The Bear's Lair: 4 Horsemen of the Economy

By MARTIN HUTCHINSON, UPI Business and Economics Editor  |  Dec. 1, 2003 at 11:13 AM
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WASHINGTON, Dec. 1 (UPI) -- The U.S. economy of 1999 had only one serious imbalance -- the stock market bubble. Today's economy has not one but four imbalances; four "Horsemen of the Apocalypse" which may well cause war, famine, pestilence and death in the years to come. Really the only major uncertainty is: in which order?

The U.S. stock market, the screaming imbalance of 1999, is still out of kilter. The extraordinary overvaluations of tech and Internet stocks in 1999 have to some extent been corrected, in many cases by the simple expedient of the companies going bust altogether.

However, all stocks became overvalued in 1999, by any traditional valuation metrics. Non-tech stocks never saw a really severe bear market. Even at the trough of October 2002, the Dow Jones Industrial Index was down only 38 percent from its peak, and still 15 percent above the level of Fed Chairman Alan Greenspan's 1996 "irrational exuberance" speech. Non-techs have now rebounded to valuation levels that are quite close to 1999's highs, bearing in mind the softening of corporate profits since that time. Reported price/earnings ratios are suppressed by funny accounting; both the non-expensing of stock options, and the surge in extraordinary items, now around 40 percent of profits.

In real terms, the S&P 500 Index is currently trading at over 30 times 2003 earnings; it is thus heavily overvalued both in terms of past history and in terms of alternative investments such as Treasury bonds, which have trended higher in yield since June. Tech stocks are less overvalued than they were in 1999, but any reasonable examination of companies with price-earnings ratios above 100 and single-digit growth rates suggests that they are still heavily overvalued, having gone through a phase of near-sanity at the end of 2002.

The second imbalance is that in the money and bond markets, and the related imbalance in the housing market. These sectors were not particularly imbalanced in 1999; short term rates, which rose from 5 percent to 6.5 percent in the year from May 1999, were too low for a period of raging boom, but by no means out of line in terms of current inflation of 2-3 percent (though asset price inflation was not included in that measure.) Long term interest rates, too, rose from 5 percent on the 10 year bond to 6.5 percent in 1999, again a reasonable cost of money premium over current and expected inflation rates. The housing market was strong, but except in California and Manhattan showed no signs of overheating; over the rest of the country house prices were generally lower in real terms than at the peak of the market in 1989. Mortgage refinancing had already hit record levels, but that could be attributed to the high interest rates of the 1980s, which had left a huge volume of mortgages available to refinance; the level of "equity takeout" from mortgage refinancing -- money borrowed on a new mortgage and used to pay down credit cards or for consumption -- was still minor, no more than $50 billion per annum.

In 2003, there is no question that the money, bond and housing markets are imbalanced. Alan Greenspan, who to puritanical eyes lost control of the money supply in 1995-96, has continued to allow M3 money supply to grow at around 10 percent per annum, although lovers of inflationary pump-priming have become seriously concerned that M3 has dropped around 1.3 percent since mid-July 2003. Needless to say, there's a benign explanation for the drop, too -- mortgage refinancing has dropped sharply from its very high peak, and money has been shifted from money market funds into stock funds, both of which tend to depress M3. We shall see.

Meanwhile, the gross domestic product deflator has risen in every quarter of 2003 and gold has reached the level of $400 per ounce, fully 50 percent above its 2000 trough. November agricultural prices announced Monday were fully 21 percent above the same month in 2002.

Home mortgage refinancing "equity takeout" in 2003 has been around $250 billion; combine that with the summer's tax rebates, and it's not surprising that consumer spending has been strong.

With interest rates turning up, inflation showing signs of strong re-emergence, and mortgage refinancing running at only moderate levels from here on out, you can expect a sharp deterioration in the consumer's support for the U.S. economy going forward.

The U.S. balance of payments, the third imbalance, was already somewhat out of kilter in 1999, at about a $300 billion deficit. You would have expected the payments balance to be out of whack in 1999; the economy was at the top of a record-making boom, a time when imports generally rise above sustainable levels and cause the payments balance to deteriorate. Sitting in 1999, and foreseeing a recession ahead because of stock market overvaluation, you would have forecast a decline in the payments deficit, to a level of maybe $100 billion, appropriate for the owner of a reserve currency, which needs to supply the world with liquidity to keep the world economy going.

At least the overall prognostication for world trade was good in 1999. The North American Free Trade Area, which came into effect in 1995, was working well, U.S. agriculture subsidies had been sharply reduced by the 1996 "Freedom to Farm Act" and the protectionist Pat Buchanan was obviously marginal in the upcoming election compared to the free-traders Al Gore and George W. Bush.

Instead, we have seen the U.S. payments deficit balloon to $500 billion, as artificial money creation has kept U.S. consumption soaring, with consequent effect on imports. This has been financed, not by foreign investment into the stock market, as in 1999, but by foreign central bank purchases of Treasury securities, a much more ephemeral source of funds. Bullish economists are now blithely forecasting that this deficit will increase still further, as the U.S. economy grows faster than its competitors'.

This is unsustainable, and the currency markets know it. The euro Friday rose above $1.20 against the dollar, for the first time in its 5 year history. Realistic optimists see the payments deficit problem being solved by a continued rise in the euro, to $1.60 by 2005, according to a majority of speakers at last week's Cato monetary conference. This would export any recessionary hangovers to Europe, an attractive outcome if you're the United States.

Unfortunately, it's vanishingly unlikely that the EU will permit this to happen. Already protectionist, their protectionism has been reinforced by president Bush's imposition of steel quotas in 2002, his huge increase in farm subsidies in the same year, September's collapse of the Doha round of trade talks in Cancun and now the U.S.'s partial re-imposition of textile quotas against China. Their natural reaction to any further rise in the euro against the dollar will be retaliation, of one sort or another, which carries the danger of sending world trade into the kind of downward spiral it saw in the 1930s.

The final imbalance is the U.S. Federal budget deficit, probably around $600 billion nominally in the year to September 2004, and $750 billion when the social security surplus is excluded. This problem didn't exist in 1999. While the budget surpluses seen around that year were relatively small, and always likely to disappear once the stock market turned down and capital gains tax receipts dropped to normal levels, there was no reason to suppose that the progress made by the Bill Clinton administration and the Newt Gingrich-era Congress against the Federal deficit could not be maintained in the long run, with moderate deficits in recessions being balanced by surpluses in booms.

However, that's not what happened. Of the roughly $750 billion per annum deterioration in the Federal budget since 1999, around $250 billion can be accounted for by the Bush tax cuts of 2001 and 2003. A relatively small amount, maybe $150 billion, can be accounted for by the drop in capital gains tax and other tax receipts from their exceptionally high levels of 1999. The remaining $350 billion is increased federal spending, over and above that which could be expected from inflation, and U.S. population growth and economic growth. In consequence, U.S. government spending, around 28 percent of gross domestic product in 1999, will have increased above 32 percent of gross domestic product in 2004, well in excess of the previous record level of peacetime U.S. government expenditure in 1982-83.

These "four horsemen" imbalances will reinforce each other. A decline in the dollar, the high Federal deficit and the resurgence of inflation will drive up interest rates, which in turn will adversely affect house prices and the stock market, which will adversely affect consumption and the "real economy." The U.S. economic position is much more serious than it was in 1999, and the outlook going forward is accordingly gloomier.

Not all of this can be blamed on president Bush. The stock market bubble was caused by a number of factors, including Greenspan, Clinton's Treasury Secretary Robert Rubin and Senator Joseph Lieberman (D.-Conn.) who blocked the proper accounting of stock options in 1995. The money market, bond and housing bubble is largely the fault of Greenspan again, although Bush could reasonably be expected to have "leaned against" the excessive inflationary easing. The trade deficit is partly the result of the first two imbalances, and of U.S. consumers' excessive consumption, though the resurgence in protectionism is clearly Bush's fault. Only the increase in the budget deficit can largely be blamed on Bush. Nevertheless it is Bush, for the next year and very probably for the next five years, who will have to deal with the quadruple problem. On the economic record of his administration so far, there is no indication that he will do so adequately.

The Revelation of St. John the Divine introduces the Four Horsemen in Chapter 6. Later, in Chapter 18, verse 11 it returns to economic prophecy: "And the merchants of the earth shall weep and mourn over her; for no man buyeth their merchandise any more."

Looks like 2004 will be a rough year for retail sales!

(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.)

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