Ill-Designed for Soft Landings
One of the great economic puzzles of our time is the international strength of the U.S. dollar, the huge U.S. trade deficits notwithstanding. Many observers view the situation with alarm and expect the exchange rate of the dollar to fall soon under the weight of an unfavorable balance of trade. Others look upon the situation with pride and confidence that American productivity has risen permanently, thanks to great technical progress in the information industry. Novel technology will allow the rapid economic growth of recent years to continue, they believe, and counterbalance all dangers of price inflation and dollar depreciation.
The puzzle of the strong dollar points straight at the related crucial question of whether the American boom will end without tears. Professional opinion on the odds for a happy ending is divided. Most analysts are convinced that Alan Greenspan and his fellow governors of the Federal Reserve System will manage the party and allow it to continue indefinitely. A few skeptics emphasize many adverse conditions and expect the worst; they dispute especially this faith in the wisdom and power of a few wise men over the economic lives of millions of people. It is well-nigh impossible, they contend, to execute a soft landing of an economic boom that is the longest since records began more than a century ago.
Shortly before his passing in 1914, the eminent Austrian economist, Eugen von Böhm-Bawerk, addressed himself to the puzzle in his essay on "Our Passive Trade Balance." He called attention to the movement of capital. The flow of goods and services may be affected and even controlled by the flow of liquid capital. A net influx of capital tends to facilitate the importation of goods and services; a net outflow of capital brings about the opposite. As long as a country attracts foreign capital, its current account, which covers imports and exports of goods and services, tends to be "unfavorable" and its currency remains strong. A country that loses capital for any reason tends to have a weak currency, which in turn promotes exports, reduces imports, and generates a "favorable" balance of trade. As economic conditions deteriorate and liquid capital leaves a country, its current account balance tends to be "most favorable."
Recent economic events in Southeast Asia seem to confirm Böhm-Bawerk's observation. Throughout the 1980s and most of the 90s, Malaysia, Thailand, Indonesia, Singapore, South Korea, and Taiwan enjoyed strong currencies while suffering large balance-of-payment deficits. A massive influx of American dollars and Japanese yen facilitated growth rates that were the envy of the world. But although their currencies were strong, pegged to a basket dominated by a strong U.S. dollar, large balance-of- payment deficits led to concerns about the stability of the exchange rates.
By early 1997 the influx of foreign capital had brought a remarkable increase in economic growth and wealth which was the envy of the world. The central banks freely created and exchanged their national currencies for dollars, yen, pounds, and marks seeking investment opportunities. The expansion of national currency together with the influx of foreign exchange not only facilitated the importation of more foreign goods, generating large trade deficits, that is, "unfavorable" current accounts, but also engendered feverish asset inflation. High yielding debt instruments and appreciating real estate attracted ever more foreign newcomers whose funds sustained the given exchange rates despite the soaring trade deficits.
The boom inevitably came to a painful end when excess liquidity and massive malinvestments, especially in real estate, caused foreign withdrawals which soon accelerated and turned into panicky runs. The central banks aggravated the runs by extending credit even further in their effort to rescue overextended banks and financial companies. The runs soon depleted the dollar reserves and, when the pegged exchange rates could no longer be maintained, caused the rates to plummet. By the end of 1997 the Malaysian ringget was down by 25 percent, the Indonesian rupiah by 33 percent, the Thailand baht by 37 percent, with the Singapore dollar losing 9 percent of its exchange value. The South Korean won soon fell over 35 percent against the dollar, and even the Japanese yen weakened and fell to a low of 127 to the dollar. Throughout Southeast Asia price inflation mounted and interest rates soared as stock markets plunged and economic expansion ground to a halt.
The situation may be comparable in the United States. Surely, the American economy is by far the largest in the world, but the United States also is the largest debtor with the largest trade deficit. The U.S. dollar is the world's most popular currency, having taken the place of gold ever since President Nixon took the United States off the gold standard in 1973. But it also is the most overextended currency in the world with some $572 billion in circulation and a money stock (M3) of more than $6.7 trillion presently rising at an 8.9 percent annual rate.(July 12, 2000). Unknown trillions of dollars held in banks outside the United Stats (euro dollars) are commonly used for settling international transactions. Surely, the American economy looks very dynamic and the value of the stock market is the highest in U.S. history, but the private economy is incurring the biggest financial deficits since the Second World War. The country is suffering record current account deficits with net external liabilities now exceeding 20 percent of GDP and rising.
Wall Street may be celebrating the decline in government deficits, but other debts continue to grow by leaps and bounds. According to the Fed's Flow of Funds, household debt (mainly home mortgages) is growing at an annual rate of 9.25 percent, total household debt as a share of personal income now exceeds 103 percent. Business debt is soaring at a 10.5 rate. Corporate debt of non-financial firms is rising at a 12 percent rate, the fastest in more than a decade. While some of these debts are going into new investments, much is spent on share buybacks. In short, corporations are going into debt to boost their share prices. Margin debt in the stock market is growing faster than any other type of credit. In 1999 it soared by 46 percent, now exceeding $206 billion, which is the highest in U.S. history. Unfortunately, if this growth of debt should come to a halt, or merely slow down, it may break the fever of the boom and usher in the readjustment.
Rising debt is not the only threat to the economic boom. Derivatives are the single greatest danger, especially to financial institutions. These are options, futures, and options on futures which are highly leveraged speculation on virtually everything: interest rates, stocks, stock indexes, and foreign currencies. Even bonds and mortgages may yield derivatives as they are split into the interest-only portion and the principal-only portion. American commercial banks, brokerages, and insurance companies are the primary source and traders in derivatives now exceeding $35 trillion. What would happen to derivative players if the markets should suddenly begin to readjust, if interest rates should rise suddenly or price inflation should return in force?
The American economy is in its 10th year of cyclical expansion, which is the longest on record. A grave risk in this setting is a sudden fall in share prices, a bear market, which would evoke a dramatic fall in consumer confidence and demand. Since consumption is driving more than two-thirds of American production and growth, a sharp decline of consumer demand would soon lead to a decline in production, which may trigger an international run from the dollar. In order to stem such a run and attract enough foreign capital to cover the current account deficit of more than 4 percent of GDP and carry external liabilities of more than 20 percent of GDP, the Federal Reserve would have to raise its rates. But such a raise at a time of falling stock prices and falling output would soon aggravate the decline and lead to a painful recession. The present pleasant scenario of rising productivity and income, high stock prices and a strong dollar would soon turn into the opposite – falling productivity and income, falling stock prices and a weak dollar, declining imports, rising inflation, rising interest rates, and rising unemployment. The longest economic boom in history would give way to a long recession.
In the face of growing economic difficulties public opinion may demand that the Fed lower its interest rates in order to redress the decline. Politicians and government officials may add their weight to an active countercyclical policy of easy money and massive deficit spending. But such a reaction by the world's biggest debtor and spender would only aggravate the situation. Even if foreign investors would patiently refrain from withdrawing their funds from the United States but only hesitate to invest new funds, the trade deficits would cause the dollar to plummet with all the dire consequences.
The dangers of a looming recession, together with a weakening dollar, would present the Fed with the choice of two inevitable evils. Compelled to choose one of the two, the Fed may raise its rates in order to defend the dollar but thereby aggravate the recession, or it may lower its rates in order to stimulate the sagging economy but thereby weaken the dollar and engender more price inflation. Whatever the Fed's choice may be, it will incite the wrath of the public and forever tarnish its sterling reputation.
Many knowledgeable investors are convinced that the American stock market is already in its early stage of cyclical readjustment. They know that, at 28 times record earnings, stock prices are rather lofty and the market may have entered a stage of "distribution" of large holdings. They are pointing at the Dow Jones Industrial Average having topped out on January 14, 2000 at 11,722, the NASDAQ on March 10, 2000 at 5,048, and the S&P on March 24, 2000 at 1,527. They are bracing for the next stage of the bear market: a precipitous decline.
The U.S. dollar in 1999 and 2000 may have received special support and strength from the unexpected weakness of the euro, the single currency of eleven European countries. While the low euro enabled several European countries to achieve an export-driven economic recovery and sizeable current-account surpluses, these were dwarfed by the magnitude of capital outflows exceeding $150 billion in 1999, driving the euro irresistibly lower and boosting the U.S. dollar.
Two political forces that are as unstable and unpredictable as politics itself are gnawing at the purchasing power of the euro. The European Central Bank is conducting an expansive policy which obviously exceeds that of its primary competitor, the Federal Reserve System. Comparative interest rates tell the story. At the present (July 21, 2000), the Fed discount rate stands at 6 percent and the Eurodollar rate at 6.69 percent; the euro rate is quoted at 3.75 percent. The American prime rate is given at 9.5 percent, the German rate at 4.25 percent. Last year at this time German banks charged 2.5 percent, American banks 8 percent. This rate differential alone points in the direction of the flow of funds. While the ECB's own target rate of expansion is said to be 4.5 percent per year, which hopefully will maintain price stability, its actual increase of the stock of money has exceeded six percent ever since its inauguration on January 1, 1999. Its governors seem to be guided by oldfangled Keynesian thought which ordains the desirability of credit expansion for most economic ailments. The other cause of euro weakness is rooted in the primitive ideology of welfarism which creates large armies of paupers on public assistance and workers on unemployment rolls. Great rigidities of the euro-zone labor market impose high costs on investors. They have to cope with very high social security taxes which finance unfunded, government-dominated pension systems. Many currency dealers are convinced that there is no hope for the euro as long as European governments are run by "unreconstructed socialists." It is hardly surprising that under such institutional conditions most European economies are stagnating with hundreds of billions of euros seeking to escape. Many billions find their way to Wall Street.
This situation is bound to draw to an end as soon as European thought leaders finally tire of the stagnation and unemployment and demand far-reaching economic reforms. This day will come because of the close interdependence, interplay, and interchange of European and American thought. When European policy makers finally embark upon reform the euro will come into its own. The U.S. dollar may then be found to be greatly overextended and the overdue economic readjustment will not be far behind.
Our Fed managers and their numerous devotees are fully convinced that the Fed has the power to prevent a painful recession. But having generated the boom phase with easy money and credit, how can it be expected to avoid the inevitable readjustment? Throughout the long history of the Fed, the governors invariably have sought to prevent the readjustments with ever larger bursts of credit expansion and, once enmeshed in a recession, sought to rekindle the boom with easy credit. Unfortunately, this merry-go-round, which characterizes all federal administrations from Herbert Hoover to Bill Clinton, has reduced the value of the U.S. dollar to a fraction of its original value.
Alan Greenspan and his fellow governors obviously are impressed by the apparent benefits of the "new economy" with its high-tech innovations and boosts in productivity. And they seem to be unsure of the enormous wealth effects of the stock market on consumer spending. Surely, they have increased interest rates in quarterpoint and halfpoint stages, seeking to stem consumer demand without stifling the expansion. But the maladjustments that are visible in the financial markets continue undiminished.
The high-tech revolution undoubtedly makes human labor more productive. Powerful computers and the Internet enable many corporations to increase their profits by cutting costs. They may economize the use of labor, eliminate middlemen, reach new customers, control inventory, manage delivery, and perform many other functions; but they necessitate heavy capital investments which entail high capital costs. Analysts estimate that computer and Internet-related efficiencies may add some two percent to annual corporate earnings in the United States. They will add little or nothing to business earnings in many developing countries in which the high costs of capital exceed the costs of labor to be saved. Such modest expectations obviously do not support stock prices that set all-time records. They cannot for long sustain the bull market which measures Internet success in hundreds of percentages. Moreover, they even cast doubt on the genuineness of the "new economy."
"The new economy" of the 1990s reminds the historian of two previous "new economies" that bred much confusion and ended in upheaval. The first "new economy" made its appearance during the roaring 1920s with soaring equity prices and negligible unemployment. President Coolidge and his fellow politicians proudly identified with the prosperity. And again during the 1960s President Kennedy's "new frontier" and his involvement in the Vietnam War ushered in a "new economy" with economic growth that lasted eight years, with both inflation and unemployment at their lowest levels in years. President Johnson boasted about his economic achievements when he left office in 1969. We know that the following decade brought double-digit inflation, a deep recession, an energy crisis, and general political turmoil. If the previous "new economies" are indicative of the true nature of economic newness, we must brace for much pain and stagnation to come.
The economic maladjustments due to many years of monetary manipulations by the Federal Reserve System are the prime source and mover of the inevitable readjustment. Once the market structure no longer reflects the unhampered choices of all participants, the readjustment is unavoidable. In the end, the laws of the market always prevail over the edicts of political controllers and regulators. They even reign over the wishes of a few central bankers. Surely, government officials and central bankers have the power to lessen or aggravate the stresses of readjustment as they have the power to interfere with the economic lives of their nationals. They may reduce their burdens of government and allow the readjustment to proceed quickly and efficiently. Unfortunately, they tend to make matters worse and prolong the readjustment with ever more political intervention such as monetary expansion and deficit spending.
The Japanese government managed to turn a readjustment that began in 1990 into a decade of deep depression the end of which has not yet come in sight. This example and many others make us fearful that the U.S. Government will turn the coming readjustment into a long and painful recession. Political intervention is ill-designed for soft landings.
Hans F. Sennholz