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The Providence Journal, Commentary Page, July, 2001

Everyone is aware of the slowing rate of economic growth nationally. Not long ago, there was the presumption that the US was mired in recession, based stock market weakness, rapidly rising energy prices, and readings from a group of indicators that reflect the strength of the manufacturing sector. What emerged from this was a reminder concerning the evolution of the US economy: while manufacturing still matters a great deal, we are in a "post-industrial" era. So, to the surprise of many, we witnessed a vivid demonstration of how our manufacturing sector could be in the midst of recession while the overall economy was not. And, economists dusted off an old phrase, growth recession: the rate of national economic growth had slowed to the point where job growth was no longer adequate to prevent the unemployment rate from rising.

Since that time, there have been strong doses of monetary stimulus injected into the economy, in terms of six rate cuts, hotly debated fiscal policy stimulus, where the checks are (finally!) in the mail, and energy prices that have declined sharply from the levels they had risen to only one month ago. The ongoing problem, many feel, is the lingering effects of the "wealth effect," where dramatic declines in the NASDAQ and sufficient pain from a falling Dow Jones Industrial Average have cost investors a great deal of the wealth they had amassed before these averages began their less-than-gracious declines.

In Rhode Island, where lagging the national and regional economies has unfortunately become the norm, the red flag went up starting in January. Several persons proclaimed that Rhode Island was already in the midst of a recession. A short one, they assured us, but a recession nonetheless. Interestingly, they never provided a basis for their assertion. Was it just Rhode Island's luck? Was this just inevitable for a lagging economy like ours since there was so much national weakness? Who knows?

Well, I think I do. A number of years ago I developed a Current Conditions Index (CCI) that reflects the current state of the Rhode Island economy. While the CCI isn't exactly setting the world on fire right now (it has fallen into negative territory for three consecutive months), it has not provided a recession signal as yet. That would require six or more consecutive months in negative territory. By following a broadly based set of economic indicators it is possible to see where Rhode Island's current strengths and weaknesses lie. Is manufacturing here in a recession? It's hard to tell: manufacturing employment here has declined every year since 1984. And, when viewing total hours worked in manufacturing, the declines are not excessive. Of course, this could be the result of data in need of revision (we won't know until February). Retail sales have fallen for two of the last three months. Yet monthly levels remain high by historical standards. Existing home sales, like retail sales, have lost their record-setting pace, yet these too remain high (at 1998 levels).

The weakness here is reflected in layoffs, which have cut into job growth and resulted in our unemployment rate surrendering its full employment status too quickly, and new home construction. Layoffs here, like the nation, have risen sharply. New claims for Unemployment Insurance (UI), the timeliest reflection of initial local layoffs, have risen at double-digit annual rates every month since February. Persons who become re-employed after jobless spells have also been hurt by layoffs. Additional UI claims have grown at a greater than 20 percent annual rate for two of the last three months. As this has occurred, Rhode Island 's unemployment rate rose from its most recent low of 3.6 percent in February, to 4.7 percent in June. Unfortunately, our string of consecutive months with the highest jobless rate in New England is not in jeopardy: our June rate was a 1.3 percentage points above the next highest rate in this region (Massachusetts). New home construction here actually began a prolonged double-digit decline in April of 2000! Interestingly, for May, this indicator improved, but not by much.

So with all this bad news and my economic indicator signaling the strong possibility of a recession, why do I not see Rhode Island entering a recession in the near future? In addition to the usually cited reasons, interest rate cuts, soon to arrive IRS checks, and declining energy prices, there is a positive wealth effect at work here. Do I mean that Rhode Islanders are more savvy investors than everyone else and that they didn't get "clipped" when the stock market declined? No, I do not. What I am referring to is the fact that the wealth effect does not pertain exclusively to capital gains or losses from the stock market. Home equity is another form of wealth that can potentially sustain or propel consumer spending. And recently, median home prices in Rhode Island have shown the most life they have in quite a while. Consider the following statistic: the median price of an existing home in Rhode Island rose from $142,000 in June of 2000 to $166,500 in June of 2001, a 17.5 percent rise. In fact, home prices in Rhode Island began their dramatic rise at approximately the same time the NASDAQ began falling from its peak. So, one of the reasons why retail sales have shown such resilience here is the home-equity-induced wealth effect.

The Wealth Effect in Rhode Island

This dramatic run up in home prices is a textbook example of supply and demand at work: strong demand for housing  accompanied by a dwindling supply of available homes for sale caused home prices to rise, which, in turn, resulted in rising home equity. These increases in home equity have permitted a healthy amount of debt consolidation to occur while fueling some of the retail sales strength that occurred here even as the NASDAQ was falling.

Rising home equity has allowed some existing homeowners to re-finance their primary mortgages at more favorable rates, with an increased principle that can be spent on durable goods, or to extend the limits of equity-based personal lines of credit, which are tax deductible and offer lower rates thanks to monetary policy. And, given Rhode Island's demographics, there is another potentially important source of equity that can be used to finance spending. As our population continues to age, increasing numbers of Rhode Islanders find themselves wishing to sell their homes and move to rental properties. In years past, federal tax law restricted persons younger than age 55 to a one-time capital gains write-off from the sale of a primary residence. Current tax law has eliminated this provision. So, this avenue for tapping home equity has also been available to increasing numbers of Rhode Islanders.

If my intuition is correct, this home-equity wealth effect in its various forms has bought Rhode Island precious time as the 6-9 month lags in the effects of the series of interest rate cuts take effect, as gasoline prices come down much slower than they rose, and while persons wait in eager anticipation for their IRS checks to arrive. Soon, all of these forces will combine to generate enough momentum for Rhode Island to avert a recession this year.

Let's hope so. Recessions are never pretty. And, let's not forget, Rhode Island is one of the most cyclically sensitive, if not the most cyclically sensitive state in the nation. Placing so many of our "eggs" in the retail sales and tourism "basket" will prove to be more than a little problematic when the next recession actually occurs and as we attempt to recover from it.

by Leonard Lardaro

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