SB, is this market doomed? I don't think so.
>Published: March 26 2001 19:20GMT | Last Updated: March 26 2001 19:38GMT
The US stock market decline is no longer confined to high-technology areas. Business capital spending is in dramatic retreat. Workers are being shed in increasing numbers in both new economy and old.
It all sits uneasily with the triumphalist rhetoric that used to echo around such places as the World Economic Forum in Davos. Indeed, the American model of capitalism appears set for the kind of global reassessment that was visited on the Asian miracle after the currency and financial crises of 1997-98. Maybe even Davos man, the supremely insulated advocate of high-octane capitalism, is about to have his come-uppance.
Of course, the extent of any reassessment depends on the movements of the US stock market. That statement is less innocent than it sounds, because the peculiar nature of the American model is not just that the stock market is bigger in relation to the economy than in most other countries. It also drives the economy through its powerful impact on saving and investment.
This part of the story is neither novel nor unique. The same was true of Japan in the 1980s. But as the numbers become bigger the potential consequences for the US are more hair-raising. In fact, US household savings have declined, as a percentage of disposable income, from 10.6 in 1984 to an estimated minus 0.3 per cent in 2001, according to the Organisation of Economic Co-operation and Development - the lowest in the OECD area apart from New Zealand.
Even allowing for the statistical distortion that arises because capital gains are not included in income while the tax on those gains is included, Americans have saved little due to the wealth effect they feel from rising property and stock markets. US households' equity and mutual fund holdings were valued in January at more than $9,000bn.
Where the story becomes more unusual is in the exceptional wealth effect in the corporate sector. Rising stock prices reduced the cost of capital in the second half of the 1990s, so leading to a surge in technology-led investment. David Hale of Zurich Financial Services points out that between 1995 and 2000 business spending on computers rocketed from $49bn to $303bn, accounting for 14 per cent of the US economy's growth in output. The corporate sector's financial deficit now stands at more than 2 per cent of gross domestic product, its highest level for decades, thanks to excess monetary growth and the high-tech bubble.
The disproportionate role of the stock market in the American model thus results in more extreme imbalances than elsewhere. Such market dependence creates a heightened risk of boom-and-bust cycles and financial disruption. And because US capital markets are open and liquid, imbalances are exacerbated from outside.
The difficulty, points out Charles Dumas of Lombard Street Research, is that a reversion to a more normal household savings rate of about 6 per cent and a cut in foreign investment are potentially lethal to the economy. Both would be profoundly deflationary.
The business sector, meanwhile, is already in the grip of a sharp negative wealth effect precipitated by the plunge in technology stocks on the Nasdaq exchange. The interplay of Federal Reserve policy and stock prices is now the battleground on which the economy depends, even if the Fed is unlikely to admit it is targeting asset prices.
The trouble with a model that is so vulnerable to the mood swings of markets is that central bankers have not worked out how to manage the moods. They hesitate to make asset prices a target of monetary policy because they are reluctant to make judgments about the "right" level for markets.
Once the mistake is made and they are at the wrong end of a boom-and-bust cycle, central bankers have to confront the problem of steering between the perils of inflation and deflation.
The difficulty is that slashing US interest rates in the hope of propping up stock markets may not have much impact if households and businesses are bent on rebuilding their balance sheets. If, on the other hand, the interest-rate remedy does work, the imbalances in the economy will be exacerbated. So the Fed will be digging a bigger hole.
Parallels between the US today and Japan in the 1990s should not be taken too far. Unlike Japan, the US macro-economoy enjoys a budget surplus, while the micro-economy is not afflicted with the same structural rigidities.
That said, the US model is not without its own rigidities and distortions, notably in the capital markets. These relate to penalties and rewards for boardroom behaviour. The most important concern the use of stock options.
A glance at profitability in the US corporate sector shows that profits peaked in 1997. Since then companies have compensated for a declining return on total capital employed by leveraging their balance sheets in order to maintain the return on equity. They repurchased shares so that that earnings per share and dividend growth increased at the cost of balance sheet deterioration. The resulting shrinkage in stock market equity helped support stock prices, and returns on directors' stock option plans.
Along with the high-tech mania this contributed to an artificially low cost of capital, which in turn led to a misallocation of resources. And now that markets are falling, the widespread use of stock options looks questionable on other grounds. At its simplest, this aspect of the US model requires directors to be paid in a currency that is prone to crazy inflation and savage deflation. The motivational impact bears thinking about. In countless boardrooms, options are now worthless. The resulting contraction in the personal wealth of business people may well have added to the negative wealth that depressing business investment.
It also puts short-term performance pressure on chief executives, on top of a capital market discipline that has never been greater. Despite the decline in underlying profitability since 1997, an army of financial pundits, including Wall Street analysts, the CNBC financial network and the print media, have been applying relentless pressure for performance. So from Motorola in the new economy to Procter & Gamble in the old, thousands of employees are being sloughed off in a manner unthinkable in continental Europe or Japan.
Shareholders have no means of knowing the cost in terms of human capital, or the future cost of training new employees when profits recover. So they cannot tell whether a chief executive is saving his skin at their expense, or engaging in long-term restructuring.
And the American model has also given us the phenomenon of the just-in-time chief executive officer to fire the just-in-time employees. At Procter & Gamble in mid-1999, chairman and chief executive John Pepper, then 60, handed over to Durk Jager in 1999 to carry out a six-year restructuring programme to cut 15,000 jobs and find $1.2bn savings a year.
Mr Jager was fired in less than 18 months and his successor Alan Lafley declared that P&G had taken on too much change too fast. This month the same Alan Lafley announced that restructuring had not gone far enough: a further 9,600 jobs needed to go. Who would bet on Mr Lafley lasting as long as the average US chief executive, who is reckoned to stay in office for a mere four to five years?
So the US model has its flaws, both macro and micro. But the rest of the world cannot afford to be too unkind. Without the US external account imbalance there would have been no solution to the Asian crisis. And the US continues to export its technological innovations around the world. In short, it may be flawed but, as with Churchill's verdict on democracy, it still looks better than the alternatives. |
