements about future earnings, could be powerful.

So, instead of seeing a severe downturn in stocks due to a lack of confidence, there is at least as great a chance that the renewed strength of stocks could buoy the economy against Y2K downsides. That's not to say there will not be problems or that lawyers won't be taking liability suits to court, but optimistic earnings could be a tonic against the negative impacts of Y2K on stocks.

The real economy

Fact is, there are a lot of reasons that the economy could go south, but Y2K is not currently thought to be one of them. By this time, there would be signs that companies were hedging costs against potential negative impacts on revenue and the cost of litigation. But there is little news that could be construed as evidence this is taking place.

Deutsche Bank's Yardeni reports that Wall Streeters are just waking to the Y2K problem, but other sources suggest that both companies and the analysts that track them have been paying attention to the problem for a long time. Since the market tends to price problems into stocks some nine months in advance, a widely known issue like Y2K (because, we're not talking about an earthquake here, this is something people can put a date to, for the most part) we should expect that by the beginning of April, the stock market will show the first tremors of real insiders' fears about Y2K.

"For the stock market, the drop in rates should offset some, but not all of the bad news on earnings," said Yardeni. "I expect that stock prices could fall at least 30%. I am not sure when investors will start to discount Y2K in stock prices, but it will be by the summer of 1999."

Certainly, Y2K, which has affected more than 50 percent of companies according to research firm Cap Gemini, has not produced significant downward pressure on stock prices, except at firms that sell Y2K products and services or those companies whose products have been benched for the duration of Y2K repairs. When Coke, Ford, Boeing or companies like that report they suffered substantial Y2K-related losses or unrecovered costs, then there will be some substance to Yourdon's argument that falling confidence will shake the markets.

Ironically, the International Monetary Fund's economists in its December, 1998, World Economic Outlook and International Capital Markets Interim Assessment says that a downturn in stock prices and rise in interest rates that stimulated savings would be good for the US economy, even if it produced short-term loss of consumption and confidence.

The real threat to the US economy, along with Europe and parts of Asia, is deflation, the general drop in prices of goods and services, which The Economist reported this week is a very pressing concern for central banks that have long focused on reduced inflation. "Even Japan, despite dreadful policy errors, has not experienced declines in prices as bad as those in the 1930s."

The solution to deflation is increased money supplies, which is just the cure for consumer concerns about Y2K. In Thailand, as well as Australia, Canada and the US, among others, the government announced it will have extra cash on hand for banks to give depositors concerned about Y2K. The resulting increase in spending when Y2K problems don't turn out to be as bad as believed -- which will be the case in most places -- could more than offset losses due to Y2K.

Now, I'm no economist, but I have done more homework on the economy that Ed Yourdon. His economic analysis, which calls on readers to prepare for the worst, is flawed by a poor understanding of economics and a general predilection to see the world and its economy in over-simplified terms that exaggerate the importance of information technology. It's not correct, based on the mounting evidence from critical dates that have already passed, to claim the US will enter a depression due to the Y2K bug. It is not a straw of sufficient weight to, in Yourdon's words, "break the camel's back."