The Genuine Uncertainty of the Y2K Future

by Paul H. Ray

0. It's about time for a recession anyway. It's late in the business cycle, and at such times, almost any random event can trigger a recession. The question is, not whether, but when, and how nasty. In this business cycle, the triggers are likely to be cascading from y2k: serious economic problems in other countries, higher costs, many direct hits to volume of sales, a possible energy crunch, inability of governments to do their normal countercyclical aid to the poor, etc. Which is to say, a very nasty kind of inflationary recession is quite likely. Once the financial markets get that this is so, they will exaggerate the problem by their usual panic response.

1. From the stock market to consumer spending and financial sector crunch: The stock market is already at a stratospheric high, in an overshoot-and-collapse mode, beyond prices that are sustainable. Sometime during the 4th Quarter - October is a favorite time - the market analysts can see that Y2K drastically reduces profits next year, and stampede for the exits. Normally a severe market correction is not that big a deal for the GDP, but this time a lot of consumer spending is supporting GDP and critically a lot of consumer spending is built upon the "wealth effect" of high stock prices. A big market correction (probably not a crash, but a big drop) would drive down consumer spending. It would also hit the rest of the financial markets hard. This will also crimp investment and capital formation.

2. Problems with foreign trade partners: Nearly all the U.S.'s foreign trading partners outside northern Europe and Canada are about one-third as prepared as we are for Y2K. Many are likely to have very severe declines in GDP because of y2k, probably combined with political and social problems: All the Asian Tigers, Japan, Russia, Italy, Brazil, South America. If so, many would be less able to export to the U.S. to get out of it, because y2k can to cut into their ability to export at all. As they become unable to buy, our ability to export to them would be hurt. A big drop in foreign trade would hit our GDP and theirs. Much political instability may result there. All this would cause a severe capital flight from these markets, dramatically worsening their economies.

3. Problems with foreign suppliers: The U.S. doesn't realize how much it depends strongly on an international supply chain in ways that it never before has. It also depends on shipping, and most container ships and tankers, as well as port facilities, appear vulnerable to y2k. Loss of those imports because foreign suppliers, or shippers, aren't functioning well can cripple parts of our supply chain, like parts for manufacturing, and food, and leave a number of industries scrambling, bidding prices up. If so, it would hit the costs and profits of many industries that don't export so much, but do use imports. Especially hard hit might be those who depend on "just in time" deliveries, and can no longer warehouse what they will need. This is very much a matter of cascades of disruptions coming into our supply chain within the U.S., and spreading here. (Just in Time systems are likely to be disrupted here, quite apart from foreign trade.) Disrupting the supply chain also would hurt our GDP, and theirs.

4. Problems of international finance: The international financial system has already been shown to be vulnerable to severe disruption by the way Mexico, Brazil and Southeast Asia all came close to upending the system. What if we see a major economic crisis in many more countries? Capital flight, bank failures, debt defaults, and stock market collapses elsewhere would not stop there. They'd ricochet right into the U.S. banks and financial markets. One of the key triggers to the '29 Crash and the following Depression was bank failures in the Balkans.

5. Stagflation with an energy crunch: We are likely to see an energy crunch, because several major suppliers to the world market seem to be really unready for y2k: Venezuela, Nigeria, Saudi Arabia, Russia (maybe Iraq and Iran). The major oil companies will be able to smooth over some of the problems, and emergency oil is being stored, but the problems are not likely to be disentangled for many months. That means an oil/gas price spike may not hit immediately, but after several months - a kind of hanging on bite afterwards. Probably just in time for the high summer demand. It's '73-74 and '79 energy crunches all over again.

The effect of an energy crunch is simultaneously to slow down the economy and increase inflation. Most of society depends on energy, and when energy costs go up and supplies go down, their own production goes down while prices go up. Everything that uses energy intensively is hurt by the higher costs, and that means an especial crunch in several sectors: tourism, transportation, utilities, farming, chemicals, some manufacturing, etc. Stagflation raises the misery index for households: both higher prices and fewer jobs.

In general, economic analysts like Ed Yardeni and Ravi Batra believe that y2k will have stagflation effects very much like an energy crunch. A number of vicious circles reinforce one another.

6. A cascade of small business failures: It's now clear that about half of small businesses are unprepared for y2k, and many are adopting a "fix on failure" strategy. They don't think systemically, and don't know computers. With that many all having problems at once, most will not be able to hire anyone to fix their equipment and systems. Many of these businesses may simply fail. They're not all retail operations, either. Many are suppliers to bigger y2k compliant companies, or suppliers to suppliers. This can directly hit the GDP. It can also give cascading effects of failures to deliver, or to manufacture, or to support other businesses. At the very least it should slow down the economy, even among y2k compliant companies.

7. Federal, state and local government failures: It's now clear that about half of all Federal agencies, and half of state, county and municipal governments will not get their act together in time. It's not just that they perform vital services for society and the economy. Most of them generate a lot of employment directly, and have numerous contracts with the private sector. That's probably income lost or delayed for many workers and companies, worsening the decline in GDP. In addition, these governments all have major health and social welfare functions that are among the most likely to be compromised. Medicaid, Medicare, unemployment compensation, food stamps, welfare payments. This would directly harm the poor and their ability to spend. It would also worsen the counter-cyclical income flows that normally moderate recessions. If anything, these government failures to spend can aggravate the recession.

On top of that, a huge amount of business in the U.S. depends on the Postal Service, if only for billing, and it appears really unready. If so, then failures to deliver bills and return payments would hit many businesses hard. This too can cascade business failures with parts of the economy that are otherwise okay. It can also hurt the poor who depend on those checks coming. This would directly reduce GDP.

8. Much higher cost, and lower volume, transactions: Our world economy, especially in the First World, depends for its efficiency, and for its level of activity, on high volumes of cheap, automated electronic transactions, many of which have date functions built in. It looks likely that a number of corrupt or noncompliant dates in transactions between companies will mess up databases, and cause delayed reaction problems: again higher cost, lower volume. Once you fall back on human backups, or can't trust what's coming in, everything would be slowed down and made more expensive. If so, this would directly cut at GDP, which is based on transaction volume, and is based on the profits per transaction. Both would go down. This would also crimp investment and capital formation.

9. Inability to deal with crime, fires, disasters. Police, fire and disaster relief have always depended on aid coming in from elsewhere when a community is in trouble. What happens when all 88,000 communities in the U.S. need help? Answer: nothing. They'd be on their own. Whatever disaster comes in the dead of winter may not be alleviated, so all the local problems are compounded. Major winter storms normally occur with a large response. What if it isn't there? It's not only lives lost, but many businesses ruined, and slow economic recovery. Statistically, this is extremely likely, and will simply worsen the effects of a recession. Most communities are not remotely ready to handle disasters alone, and the resulting confusion and poor response would also hurt. This can slow the economy noticeably.

10. The cost of an explosion of lawsuits. If any large fraction of the trillion dollars in y2k related lawsuits is true, then this would be a huge direct hit on GDP around 2001 or 2002, and in the in-between-time, it would distract managers for huge numbers of hours. It is likely to tie up the civil courts, so that special courts are likely. This would tend to drag out and worsen any recession, slowing recovery and making the economy much less efficient.

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