« home

PINCHAS LANDAU:
--------------------------------------------------------------------------
Light at the end of the tunnel

After getting off to a bad start, 2003 turned out to be the first good year this century for the global economy

If you invest in shares, you will be sorry to say farewell to 2003. Whilst not in the same class as 1999, it was a great year for investors — at least in those classes of investments.

Bond investors, on the other hand, will see the outgoing year differently. For them, the long bull market in bonds — some would trace it all the way back to 1982 — finally came to an end. But, even then, it depends on what kind of bonds you’re talking about. Those issued by governments of "emerging economies," including Israel, had a banner year.

That’s the easy part, identifying what investments did well this year. Less straightforward is pinpointing the reason or reasons for the stockmarket boom and trying to correlate it with the performance of national and regional economies.

For if the market frolic reflected what analysts like to call "economic fundamentals" — meaning growth, higher levels of production, employment, etc. — then it doesn’t really make a lot of sense. Why, for example, did the German stock exchange rise more than the US exchanges (see accompanying chart), given the under-achievement (to put it charitably) of the German economy this past year?

The contradictions affect emerging markets just as much as developed economies. The stellar achievements of Brazil’s stock market make sense, in light of that country’s record this year of major structural reforms and firm economic management. But then, why did Venezuela do just as well, when the country is undergoing massive political unrest and its economy is imploding?

One possibility is to simply note that stock exchanges suffered through a severe slump for the better part of three years and were therefore overdue for a change of sentiment and direction.

The bull market of the 1990s ended early in 2000: The Dow Jones Industrial Average peaked in January and the Nasdaq — which is dominated by technology-oriented companies — in March of that year. Thereafter, the overall trend remained negative, through October 2002. With hindsight, we know that at that point most global markets "hit bottom" — but this wasn’t at all obvious in the first weeks of 2003. As the war in Iraq moved from threat to certainty, the world became a very nervous place, and this was well-reflected in the activity on the financial markets.

However, as soon as the war began, the markets took off, and never really looked back. Only then did it become clear that October 2002 had indeed marked the end of the bear market: As the markets marched steadily higher during the rest of the year, the gloom and fear gave way to optimism and hope.

In fact, 2003 seems to have encapsulated the entire investment cycle of "fear-hope-greed." By year-end, the scale of the advance recorded by some markets, and the valuations being achieved by many shares and some entire sectors, arguably far surpassed any reasonable hope and rather suggested the return of 1990s-style greed.

SO WHAT has been driving the new boom? The true bulls claim that corporate America has made a dramatic recovery, resulting in a sharp rise in corporate profitability, which is expected to continue in 2004, thereby justifying much higher equity prices. In support of this argument, the bulls cite corporate profit data and extraordinary rises in the productivity of the US economy.

In essence, this is a reprise of the arguments put forward to justify the bull market of the late 1990s, and often they are being made by the same people.

However, the crash has left in its wake a considerable residue of suspicion regarding both the data, and the people and financial institutions that use them.

The discovery that many supposedly respectable corporations cooked their books — and indeed continue to do so, by using legalized accounting fictions, such as not costing stock options or ignoring pension fund shortfalls — has created an understandable reluctance to rely on what companies, and their auditors, present in their accounts.

As for productivity data — this area of economics has become a quasi-religious quagmire. You either believe, in the fundamentalist sense, that the data reflect reality, or you don’t believe, in the heretical sense, that they do any such thing.

The chairman of the Federal Reserve, Alan Greenspan, is a long-time Believer and adherent to the New Economy faith. This is enormously important, because it largely determines attitudes towards Greenspan and his policy; these, too, have become a matter of belief and dogma.

Greenspan has been boss of the Fed since 1987. In that time, he has charted the course of monetary policy through an incredible series of events: Black Monday in October 1987, the US recession and banking crisis of 1990—92, the crisis in Mexico in late 1994, the domino-like collapse of Asian economies in 1997, the bankruptcy of Russia and the collapse of the LTCM hedge fund in 1998 and on through the Nasdaq-led stock market boom and bust, to the recent recession and the fear that the US, like Japan, would slip into a deflationary spiral.

Is Greenspan a Solomonic genius whose wisdom allowed the US to not merely weather this series of shocks, but to regain its dominant position in the global economy — which it had all but lost in 1987? Or is he an opportunistic bungler, lurching from one crisis to the next, and actually responsible for the boom-bust volatility that has afflicted the US and the world during his unprecedentedly long chairmanship?

If, like Greenspan, you are a Believer in the New Economy and its impact on productivity, you are likely to regard him as the savior. But if you are an Infidel with regard to the IT (information technology) revolution, you probably discount the productivity data as flawed and unreliable — and think that the same descriptions apply to Greenspan as well.

WHY IS all this particularly relevant to how you see 2003? Because of Greenspan and his policies, of course. In order to see why, let’s move from the hot (and often putrid) air of the financial markets, to the (supposedly) solid ground of what economists call"the real economy, where actual goods and services are produced, distributed and sold by real people.

The accompanying chart juxtaposes the very different experiences, over the last two years, of the US economy on the one hand, and of "Euroland" — the 12 European countries that currently make up the European Monetary Union centered on the single currency, the euro — on the other.

The graph tells a simple story: The US recovered far more quickly and effectively from the recession of 2000—2001, than did Europe. By the third quarter of 2003, the annual rate of growth in the US economy was an awesome 8.2 percent — the highest for any quarter since 1984. The Europeans, however, have continued to crawl along at near-zero growth.

Is this conclusive proof of the dynamism, flexibility and sheer management capability of US companies? Or is it perhaps the result of a massive injection of liquidity into the US economy, which has allowed consumers to keep spending and thereby keep the wheels of commerce turning?

Obviously, Believers in the New Economy say that the former is the dominant factor. Yet the fact is that Greenspan lowered interest rates a record-breaking 11 times in 2001, and continued cutting in 2002 and 2003, until rates stood at a 40-year low of 1%. He has repeatedly declared his intention to keep rates very low for some time — despite the fact that classic economic theory suggests that holding interest rates below the rate of inflation for a long time is likely to generate inflationary pressures.

Greenspan, however, believes that this is no longer the case, because the New Economy has created long-term disinflationary pressures.

At the same time, President Bush has astutely wielded his own standing (after 9/11) and the Republican control of both the House and the Senate (after the November 2002 mid-term elections) to push through major tax-reduction packages. Given such huge boosts from both fiscal and monetary policy, the US economy has responded in text-book manner, with activity surging — led by housing, financed by super-cheap mortgages.

Of course, in such an environment, stocks have soared across the board, because "a rising tide lifts all ships." The flood of liquidity has been such that all the ships in the Western hemisphere, even the sinking, mutinous tub called Venezuela, have been lifted — at least temporarily.

BY WAY of contrast, the Europeans have suffered under the rule of a fanatically "monetarist" central bank (the ECB) which, obsessed with the need to crush inflation, has ignored the very low rate of growth of the key European economies and lowered interest rates slowly and extremely reluctantly. In addition, the Europeans had saddled themselves with something called the Stability and Growth Pact (SGP), the rules of which decreed that countries with budget deficits must raise taxes and/or cut government spending, even during recessions.

This policy mix — the very opposite of that applied in the US — was a recipe for continued recession. Fortunately for the Europeans, their absurd situation has recently been ameliorated. The new president of the ECB is a savvy Frenchman, who will probably be more attuned to the real needs of the economy than his Dutch predecessor. Better still, the Germans and French have rebelled against the madness of the SGP and effectively neutered it.

True, the result of this revolt has been — and will continue to be — to weaken the European Union. Furthermore, the Union is now in an even bigger mess, because it cannot agree on a constitutional framework that will allow it to function properly, as it expands eastwards, absorbing into it the countries of Central and Eastern Europe and the Baltic states.

The glaring disparity between American success and European failure raises an obvious question. We noted earlier that, despite the huge discrepancies in economic performance, European stock exchanges mostly achieved higher returns than did the American ones. Yet stranger still, at least on the face of things, is the fact that the American currency has effectively collapsed versus the euro — and indeed, in relation to almost every other currency on earth (see graphs).

However, the weak dollar phenomenon has a straightforward explanation. The low interest rates and tax reductions that have fed the consumer boom in the US and thereby kept the American economy growing at a faster pace than its rivals, have exacted a heavy price.

This takes the form of the "twin deficits": the first in the balance of payments, covering America’s business with the rest of the world, the second in the Federal budget.

The former has been growing steadily for many years. However, it is now so large — around $600 billion per annum, or well over 5% of GDP — that it threatens the stability of the entire American economy, and hence the global economy as well. The latter represents the singular achievement of the Bush administration, which inherited a large budget surplus (thanks to the long boom) and has turned it into a hefty deficit (partly caused by the recession, but primarily the result of government policy).

All deficits require financing; the larger they are, the less enthusiastic anyone is to finance them (try asking your bank manager to triple your overdraft). The US relies on the rest of the world to put up the money to allow it to maintain a higher standard of living than it can actually afford; however, the world is rapidly losing its appetite for American debt and American dollars. The result is the ongoing slump in the value of the dollar.

WHICH BRINGS us to Asia. The best news for the world economy this year has been the unexpected recovery of the Japanese economy, after many years in the doldrums. Opinions differ as to the viability of this recovery, but if it develops further, it is a major plus for 2004.

But there can be no question that Japan is feeding off China. The extraordinary pace of growth in the Chinese economy has made China the second source of dynamism in the global economy (after the US). However, two problems have emerged regarding China.

One is that the Chinese economy is displaying increasing signs of over-heating. If the government does not act toput a brake on the pace of economic expansion, it is likely to face a serious inflationary problem. On the other hand, if it deliberately slows the pace of growth, it could trigger a sharp political backlash.

The second issue is the rise of anti-Chinese sentiment in the US. This stems from the massive, and rapidly-growing, trade deficit that America is running up with China. The Americans (supported by the Europeans and the Japanese) want China to revalue its currency, which — so it is widely believed — will staunch the loss of manufacturing jobs in the US by reducing China’s cost advantage.

Many economists, including the Fed’s Greenspan, regard this belief as unfounded. What they are far more concerned about is that pressure on the Chinese to allow their currency to float freely will destabilize the world’s currency and bond markets.

This would happen if the Chinese (and Japanese) stopped their massive interventions in the markets, wherein they buy US dollars and sell their own currency. This process has led to them accumulating huge amounts of foreign currency reserves ($600+ billion in the case of Japan, $400+ b. for China, and large amounts for Taiwan and Hong Kong as well). These holdings are invested primarily in bonds issued by the American government and its agencies.

If that flow of buying and investing were to dry up, there would be no one left to finance the US deficits. The dollar would fall precipitately, or US interest rates would have to rise sharply — or both. In any event, the fallout would be disastrous for the US and world economies.

This — along with the continuing threat of "mega-terror" attacks on Western cities and terrorist destabilization of the Middle East — is the primary threat facing the global economy in 2004. But it stems from the same basic problem that was apparent, and indeed worsened, during 2003 — namely, the imbalances in the global economy.

Put simply, if also simplistically, a situation in which America does all the spending, Japan does all the saving, China does all the producing and Europe does steadily less of everything, is unsustainable.

However, the likelihood is that the positive trends of 2003 will extend through at least the first few months of 2004, and perhaps well beyond. The party’s not over yet, so enjoy it while it lasts.