The Slow Road to Recovery
Two months ago, the stock market was telling us that deflation was on the way and that the US economy would be leading the world into a global recession. Since then the market has staged a strong rebound and people are feeling more optimistic again. My feeling, however, is that the excesses of the late 1990s bubble have only partly been dealt with and that until they have properly worked their way out of the system, the real recovery will remain elusive.
At a recent conference in London, David Hale, the chief economist of Zurich Financial Services, presented a bullish case for the US economy. Hale argued that despite the decline in the US stock market, which from its peak in 2000 to the recent trough in October had fallen in value by a sum equivalent to 90 per cent of GDP, the economy had shown tremendous resilience. He ascribed this to several factors.
First, the prompt response of the Federal Reserve to the slowdown by cutting interest rates. This enabled Americans to refinance an estimated $1.5 trillion of domestic mortgages this year. At the same time, they extracted some $130 billion from their housing equity to fuel consumer spending. In addition, low interest rates have boosted US house prices, which have been rising by around 8 per cent over the last few years, thus off-setting losses from the stock market. Secondly, Hale highlighted the stimulus to the US economy provided by the increase in US government spending due to post-11th September military expenditure. This has provided a demand boost to the economy equivalent to 4 per cent of GDP, the most dramatic increase in government outlays since the early 1980s. Thirdly, productivity growth has continued strongly into the slowdown and is currently running at over 5 per cent per annum. Finally, Hale argued that the US banking system was in a strong position since it has largely protected itself from bad loans through the use of credit insurance. Much of the financing for the telecoms boom, he observed, came from capital markets and thus the collapse had not damaged the banks.
As a result of these factors, Hale looks forward to reasonably robust economic growth next year (of 3.5 per cent). Many people expect this growth will translate into further gains in the stock market in coming months. In a recent interview in Barron’s, the US financial weekly, Steve Leuthold, a highly respected fund manager, argued that a new bull market had already commenced, with likely gains of 50 per cent from the October bottom. Leuthold pointed out that retail investors who had piled into tech stocks in 1999 and 2000, are now selling stocks to buy bonds. As a good contrarian, he believes that money can be made by going against the crowd.
I believe that these commentators are wrong. Why? The main cause of the 1990s bubble was excessive credit creation. This fuelled consumer spending and business investment and provided liquidity for the bull market in stocks. It resulted in an overhang of debt, excess capacity in the private sector and a severely over-valued stock market. One symptom of the imbalances that developed in the US economy was an excess of consumption over income, reflected by a widening current account deficit.
It has been more than two years since the US entered its downturn. However, the imbalances remain in place and in some cases are even worse than before. The Fed’s policy of lowering interest rates has encouraged people to get even further into debt. By the end of last year, the economy required $8 of new debt to generate $1 in incremental GDP growth. This figure has declined somewhat, but credit is still growing more than twice as fast as the economy. In addition, the current account deficit continues at an amount equivalent to around 4 per cent of GDP.
The slowdown in the US economy was initially triggered by a decline in business investment. Over the past couple of years, we have heard a lot about firms slashing their technology budgets, while the telecoms companies virtually ceased spending on new equipment. Some argue that given the short life of most technology products we can now expect a pick-up of business investment. Yet the aggregate figures show that very little capacity has actually been taken out of the economy and capacity utilisation remains near its low.
Andrew Hunt, an independent economist, believes that a combination of low interest rates and soft bankruptcy laws in the US is enabling marginal businesses to continue in operation. “When companies are declared-or declare-themselves bankrupt,” writes Hunt, “they are in effect given protection from creditors. Hence, they do not have to liquidate their assets and capital does not exit.” Companies which emerge from bankruptcy, shorn of their debts, tend to make life difficult for their competitors, thus eroding profitability in their industry. And without a pick up in corporate profits, we are unlikely to see an increase in business investment, which normally takes the economy into a new business cycle.
The situation in the US has much in common with that of Japan, following the collapse of its bubble economy. Neither country was prepared to swallow the bitter medicine necessary to purge the economic system from the effects of its over-indulgence. Instead both chose to protract the process. As a result, I believe that the consequences of the millennial market mania will remain with us for some time to come.