WASHINGTON, Sept. 29 (UPI) -- Conventionally, there are thought to be two routes to escaping from economic depression: pumping up the money supply and boosting public spending. Unfortunately, the Bush administration and the Fed have now carried both about as far as they will go, and last week's economic statistics suggest the U.S. may still not have escaped depression's clutches. So, if depression or deep recession sucks us in again over the next year or so, what to do next?
Make no mistake about it: the economy may look superficially strong, but the undertow towards decline is ferocious. U.S. consumer spending in the last few weeks has been weaker than expected, at a time when the consumer has been blessed with record levels of mortgage refinancing, followed by a very substantial tax rebate. It is likely that the fourth quarter's retail sales and consumer spending figures will come in much weaker than those to early August, at which point economists' attention will turn once again to business investment, supposed by now to be pulling the U.S. economy out of the mire.
U.S. business investment, however, is not showing the strength that many had expected. While world semiconductor sales were modestly strong in August, according to figures released Monday, the overall trend of the last six months has been weak, with the SEMI book to bill ratio consistently below 1. Since information technology equipment is the area in which business investment can be expected to be strongest -- there is still, I think, an overall secular up-trend in IT's share of the economic dollar, and the temporary surge in investment due to the Y2K nonsense has now been entirely absorbed -- the lack of a stronger upturn is damaging news for business investment and the economy as a whole.
Housing sales have been extraordinarily strong this year, much stronger than I had expected, and the example of the Tokyo real estate market in the late 1980s demonstrates that a house price bubble can continue far beyond the limits of rationality before returning to earth. Nevertheless, the modest up-tick in interest rates since June has at least diminished the huge volume of mortgage refinancing, and that in itself can be expected to depress consumer spending and, eventually, the bubbly housing market.
Most important, the stock market has risen sharply this year and remains at a level that defies rationality. An article in TheStreet.com last week detailed Cisco's share repurchase plans, that have devoted the company's entire cash flow since 2000 simply to keeping the number of shares outstanding constant in the face of massive stock option issuance. This demonstrates that for even the strongest companies involved in the 1990s tech boom, funny accounting continues to play an all too prominent role in reported earnings, so that price-earnings ratios, already high in nominal terms, are in real terms astronomical. I have forecast several times in the past that I expect the Dow Jones Index to go to 5,000 before companies are reasonably valued, and the S&P 500 Index to 600. I remain of this view, and believe that the initially gentle slide towards these levels began last week. The continuing U.S. trade deficit of $500 billion per annum, now joined by a Federal budget deficit of at least that amount, are further evidence that the present situation, and present level of stock prices, is wholly un-sustainable.
If I am right, and the stock market and U.S. economy enter a period of serious slippage, there are no more monetary or fiscal tools left to fight decline. At 1 percent, the Federal Funds rate is heavily negative in real terms and about as low as it can go without causing serious disruption to the money market mutual fund industry. Similarly, at $500 billion in the year to September 2004, based on an economic projection that appears optimistic, there is no more room for fiscal stimulus, and an increasing need for fiscal tightening (no, we do NOT need a prescription drugs entitlement at this time!)
It is thus likely, that by the Presidential election of November 2004, the economy and stock market will be in a state of serious recession, much as I had forecast at the time of the last Presidential election in November 2000. Their path to getting there will however have been different, with a much more gentle decline than I had expected, and even something of a recovery, in 2001-2003, followed by a steeper and more serious decline from now to the end of 2004.
As I said, traditional Keynesian remedies for recession, trotted out every time there appears to be a problem, will not at that stage be available. However, there is a dirty secret about Keynesian stimulus by a burst of government spending: it doesn't work. As the U.S. economy of 2001-2003 has exhaustively demonstrated, such stimulus can provide a considerable boost to the economy in the short term. However, increasing the size of government, which increases the percentage of national output absorbed by government, inevitably less efficiently allocated than by the private sector, is a serious depressant to the long term rate of economic growth, as I demonstrated two years ago using Organization for Economic Cooperation and Development figures dating back to 1960 for the OECD's 30 members. Thus after a few months of stimulus, Keynesian spending leaves the economic situation worse, not better.
Two well known examples demonstrate its fallaciousness.
First, in the U.S. in the 1930s, continual increases in government spending, accompanied by a massive increase in regulation and an extraordinary harassment of business, particularly the capital market, kept economic growth at a very low level for no less than 12 years. The descent from 1929's boom conditions to 1932's deep slump was inevitable, and unlike this time round was over very quickly (33 months top to bottom, a point we passed last December) but it was exacerbated by a tariff increase and an income tax increase, and was then prolonged for more than a decade by the spending increases and anti-business regulation of the New Deal.
The right policy was demonstrated by British Chancellor of the Exchequer Neville Chamberlain, who in 1931-32 devalued the pound by leaving the Gold Standard, cut public sector wages by 10 percent, refused to impose farm subsidies, for which there was much demand at the time, and eliminated the "free rider" policy of unilateral free trade that had been a British shibboleth since 1846, but which the country could no longer afford. (Even after the Ottawa agreement of 1932, however, Britain's external tariffs, at 10-15 percent, were far below those in France, Germany, Japan or the United States -- it wasn't Britain's fault that world trade in the 1930s reverted as a percentage of output to the levels of a century earlier.) The result was a decade in which Britain exhibited considerable economic growth, and a performance far superior to any of her major trading partners.
Similarly in Japan, the extraordinary rise in public spending and the public sector deficit in the 1990s, together with a refusal to allow the necessary bankruptcies and destruction of bubble-era overcapacity, kept the Japanese economy in a state of zero growth for more than a decade, and took the Tokyo stock market down from an index value of 39,000 far beyond the 15,000 that was probably its equilibrium, to a low so far of below 8,000.
Only since the arrival of prime minister Junichiro Koizumi in 2001 have brakes been put on the expansion of Japanese public spending. The result has been economic recovery, at first hesitant but now apparently gathering momentum. The banking sector problems, that foreign observers had declared were essential to solve before recovery could begin, are lessening as economic recovery returns many of the banks' customers from the casualty ward to normal life, and the Japanese stock market has begun a steady rise from a level at which by any standards it is reasonably valued. Provided Japan takes no notice of U.S. Treasury Secretary John Snow, and ensures that the yen's trade-weighted exchange rate remains fairly weak, even if the yen strengthens somewhat against the probably very weak dollar, recovery is likely to continue. Koizumi has followed more or less the path of Chamberlain, and appears likely to be similarly rewarded by an economy which shows relative strength in an otherwise recessionary world.
The other economy that has recovered from financial crisis to a position of unexpected strength is Vladimir Putin's Russia. The Russian collapse of 1998 only peripherally involved the equity markets, which were overvalued, but nowhere near as outrageously so as the U.S. market in 2000. Instead, it involved the collapse of the banking system, which was riddled with corruption and whose deposits had almost all disappeared overseas. After a couple of years of very real hardship, involving a stock market drop of more than 90 percent, Putin stabilized the currency, keeping the money supply under tight control, reduced public spending, and instituted a new income tax at a flat rate of 13 percent, thus greatly diminishing the black economy. In addition, of course, world oil prices have recovered very substantially since 1998, making Putin's task easier. Nevertheless, Russia's economic recovery, to a position where its larger companies are again attractive to international investors and its economy is showing growth in the high single digits with no sign of overheating, and where the stock market has recouped more than half the losses of 1998-99, has been quite remarkable.
I could go on. But the examples above, from four different countries in three different eras and situations, show what must be done. The U.S. dollar must be allowed to decline (like sterling in 1931) to a level at which the trade deficit significantly diminishes -- perhaps $1.50 to the euro at some point in the next 12-18 months -- after which a tight money policy must be instituted, to increase the rewards of saving and restore confidence in the U.S. economic system. Public spending must be put on the tightest of leashes, so that it declines as a percentage of GDP and the budget is brought back towards balance by spending cuts, shrinking rather than increasing government's share in the economy. Taxes must on no account be increased; to do so would only repeat the disastrous mistake Herbert Hoover made in 1932, sucking resources out of the productive sectors of the economy. Most important, in order to avoid a 1930s style collapse of world trade, protectionist actions, such as 2002's steel anti-dumping duties and increase in farm subsidies, must be avoided completely, and every effort must be made to restart the process of the Doha round of trade talks, and thereby kick-start the engine of world trade.
Such a policy will sharply reduce the excessive consumption that the U.S. people have enjoyed since the middle 1990s, and will increase U.S. savings rates back towards a sustainable level -- much higher savings will be needed to restore savers' personal balance sheets after the stock market drop and probably a house price decline. By reducing the consumption patterns of the U.S. population to a level at which they can be supported from the country's production, the competitiveness of the U.S. economy will be restored, and its economic growth will be enabled to restart on a sound basis. Only by such a reduction, in a deflationary environment worldwide, will the U.S. be able to avoid very high unemployment and the misery that brings (cutting immigration levels, for at least the next few years, won't hurt either -- there will be no significant labor deficit in the U.S. this side of 2010.)
Unfortunately, neither the President nor any of his Democrat challengers are offering anything like such a program. The period from 2005-15 is thus likely to be a long, cold decade.
(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.)
