This is an excellent article primarily for the questions it raises as to who is responsible for deflating the US economic bubble and how it will come to an end:
Tension Rising
By John H. Makin
The tension is rising in U.S. and global financial markets. On June 30, the Federal Reserve took a timid first step toward tightening U.S. monetary policy by raising the federal funds rate by 25 basis points—from 4.75 to 5.0 percent. It also rescinded the bias toward tightening that was articulated in May. The U.S. stock market rallied by more than 5 percent in the space of two weeks, while long-term interest rates fell by 20 basis points from where they had been before the Fed "tightened."
With U.S. interest rates starting to fall again, and the stock market rising, the incipient extra rise in U.S. demand growth—and in the U.S. current account deficit—is weakening the dollar. On July 19-20, the dollar fell by more than 3 percent against the yen and the euro, even before the May trade deficit was reported at $23.9 billion, a monthly record.
Meanwhile, in Japan the economy has stopped deteriorating purely on the strength of the massive fiscal stimulus thrust upon it by the government during the first half of the year. Monetary policy is still too tight, as evidenced by the more than $30 billion in dollar purchases by the Bank of Japan required to avoid further appreciation of the yen. When an economy that can't sustain growth without massive fiscal stimulus experiences a strengthening currency, monetary policy is too tight. The dollar buying by the Bank of Japan should be allowed to increase growth of the money supply. The Bank of Japan is preventing that and is offsetting (sterilizing) its currency intervention's impact on the money supply.
The major engines of Europe—Germany and Italy—continue to experience weakening economic growth. The euro has, until late July, drifted downward against the dollar, searching for a level that will re-ignite growth in Germany's and Italy's export-oriented economies. The euro may resume its fall unless German growth picks up. Meanwhile, the interest-rate-sensitive peripheral economies in Europe—Spain and Ireland in particular—thrive on monetary conditions that are too unrestrictive to balance demand with s upply growth in those prospering areas.
The Perils of August
With all these tensions in the background, we find ourselves in the month of August, when major economic misalignments are often addressed, either by policymakers or by markets. In August 1971, the Nixon administration ended the Bretton Woods system by unilaterally breaking the link between the dollar and gold. In August 1982, the Mexican finance minister Jesus Silva Herzog announced to a discomfited American Treasury that Mexico could no longer meet the interest payments on its rapidly expanding debt. In August 1990, Saddam Hussein attacked Kuwait, initiating a tense six-month crisis that ended in the liberation of Kuwait and the start (in March 1991) of the current U.S. economic expansion.
These crises, appearing at intervals approximately a decade apart, may contrast with the pattern of annual crises that has emerged since 1997. The Asian crisis began in June 1997 and intensified rapidly over the summer, although by September of that year the delegates to the IMF- World Bank annual meetings were congratulating themselves for having contained a crisis that was to spiral out of control by the end of the year with the collapse of a major bank and brokerage house in Japan and the virtual collapse of the Korean financial sector.
After a brief celebration during the spring of 1998 of the end of the Asian-Latin crisis, the crisis re-emerged with a vengeance in August, when the Russian government, having received its $5 billion loan from the IMF, devalued its currency and defaulted on its debt. Those measures set off the shock waves that culminated in the near collapse of Long-Term Capital Management in September. Ironically, the Asian crisis and the Long-Term Capital Management crisis gave the U.S. expansion a boost by lowering commodity prices, pushing safe-haven capital to the United States, and inducing the Federal Reserve to cut interest rates by 75 basis points.
The real question facing the U.S. and global economies whether the U.S. stock market bubble—and yes, it is a bubble—will be deflated endogenously (that is, by natural market forces) or by the Fed's ever-so-gently raising interest rates.
Now, in the summer of 1999, we are witnessing the unraveling of the unexpected bonus provided to the U.S. economy by the Russian and Long-Term Capital Management crises of the summer of 1998. The real question facing the U.S. and global economies is whether the U.S. stock market bubble—and yes, it is a bubble—will be deflated endogenously (that is, by natural market forces) or by the Fed's ever-so-gently raising interest rates, while Chairman Greenspan suggests to markets, as my parents used to tell me, "This spanking is for your own good."
The Fed's Dilemma
The basic problem the Fed faces is the high likelihood that the bubble will burst and the certainty that someone will be blamed when it does. If the Fed raises rates quite a lot and the stock market then collapses, the Fed will be blamed and could be subjected to a curtailment of its quasi-independence by an angry Congress looking for scapegoats. Alternatively, if the Fed raises rates only by 25 or 50 basis points, the bubble will grow ever larger, and when it bursts, "irrational market forces" will be blamed. Then the U.S. Congress will seek to pass a set of new laws that, while not doing anything to prevent future crises, will certainly hobble the performance of the economy.
In considering whether it's to be the Fed that reduces the bubble before it gets even larger or market forces, it may be worthwhile to lay out the scope of the task that probably faces the Fed if it is going to bring U.S. growth back into line with long-run potential. The realities underlying U.S. growth in mid-1999 suggest that the federal-funds rate will have to be raised to at least 6 percent over the coming year. Consider the following. Greenspan's and the Fed's concession to the new paradigm is that productivity growth has risen from 1 percent to 2 percent. Add labor-force growth of 1 percent, and you get a long-run sustainable growth rate of 3 percent—the growth rate that should be sustainable at stable wages. But growth for the past two quarters has averaged about 5 percent—although, by year-end, the four-quarter average may be down to the 4 to 4.5 percent range if second-half growth averages around 3 to 3.5 percent.
Slowing growth by a full percentage point—from, say, the current annual average of 4 percent to 3 percent (the Fed's long-run target)—would normally require about 150 basis points of Fed tightening over a year. If we calculate from the 4.75 percent federal-funds rate that prevailed in June of this year, that would leave the Fed funds rate at 6.25 percent by next June. Any extra acceleration of consumer price index or wage increases would, of course, call into question whether the Fed could proceed along a smooth glide path and gradually raise rates to bring the growth down to a sustainable level. So far, the most basic measure of inflation—the CPI—has risen on an annual basis from about 1.5 percent early this year to about 2.0 percent now, largely on the basis of higher energy prices. Some dismiss this as insignificant, but I can think of no better indication of incipient and actual pressure on capacity than rising energy prices. Yes, oil suppliers have tried to restrict energy supplies, but in the past they have failed to do so because of the lack of demand for energy products. Their success this time suggests that global energy demand is growing more r apidly.
Aspects of the Current U.S. Economy
On an underlying basis, the U.S. economy is in a classic investment-led expansion, as we have discussed a number of times before. The ongoing high-tech revolution in the United States, especially in communications and data processing, and rapidly falling computer prices have been part of a broad investment-led expansion that has seen the share of investment in the U.S. GDP rise from 12 percent in 1990 to more than 17 percent in 1999. Neoclassical growth theory is very clear on the consequences of the rising share of investment in GDP. A larger capital stock eventually reaches the point of diminishing returns, so that the marginal product of capital begins to fall and thereby compresses profits on the revenue side. Some business managers might call it a lack of pricing power; others will be disappointed ultimately with regard to revenue projections undertaken at the time the decision was made to add to the capital stock.
The further by-product of a rising capital stock is a rising ratio of capital to labor that pushes up the marginal product of labor and thereby pushes up real wages. Real wages that are consistent with productivity increases are acceptable, but, as the capital/labor ratio continues to rise, the ability of more capital to add to the product of each unit of labor goes down and productivity growth begins to slow. Recall that the Fed has already granted a significant increase of productivity growth from 1 percentage point to 2 percentage points per year. That is probably realistic, but it might be too generous late in a capital expansion, when the marginal product of capital begins to fall.
The stylized version of a U.S. financial collapse tied to the rising current-account deficit is that foreigners "simply refuse to continue lending tot he United States."
The other aspect of the U.S. economy that is gaining great attention is America's rising current-account deficit. Many see this as a pressure point that could interrupt the steady rise in U.S. equity prices and, thereby, U.S. consumption growth and the strong U.S. expansion. Unfortunately, the current account is not an unambiguous guide to gauging the sustainability of the U.S. expansion. The current-account deficit of the United States measures the sum of public-sector dissaving and private-sector dissaving. Since public-sector dissaving—the U.S. government budget deficit—has turned to a surplus while the current-account deficit has continued to rise, it must be true that private-sector dissaving has jumped sharply. Indeed, that is true. But part of the jump is entirely rational. Households that have experienced large gains in equities have been converting some of those gains into purchases of durable goods, especially housing, automobiles, and appliances. Though spending on automobiles and appliances is counted as consumption, it includes a savings component because durable goods last more than a year and represent a stock of future consumption services, just as savings of financial assets may do. However, durable goods are less liquid than financial assets, and their value falls with depreciation, whereas, on average, financial assets appreciate on earning either interest or capital gains.
The stylized version of a U.S. financial collapse tied to the rising current-account deficit is that foreigners "simply refuse to continue lending to the United States." This view is problematic. Rather, foreigners will continue lending $250 billion- $300 billion per year to the United States only at higher and higher U.S. interest rates, with the required rate going higher as opportunities outside the United States become more attractive. On the other side of the ledger for the U.S. currency, a sudden cessation of capital flows to the United States would cause the dollar to collapse, making U.S. producers (already highly competitive) even more competitive in a world where excess capacity exists in many areas, like autos and steel. Japan is already struggling (the $30 billion buying intervention) to avoid the dollar depreciation that results from its too-tight monetary policy coupled with some additional investment by global portfolio managers and selected Japanese equities.
Japan and Europe would be hurt if the United States becomes a major exporter of deflation. Germany, for example, would fare badly if the dollar collapsed and the euro appreciated back to 120. So far, the euro's depreciation against the dollar, from that level down to virtual parity, has failed to produce enough of a resurgence in the export sectors of Germany and Italy to re-ignite noticeable growth in their economies.
Is the U.S. Equity Bubble Ready to Burst?
Despite these tensions, the U.S. equity bubble is at levels that are more stretched than they were in October 1987. Ironically, this line was crossed just after the Fed's "tightening" on June 30, when relief at removal of the Fed's bias toward further tightening caused the equity market to rally more rapidly than interest rates fell. Stocks in the United States are now at levels that are either unsustainable or, alternatively, suggestive of a radical new paradigm in the valuation of equities, as postulated by James Glassman and Kevin Hassett in their forthcoming book Dow 36,000 . I have suggested that part of the reason for the high valuation of U.S. equities is the market's perception of an implicit guarantee from the Fed, based on its behavior last fall, that stock market drops of more than 20 percent will be cushioned by Fed rate reductions or huge liquidity injections. Glassman and Hassett argue rather that past models of equity valuation have become inappropriate as households come to believe that stocks are really less risky than bonds and, as a consequence, attach a lower and lower risk premium to the returns required to hold stocks instead of bonds.
The problem with all these arguments is that they are frightening when run in reverse. If the stock market collapses because of the lack of profitability or, alternatively, because the Fed simply pushes rates up to a level that forces stock prices to fall, all the factors that have been magnifying and justifying the high valuation of U.S. equities are undercut. A drop in the stock market by more than 30 percent, without cushioning from the Fed, would de facto undercut the Glassman-Hassett argument that stocks are really less risky than bonds. When stocks are rising at 20 percent or more a year, bondholders earning their 5 or 6 percent look like fools. When stocks are falling at 20 percent a year, bondholders earning 5 or 6 percent look like geniuses. The characterization can shift very rapidly when greed turns to fear.
Stocks in the United States are now at levels that are either unsustainable or, alternatively, suggestive of a radical new paradigm in the valuation of equities.
The Fed is now in the unenviable position of having embarked on a tightening journey with no clear destination. It is entirely possible, and even likely, that inflation will not provide a dramatic signal of the need to tighten. Indeed, as I demonstrated above, even with inflation staying at 2 percent, if growth is running at 4 percent and the Fed feels that 3 percent is sustainable, it will need to raise interest rates by another 125 basis points over the coming year on top of the 25 basis points initiated on June 30.
Further, a rate increase of more than 100 basis points, which is more than twice what markets are currently expecting, could actually be insufficient to cause a stock market collapse. In 1989, when the Bank of Japan was attempting to prick the bubble in equity and land prices, it raised rates by 150 basis points—from about 2.5 to 4 percent—before the stock market began to buckle. Land prices only began to come down a year later, although their fall was even more spectacular than the collapse in the equity market. Going back further, in the lead-up to the 1929 stock market crash, the Federal Reserve raised interest rates by nearly 300 basis points, to 6 percent, while inflation was zero. It took a 6 percent real short-term interest rate to cause equity prices to give way in 1929.
Once an equity-market bubble starts to rise it is quite robust. If approached delicately by a timid central bank, the equity market will shrug off small increases, just as it did the initial one on June 30 of this year. The equity-market bubble has virus-like properties. The mere prospect of higher interest rates administered by the central bank is pored over by market participants, so that by the time the central bank does raise rates, the market has immunized itself to their impact. Of course, there is a limit to this process, but the ability of the market to anticipate and prepare itself for Fed rate increases probably accounts for the resilience of most bubbles in the face of central bank tightening.
Undoubtedly, the market will be resilient to the well-telegraphed messages of the Greenspan Fed to raise interest rates. In June Chairman Greenspan, in effect, overprepared the market for a rate increase and a possible asymmetric bias, and when the market saw just a rate increase in July, it shrugged and roared higher. Another 25 basis-point rate increase between now and the end of the year will not interrupt the sharp rise in the stock market. In fact, once such a rate increase is over and the Fed indicates with a neutral bias that any further rate increases will be data driven, the markets will experience further relief rallies.
So how does the bubble eventually burst? History suggests that the pressure usually comes from economic strength outside the United States that creates competition for the capital that is driving up the stock market, or from a Fed that can no longer tolerate the financial risks of a rapidly rising bubble. The alternative—inflation pressure that gives the Fed a traditional rationale to raise interest rates—has seldom been the means by which a bubble is eventually burst. Indeed, the absence of inflation pressure is a necessary condition for a bubble to emerge. We have already suggested that the Federal Reserve, absent inflation, is not in an aggressive or preemptive move, and even if it were and it raised rates by another 125 basis points, that too, based on historical comparisons with Japan in 1989-1990 and the United States in 1928-1929, might be
If Japan begins to recover, higher U.S. interest rates will be required to sustain the high level of imported savings from Japan and elsewhere, and this rise in U.S. interest rates will put increasing pressure on the U.S. bubble.
insufficient to burst the equity market bubble. So we are left with the possibility of a rapid resurgence of growth in another major economy that pushes up U.S. interest rates and creates competition for capital fueling the U.S. stock market bubble. Here, the most viable, and perhaps increasingly likely, candidate to produce a shock is Japan. Since the United States is a heavy importer of savings from Japan, a recovery in Japan would cause a reduction of U.S. capital inflows at current interest rates. If Japan begins to recover, higher U.S. interest rates will be required to sustain the high level of imported savings from Japan and elsewhere, and this rise in U.S. interest rates will put increasing pressure on the U.S. bubble. In deed, a rapid recovery in Japan could see interest rates there rise by more than 200 basis points, which would require an equal or larger increase of interest rates in the United States. No equity market bubble of the scale we now see in the United States has withstood that kind of interest rate increase.
The Prospects for Recovery in Japan
What about the prospects for a Japanese recovery? Right now they are not good, but Japan may soon be forced to engineer a more rapid expansion of domestic demand through monetary policy, and thereby prompt a recovery. Japan's ability to use public works and fiscal policy to stimulate the economy is rapidly coming to an end. Although the stimulus packages effected in 1998 enabled rapid annualized growth of almost 8 percent in the first quarter of 1999, that growth is not sustainable. In fact, growth during the second or third quarter of this calendar year may be negative. While the Japanese government plans yet another stimulus package, its size—approximately 5 to 10 trillion yen—is small by past standards, and it may not be manageable in view of the rising pressures on the market for government debt in Japan. Japan's increased sales of government debt this year will total more than 40 trillion yen, and more than 50 trillion next year—more than the total of Japanese government tax revenues. The rise in interest rates resulting from heavy supply pressures was mitigated in the spring of 1999 by having the Bank of Japan push short-term interest rates to zero. But with even larger supplies of debt coming and with short-term interest rates already at zero, the Bank of Japan will have to ease monetary policy by another criterion, more rapid expansion of the monetary base, to accommodate so much government debt.
The Bank of Japan is already being squeezed to ease liquidity by the tension of mandates to maintain zero overnight interest rates while simultaneously pegging the dollar at a support level of 120 yen per dollar. These requirements mean that the Bank of Japan has to keep enough liquidity in the system to hold overnight rates at zero while simultaneously buying dollars to prevent the dollar from depreciating against the yen. The Bank of Japan's policy of "sterilizing" the positive impact on money growth from its intervention in support of the dollar is the equivalent of trying to paint a house by putting paint on one day and then scraping it off the next. Sterilized intervention will not provide sustainable support for the dollar, but the need for Japan to avoid currency appreciation will eventually force it to stop, either directly or indirectly, sterilizing dollar intervention and to push up its monetary base more rapidly from the current level of about 6 percent annual growth that has prevailed over the past several months.
In sum, Japan has done all it can to sustain its economy with fiscal policy and will now have to resort to a more expansionary monetary policy. That policy will eventually stimulate aggregate demand growth in Japan, the critical element that has been missing for the past several years, since the imposition of a higher consumption tax in April 1997. Under this scenario, the initiation of a Japanese recovery will encourage more rapid recovery elsewhere in Asia, and may even help to stimulate the lagging European economies.
The Effects of Global Recovery on the U.S. Economy
A global recovery, however moderate, would mean that the current level of capital flows to the United States will not be sustainable at an interest rate that supports the current level of the stock market. In short, as capital flows to the United States are redirected elsewhere, U.S. interest rates, without any help from the Fed, will rise on their own to a point that eventually will cause a sharp fall in U.S. equity prices. A sharp fall in U.S. equity prices will produce a sharp drop in U.S. demand growth and will require further rapid easing of monetary conditions in Europe and Japan. Otherwise, the collapse in the U.S. stock market will administer a deflationary shock to the world economy that will dwarf the shock from Asia during 1997 and 1998. The past failure of central banks to recognize the need to offset deflationary shocks implicit in equity market collapses has led to world depressions. We can only hope that the outlook of major central bankers in Japan and Europe will be transformed by the time world market conditions require additional liquidity creation from their institutions.
Right now, the outlook for rebalancing global demand growth is not encouraging. The head of the European Central Bank, Wim Duisenberg, has alternated between suggesting that the strength of the euro will emerge when the U.S. stock market collapses and suggesting that the weakness of the euro will require a possible tightening by the European Central Bank. Meanwhile, the head of Japan's central bank has suggested that, because short-term interest rates are zero, his institution can do no more to stimulate the Japanese economy. These misperceptions have two things in common. They both overlook the significance of the growth rate of money, rather than interest rates, as a guide to the stance of monetary policy, and they both suggest a continued concern that inflation is a bigger problem for central banks than deflation. If the two attitudes are not adjusted before the U.S. stock market collapses, that collapse will entail a global depression. If they are adjusted, and if an easing of liquidity follows the implicit liquidity-tightening attendant upon a stock market collapse in the United States so that global demand growth, while slower, does not collapse, then the world economy will weather a sharp drop in the U.S. equity markets. Meanwhile, the underlying health and strength of the U.S. economy, not to mention the finances of the U.S. government, can help to sustain U.S. growth.
A global recovery, however moderate, would mean that the current level of capital flows to the United States will not be sustainable at an interest rate that supports the current level of the stock market.
A strange and, I fear, as-yet-unrecognized dilemma faces the central banks of Japan and Europe. If they don't ease, the world economy can't prosper without the demand boost from a U.S. stock market bubble that, in turn, implies a rising U.S. current-account deficit. Then again, it is also true that if they don't ease, the U.S. stock market will fall, because the interest rate required to enable financing of the U.S. current-account deficit will rise until the U.S. equity market collapses.
Perhaps it is this kind of paradox that eventually brings bull markets to an end. Either markets put interest rates up too high for the stock market to bear, or central banks do. My guess is that the markets will do it.
John H. Makin is resident scholar at the American Enterprise Institute. #10752.
aei.org |
