The case for aggressive easing.

ON FEBRUARY 13, CHAIRMAN Greenspan delivered his Monetary Policy Report to Congress. His comments suggested the economy may be rebounding already--a "V-shaped" recovery from the weakness of the last half of 2000. Markets responded as if the speech signaled a limited amount of easing.

Weakness appears to have returned in February--layoff announcements and unemployment claims were accelerating. Commercial paper sagged two straight months for the first time since 1994.

Plummeting consumer confidence is one of the reasons we suspect this slowdown will last longer than lust one or two quarters. We agree with the Fed chairman that recent productivity gains are secular and, in the long run, the economy will return to 4% growth. But the linkage between confidence and productivity gains is indirect. It works through capital spending that creates high value-added jobs, which return to labor not only increased wages but also a sense of confidence in the value of their skill set.

Forecasters have trouble predicting rapid reversals in consumer confidence. In the past, as shown in the chart, the labor market drove consumer confidence. Since the capital spending boom set off accelerating productivity, however, confidence has more closely tracked the stock market--with a six-month lag. That suggests stocks' current volatility could show up in confidence numbers as late as mid-year.

During the tech boom, equity stakes increased as a share of compensation. Since the tech sector correction began, wage bargains moved back toward wages and away from stock options. If job losses mount and the historic relationship to jobs resurfaces, restoring confidence will get more difficult even if stocks rebound.

The argument for a "V-shaped" recovery is founded on historical patterns of inventory correction. A typical slowdown to burn off excess hard goods production lasts about two quarters. There are two flaws that apply to that argument: 1. "Say's Law," and 2. "service inventories."

The wealth effect generated household spending beyond its demographic foundation for the past four years. Household debt is at a historical high and saving is negative. More compelling, both households and business have already curbed spending. In the fourth quarter, business equipment investing fell negative for the first time since the last recession.

Service production now dominates the U.S. economy, but its production is difficult to identify. Not only is it difficult to define and identify the end product of service production, we don't know how to measure its inventory. So much of service production is tied up in the human capital of its labor force that inventory correction in those sectors may be logically equivalent to layoffs--another risk for a severe, long-term labor market contraction.

Over the term of this ten-year expansion we saw two soft-landings, in 1995 and 1998. Indicators appear clearly weaker now than during those two periods. We see a need for more Fed easing--the sooner the better.