In an interview with John Roberts, CRN director of editorial research, Shilling gives his 12-month economic outlook, gauges the economic impact of energy prices and global political unrest, outlines future trends in interest rates and business capital spending (including IT investment) and looks at the role of overseas outsourcing in technology.

CRN: What's your overall assessment of economic conditions for the next 12 months, particularly growth and business investment?

SHILLING: The economy is slowing, and I suspect that by the end of the year it could very well be in recession. The basic reason is that housing activity is weakening, and that has been the mainstay of consumer spending, which in turn has been propelling the economy. During the past 17 quarters of expansion, spending growth has exceeded income growth by 2.5 percentage points on average, on an annualized basis. And housing is what has been supporting that, with people pulling money out of housing by home equity loans or refinancing. Homeowners have been reasoning that their house is a continually refilling piggy bank, so they can borrow more on their credit cards or save less because their nest egg--all their saving requirements--is taken care of by that house.

CRN: Something on the order of $600 billion in home equity has been taken out by consumers in the past couple of years.

SHILLING: That's right, and that is what is sustaining consumer spending, which accounts for 70 percent of GDP. Once consumers see that housing price appreciation is no longer the order of the day, then they are going to curb their spending, as they basically have no alternative. Construction and mortgage brokerage and all of what is related to it has accounted for about a third of the job creation so far in this expansion. If you wipe that out, you're taking a big check out of your economy. And housing prices don't even have to decline. If they simply level off, you have got a lot of people in trouble. And because we are essentially buying the world's excess goods and services, if U.S. consumers get into trouble, then you not only have a recession in this country, but also a global economic turndown.

CRN: What's your take on business investment in the coming 12 months?

SHILLING: A lot of people have looked on this as the "great white knight" that's going to ride to the rescue and pick up the slack in consumer spending. But two things are important here. One is that business investment [in software and hardware] has already been quite strong. If you look at the last couple of years, it has been growing at about a 10.5-percent annual rate. That's not markedly different than the 12.5-percent growth rate back in the late 1990s, during what was clearly an overblown capital-spending boom. So the first point is that in investment spending, the growth hasn't been all that weak.

The second point is, what do you do for an encore? You still have a lot of excess capacity left over from the late 1990s boom. My favorite example is fiber optic capacity. At the bottom, 3 percent of the existing capacity that was put in place in the late 1990s was being used, and now the figure is only about 5 percent of capacity. This is admittedly an extreme case, but there's a lot of capacity left over. So how much can you expect investment to grow from here to really spur the economy? Moreover, to make up for the consumer spending component I cited earlier, investment would have to grow at a 30-percent annual rate, and that is just not in the cards. So this idea of capital spending rescuing the consumer is not realistic.

CRN: So we could see a significant slowdown in consumer spending and constrained growth of business investment. That makes for a rather pessimistic outlook for the economy in general.

SHILLING: Yes, it does.

CRN: How much is political risk going to figure into economic growth in the coming year?

SHILLING: I think this, by and large, is overrated. If you go back to Sept. 11 [2001], there was a very strong feeling that everybody was going to crawl into their root cellar and never come out. Then GM introduced zero interest-rate financing, and people went back to buying cars. We had one quarter of softness in the economy, and then people went back to the stores. American consumers are pretty resilient, and as long as they've got money and can borrow it, it appears that it would take a tremendous jolt to scare them out of that.

CRN: If energy prices stay high in coming months, how much of an impact would that have on the economy?

SHILLING: It's going to have an impact, but not enough to sink the ship. Energy is important, but consumer spending on energy today is about 6 percent of their total spending. If you look back to the early 1970s, it was 9 percent. Two things have happened. One, we've had some energy conservation. Two, the service component of spending has increased so much relative to goods that goods--including energy--are simply a smaller percentage of the total.

CRN: Do you think technology spending will be a more or less important investment priority for businesses going forward? Or will it be constrained?

SHILLING: We've entered a new phase in technology spending. If you look at it historically, the glory days are during the stars-in-the-eyes phase when everybody thinks all new technologies are going to the moon. That's what we had in the late '90s. Then two things typically happen. One, new tech always kills itself with excess capacity. Two, new tech is superseded by newer tech, something we are seeing now in, for example, telecommunications. There is a lot of history involved, but I think it is important because what it says to me is that these glory days are over.

But that doesn't mean that new tech isn't going to be very important in the future. It is really a key factor in our [company's] long-term forecast of deflation. In a peacetime environment without oversized government spending, when you get a wave of new technology, you get deflation. It's great for the economy, and it's great for holding down prices and promoting growth. But it is tough on the majority of [technology] players. There are winners, but they are going to be few and far between.

So we are going through a phase, and now we are in phase B. There will be fewer players in the technology space. And there will be a lot harder of a look among businesses as to what technology spending is going to do to cut costs and promote productivity. Why? There are three reasons. One is that sales growth has been good--not spectacular, but good. Second, productivity growth has been strong. Third, and most important, American business has done a super job in holding down labor costs.

This has created profits, and a lot of it has piled up into cash. And I don't see any reason that this is going to change. I don't see any reason that American business is going to suddenly lose the kind of discipline that was really borne out of some tough times in the early part of this decade that gave them the zeal to be cautious. And if the economy is going to be back in the soup later this year or early next year, I would think there would be renewed enthusiasm to be parsimonious in technology spending.

CRN: So if our readership looks at that cash pile sitting there as a potential source of financing a new wave of technology spending, that might not be the case.

SHILLING: When you look at capital spending, you have got to see the motivation for it. Profit growth is one motivator, no question about it. If profit growth is strong today, businesses assume it will be strong tomorrow, and they will want to make sure they have adequate capacity and so on to meet it. But if the economy weakens, profit growth will likely weaken as well. Another big motivator, of course, is controlling costs.

But both of these [financial measures] are affected by globalization. Today, capacity shouldn't be measured just in the U.S.; it should be global. And in a lot of places, such as Taiwan, industries are moving up the scale of sophistication. They are not just factories anymore. [It's the] same for China and Japan. So for a lot of U.S. businesses looking to cut costs through technology, it is a trade-off: Do I automate further here at home, which involves more hardware and software, or do I move the operation overseas?

CRN: So you don't see the move to overseas outsourcing in the tech industry falling off anytime soon.

SHILLING: I don't see any reason for it. As I mentioned above, they are getting more and more sophisticated overseas. Of course, there are a lot of factors involved in the decision to automate here or ship the operation overseas, such as proximity to the customers, worries about pirating [technology], as well as technology transfer issues. There are a whole host of issues that have to be weighed carefully. But the point is that American business today--in a way that was just not there 20 years ago--does have that option [to outsource overseas].

CRN: So if a reseller can go to a business and demonstrate that technology spending will yield a measurable return on investment quickly, then the customer will spend the money. But if you can't demonstrate that, they won't spend.

SHILLING: That's right.

CRN: Many economists are concerned that the Federal Reserve will overshoot when it comes to interest rates, raising them too high and pushing the economy into recession. Are you concerned about that as well?

SHILLING: The Federal Reserve almost always overshoots. Since 1954, the Fed has undertaken 11 credit-tightening campaigns, and in only one of those--in the mid-1990s--did they succeed in effecting a "soft landing" for the economy. So the odds are that they will keep going until something happens, and that something is almost always a recession.

They do this because they cannot risk ending rate hikes too soon. If they were to back off and it turned out that inflation and the economy took off like scalded dogs, then they have to come in and really crush the economy to re-establish their credibility. And they don't want to do that. That is what happened in the late '70s. Inflation was out of control, and they had to precipitate not one but two recessions to let people know they had some teeth. And they don't want to repeat that. So I think the odds are this time that the Fed will persist.