I'd like to pose a serious question for everyone to ponder, and it will require thinking in a way that most of us probably haven't been thinking. Let's step into Greenspan's shoes for a moment. Don't worry; I haven't turned Clown. It's just that I think we'd all stand the best chance of making it through this difficult period of history if we understood a little better what might be going on in the minds of those at the helm.
So - you're the Fed Chairman. You've blown it. You watched as a massive bubble in equities formed under your watch, as you fanned the flames with easy money due to your own human fears over the LTCM and Y2K "crises". Now you've got a two-pronged problem: both corporate and consumer spending were abnormally high over the past couple of years, and the positive feedback at work caused the economy to build significant excess capacity. They both need to be worked back down to sustainable levels. Now what?
Option 1: You can step back and let the free market run its course. History suggests that the free market would overshoot in its response, thanks again to the positive feedback and human nature involved. Both imbalances are corrected quickly, but together, and the positive feedback from one causes the other to worsen. The recession is quick but severe, as the economy displaces potentially millions of workers simultaneously. If the cap ex boom needed to ditch 1,000,000 employees, and the consumer-based boom needed to ditch 1,000,000 employees, the aggregate job loss would actually be far greater than 2,000,000 if both happen concurrently.
Option 2: Is there a better response? Sure, tinkering with the economy got us into this mess in the first place, and my gut says "Let the Free Market work it out! Stay the hell away and we'll sort it out without your meddling." But, then I think there may be some merit to the idea of tinkering. You have two problems under the free market response: the unusual (unsustainable) bulge in corporate capital spending must be corrected, as well as the bulge in consumer spending. It might be desirable to meddle just enough to let the economy work down one problem at a time, reducing the positive feedback involved.
Now how does one go about that? Well, corporate spending isn't that easily manipulated. The money that was spent was predominantly burned in the three pillars of the New Error: computing equipment for the Y2K/Internet/dot bomb fad, wireless network builds, and broadband network builds. We're left with overbuilt capacity and immense debt loads there, so it is unlikely that corporate cap ex can be supported at Y2K levels.
How 'bout consumer spending? It just so happens that American consumers are more than happy to dig ever deeper debt holes to bury themselves in, so perhaps a little nudge is all that is necessary to convince them to continue their borrow and spend habit for a few more quarters. What's required? The effective liquidity for the consumer must be held constant, or even increased slightly. This is the key that really didn't hit me until recently: Greenspan will do whatever is necessary to interest rates and the money supply to attempt to keep consumers doing in 2001 exactly what they did in 2000. He understands the role stock valuations play in consumer spending. Despite his rhetoric that he doesn't target stock prices, he views the stock market (rightfully so) as a major component of the effective money supply. So, witnessing a massive asset deflation, he is doing whatever is necessary to stabilize asset prices. He doesn't even care what happens to the money supply, so long as the level of demand is sustained at the same level as in 2000. This might give the economy enough time to get well into correcting the imbalances from the crack-up cap ex boom, before it has to deal with the asset deflation impacts on consumer spending. Laid-off workers no longer needed at Intel, Sun, Cisco, etc. would hopefully have time to be reabsorbed into other positions within the economy before the other shoe drops. Then, with cap ex stabilized, the asset markets can continue their deflation, as it becomes obvious to everyone that the economy is mired in a much longer term correction.
I'm not saying that this solves anything. I sincerely doubt that Greenspan even believes at this point that a recession can be avoided. There simply isn't any way to reallocate resources within the economy quickly enough to make up for the lost demand from the cap ex boom. All he can hope to do is bring the economy down in two steps rather than one much bigger step. This is one of those cases where 1 + 1 actually approaches 3.
What does this mean from an investment perspective? As long as Greenspan targets equities, it will be a difficult environment to short in. I doubt that stocks can make appreciable upside, although those with inflation-hedge properties may go up as the currency splits 3:2. When the other shoe drops, the bear will resume with a vengeance, as consumer debt growth will finally cease and the liquidity trap will set. The dollar should eventually decline significantly, as foreign investors finally realize there is no growth here, and years of imbalances and trade deficits finally take their toll. Unless inflation and demand get out of hand, gold and oil will have a difficult time getting anywhere. Only if the currency comes under attack concurrently with resumption of the bear will investors finally seek hard assets. That could be a long while. The economy will continue to shrink slowly until debt levels, equities, capital expenditures, and consumer spending find a stable base from which to build. The bottom line - and the reason deflationary periods are so dismal - is that there won't be many ways to make a decent ROI anywhere. Capital has been forced down the throats of the markets for so long that available ROI has plummeted, and this will only worsen as cash flows degrade further into the recession. This is the conclusion I arrived at in 1999, and it's the reason why I insisted on learning how to sell short.
Could the overall damage be lessened by stretching the dislocation out in time? Frankly, I don't know. I think it's an incredibly risky experiment, printing mountains of dollars to support asset prices to give the economy time to work off the cap ex bubble. If he is the least bit too accomodative, inflation flares quickly, the fixed income market tanks, and the debt bubble comes crashing down. Consider that, even with very low interest rates historically, the debt service burden on consumers is near all-time highs. Now think what happens if interest rates tick up a little - debt service burden surges. Borrowing cut off immediately. Credit bubble collapses.
If he doesn't do enough to support the consumer debt binge, or if the markets finally get a whiff of the genuine severity of things, the asset prices collapse anyway, and consumer spending crashes in tandem with the cap ex crunch.
So, is it worth the risk? Perhaps the Fed should operate along the lines of the medical profession: first, do no harm. What is the harm in permitting Wall Street to plunder for another few quarters while the cap ex problem is allowed to work itself out some? People throw away another couple quarters of 401K money, and any truly rational investors who seek positive real returns or <gasp> sell short, get hosed. But it's all for the greater good, right?
Does the problem lie in the response of the rational investor? Is there some negative economic impact if capital flows suddenly divert from stocks into gold? Just the wealth effect. Print some more money and that problem goes away, right? If the bond market becomes angry, you respond quickly with rate hikes. And in a deflationary environment, what does the bond market care anyway?
Part of the problem may be explained by another medical profession phenomenon: you can't do nothing. Does anyone ever go to the doctor and hear "Sorry, we really can't do anything for you." Rarely. Usually, the doctor and patient both want to try something. Maybe that's all that's happening here.
So, go ahead, Greenspan. Try something. And - good luck; I hope for the economy's sake that you are right. But, I'm betting on the immutable behavior of the all-powerful Invisible Hand, and that means I'm betting against you.
BC |
