This month, Wall Street appears to have ignored altogether the lack of a football, and instead celebrated a non-existent field goal. After an initial dip that may have owed much to a downward forecast revision by tech bellwether Intel, the market rose on the day Friday, while bond prices soared, as investors' rejoiced that the Fed would not soon be raising interest rates.
The optimism before Friday's report was truly startling -- many commentators explained carefully to their readers that actually the consensus estimate for job gains (128,000, according to Thomson FirstCall) was far too conservative, and the real figure would be well over 200,000, signaling the reality of an economy roaring back to life. As Larry Kudlow, chief economist of Bear Stearns wrote in National Review on Thursday: "Before the December and January jobs reports, I took the 'over' in the pre-announcement betting. ... Fearlessly, I'll take the "over" again."
Gee, Larry, let me know where I can get some of this action. For the 40 months that I have been writing this column, Kudlow has consistently taken the "over" on every economic statistic. On employment, he's been right maybe 3 times.
February's employment report was truly dreadful. Instead of the 128,000 job gains predicted by the Wall Street consensus, according to Thomson FirstCall, there were only 21,000 job gains, fewer than the downward 23,000 revision to January's gains. It's clear that we're not going to get the 3.8 million new jobs in 2004 absurdly promised by Bush in January's Economic Report of the President, far from it. But the interesting question (intellectually, if you're not hoping to be one of the 3.8 million) is: why not?
Employment patterns are not following those of a normal economic recovery (even the "jobless recovery" of 1991-93 had created millions of jobs two years after the low point) for one very simple reason: this is far from a normal recovery.
Its abnormality can be shown in a wide variety of ways, one of which is that in the first two months of 2004, the Bank of Japan is reported to have bought over $100 billion of U.S. Treasury bills and bonds, thus single-handedly financing approximately the entire federal budget deficit in those months. This has propped up the U.S. dollar exchange rate against the yen, presumably the Bank of Japan's reason for doing such a wealth-destroying (in yen terms) thing. More important as far as the U.S. economy is concerned, it has enabled long term bond rates to remain artificially depressed, well below where they would normally be given today's level of inflation and demand for money, thus further fueling reckless expansion in the U.S. housing finance sector. Since homeowners who refinance their mortgages frequently buy a Toyota with the "takeout" proceeds, there is I suppose some rationality to this from a "Japan Inc." perspective, but there's no question that it throws a thoroughly non-market-driven monkey wrench into the economy's price signaling mechanisms.
Some further signs. The U.S. corporate sector financing gap in the fourth quarter of 2003 was minus $74.7 billion, slightly lower than the third quarter's minus $78.8 billion -- the first time since 1975 that corporate cash flow has exceeded capital spending for three consecutive quarters. While good news for the corporate sector, this is not a sign of robust economic growth. It is instead a sign that corporate capital investment, having surged to unimagined levels in 1999-2000, is still severely depressed and is not about to return soon.
The dearth of capital spending is remarkable, since companies can benefit from 50 percent bonus depreciation for tax purposes until the end of 2004. It is not surprising, as capacity utilization remains below 75 percent and is showing no sign of fast recovery in spite of ebullient growth in gross domestic product. That's why there aren't any jobs -- in a normal recovery, by this stage, companies are hiring people and planning facilities expansion. Not this time.
The productivity of capital in the United States reached a post-World War II low in 2001, as huge amounts of capital raised in 1999-2000 were deployed to very little economic benefit. When 2002 figures for multi-factor productivity are published by the Bureau of Labor Statistics in April it will be very interesting to see whether capital productivity, in 2001 down 32 percent in the non-farm business sector from its 1966 peak and 8 percent in the 5 years from 1996, has fallen any further.
The stock market remains at extraordinarily high levels by historical standards, with the cost of equity capital correspondingly low, itself a factor leading directly to low capital productivity. While some of the particular market abuses that disfigured the late 1990s have brought retribution, the overall climate remains one of "easy money" and inattention to shareholder value, with the refusal to expense stock options and the continued overuse of "extraordinary items" to remove costs from companies' income statements being obvious symptoms of malaise.
Consumer spending has remained strong, in spite of a general lack of consumer confidence, mainly because of the cash flow from tax rebates and mortgage refinancing. Unless the Bank of Japan buys $200 billion of T-bonds next month and drives long term interest rates down so far that everybody can refinance again, this is not going to continue. February, which showed strong chain store sales Thursday and is likely to show strong retail sales next week, was an exceptionally strong month for tax refunds, caused by the decline in withholding tax rates in the middle of 2003, and was also a very strong month for bonuses, which on Wall Street were up by 25 percent.
However, March and April, when late-filed tax returns are received by the Treasury, will be nothing like as strong, because the rise in the stock market in 2003 produced a high volume of capital gains tax liabilities. These will provide the Treasury with the first positive revenue surprise since 2001, but will on balance negate the payments of tax refunds due to consumers -- in general, of course, refund tax returns get filed before tax returns with a balance due. Thus, unless the economy finds a new driver from here on, consumer spending will cease to be the backbone of the economy as it has been for the last 3 years.
At this point, with both tax cuts and monetary laxity about played out as stimuli to the economy, the central contradiction in the economic picture will begin to take effect. The United States, far from being the economic dynamo that its admirers like to paint, has been living hugely beyond its means since 1995, and now faces severe problems of budget deficit, balance of payments deficit and capital overhang.
Capital overhang sounds arcane but isn't; it is the syndrome, first diagnosed by John Maynard Keynes in the 1930s, which occurs when a country has through a stock market or real estate boom over-indulged in capital investment, and faces a prolonged period of low returns, over-capacity and low investment in new facilities. It occurred in the United States in 1929, in Japan in 1990 and in the U.S. in 2000. The Greenspan/Bush policies of throwing money and tax cuts at the problem have certainly mitigated its immediate effects, as did Japan's low interest rates and budget deficits in the 1990s, but in the long run the price of depressed capital markets, low returns and low investment must be paid. By now, there is over-investment in housing as well as in capital equipment, and a correspondingly greater drag on the economy to be faced.
Expect the economic figures that appear over the next few months to produce primarily negative surprises, as Wall Street analysts fail to realize the depressing reality of today's economy. Judging by its performance Friday, the stock market will largely ignore these negative surprises, maybe for some months to come. Probably by the summer, however, the truth will dawn that the tax cuts and monetary stimulus have failed to cause a true recovery, and that even the Bank of Japan cannot bail out the U.S. economy forever.
When this realization dawns, you can expect optimism to turn to panic, and Charlie Brown to turn on Lucy and pound her into the playing field!
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of "Great Conservatives" (Academica press, April 2004) -- details can be found on the Web site greatconservatives.com.