What a fine distraction war is!
There we were worrying about rising unemployment, depressed company earnings, the failing consumer, the weak world economy, unfunded company pensions, rising deficits in local and federal government, the falling stock market and -- bang! -- scenting the declaration of war on the evil butcher of Baghdad, the Dow Jones industrial average leaps 3.6 percent Monday, rounding out a five-day climb of 8.2 percent.
It's clear, all we needed was a war. But is it?
The war, which, the market judges, offers swift "closure" to the uncertainty over Iraq, is a distraction from a profoundly sick economy. Take a look.
Begin with the U.S. stock market. Isn't the market cheap now, having shown over the past few years the sort of capitulation the whole world would welcome from Saddam Hussein? And, therefore, might not the market be able to rise now and put a head of steam into the economy?
According to charts supplied by the New York Federal Reserve, the price to earnings ratio on the S&P 500 was at 29.5 on March 5. A low level? When Federal Reserve Board Chairman Alan Greenspan mentioned "irrational exuberance" in stocks in December 1996, the ratio was below 22.
The p/e ratio is close to the levels it was at in 2000 when the U.S. economy and U.S. stocks were just beginning their downturn. Stock prices have fallen since then, but so have earnings.
Valuations on mainstream U.S. stocks therefore remain rich. Can earnings justify them? That will depend on the economy. Can it improve, or at least keep going?
There have been worries recently about the ability of the U.S. consumer to keep doing what he does best: consume.
The consumer is carrying more debt than ever before. The growth in household debt has been astonishing in the past two years. It had climbed to 73.7 per cent of household income as of the fourth quarter of 2002, from 66 percent at the end of 2000 and just 60 percent in 1995.
Why is the debt soaring? There is an obvious answer: because interest rates are so low. Yet, surprisingly perhaps, this does not mean that servicing of mortgage debt has dropped to an unusually low share of income.
In the third quarter of 2002, U.S. households spent 6.24 percent of their disposable income on mortgage payments. That is one of the highest levels since 1991, when the U.S. economy was in recession. And what if incomes fall, or interest rates climb?
What about businesses? How are their finances? Are they not benefiting from ultra-low interest rates?
Take the interest cost to cash flow ratio of non-financial corporations. In the third quarter of 2002 the ratio was 17 percent. That was below the level at any time in 2001 and for about half of 2000, when this ratio soared.
But, before then, the 17 percent figure is higher than at any time since 1992, when the economy was emerging from recession and the Fed funds rate averaged 3.5 percent during the year, roughly twice its average level in 2002. In short, even with very low interest rates, U.S. corporations are spending a lot of their money servicing debt. What if interest rates rise? What if the economy weakens further?
The Fed funds target, the benchmark short-term interest rate in the economy, is at 1.25 percent, a 40-year low. It could be pushed lower, but not by much. The scope for it to rise, on the other hand, is considerable, meaning that debt might suddenly get more expensive.
Meanwhile, there are other signs that the economy has over-reached itself. The trade deficit is the largest in U.S. history. Imports of goods are running at a record level (briefly touched in the heady summer of 2000) of about $120 billion per month.
Exports of goods, however, are running at about $80 billion per month. The deficit on the current account (the broadest measure of trade, which includes services such as tourism and income items such as interest and dividends) rose to an annual rate of $542 billion in the fourth quarter of 2002 -- a record figure at about 5 percent of U.S. gross domestic product.
And what about government finances? Writing in February, the National Association of Governors, which represents U.S. state governors, said: "Fiscal Year 2004 will be the third year in a row of major state fiscal problems, making this the worst fiscal crisis since the Second World War."
The NGA's latest study of finances in the states found that the current shortfall for 2003 "is about $30 billion and is projected to be about $82 billion in 2004." The shortfall will have to be met either by cutting expenditure or raising taxes. That is not going to help growth.
Meanwhile, at the federal level, as U.S. President George W. Bush cuts taxes, a record deficit is building -- even before the war has been accounted for.
Since Bush and British Prime Minister Tony Blair are going to be leading a small coalition of countries into war, rather than waging it with the backing of the United Nations, a heavy financial burden will fall on the coalition. Bush is expected to ask the Congress to appropriate about $100 billion with which to wage the war.
If all this money, or more, is spent in the forthcoming war, the United States is likely to find itself running a fiscal deficit of about $400 billion even on current government estimates.
That would be the largest in its history, although at about 3.8 percent of GDP, it wouldn't be nearly as large as a share of the economy as the 6 percent of GDP deficit run up 20 years earlier by then president, Ronald Reagan. But Reagan's 6 percent deficit isn't out of Bush's reach.
We could go on. The U.S. economy is profoundly sick. That is why ultra-low interest rates and sweeping tax cuts have not been able to spur it into life.
And so far we have left out what we would judge one of the most dangerous trends of all: the fact that house prices have soared in a spiral that repeats the stock price inflation of 1998-99.
Just as stocks then caused the U.S. economy to soar on false fuel, house price inflation in 2001-02 has propped up the economy, stopping it from heading where it wants to go -- toward a deep recession. Just like the stock boom, the housing boom will end up by doing profound harm, leaving home-owners with debts that exceed the value of their home, their collateral.
Unpalatable though recession always is, the U.S. economy needs one. It has become unbalanced, distorted and profoundly sick, largely because too much cheap money has flowed through its veins for a decade. The war, which we hope will be short, as bloodless as possible, and successful in ridding the world of Saddam, will add to the problems, not alleviate them.
It is hardly the time for the U.S. markets to be celebrating.
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