January 7, 2001
2001 US Supreme Court — The Rest of the World v The US Economy
In the dock today, the judge, Mr Financial Markets, calls upon Mr US Economy to defend himself against the allegation that he is nothing but a fraud. The prosecution contends that he is a pumped-up, overweight bully with little or no substance, other than the ability to extract cheap capital out of the rest of the word; such profligacy now threatening the livelihood of the globe.
In his defence, Mr US contends he is a well-intentioned family man, performing strongly but badly misunderstood by the financial markets and fickle commentators.
Recent comments show just how divided the jury has become during the course of this short, sharp trial that began in December.
According to the newly elected master of the jury, President-elect Bush, the US economy is in danger of going into a “tailspin”. Probably not the most subtle language to use on his first outing but maybe a taste of things to come.
The sagacious old owl of the courtroom, counsel for the defence Alan Greenspan, has been typically circumspect. But his actions this week suggest a hint of panic.
The case for the prosecution is based on the rapid downturn, plus evidence of deep character flaws in Mr US that have been skilfully disguised over the years.
In contrast, the defence case rests on innocence until proven guilty, and it hopes that over the course of the trial the jury will realise just how honest and robust the economy will remain, despite recent slurs.
On the face of it, the prosecution’s case is strong and is all about the emperor having no clothes. Over the past few years, much of the boom has been driven by so-called `confidence’. Since 1995, with US consumers and companies positively messianic about the new economic future, spending has exploded.
Share prices have bubbled and old ways of valuing assets were ignored. The US became a society that knew the price of everything and the value of nothing.
The most conspicuous result of all this has been the evaporation of savings, which is made all the more unusual because interest rates have not been particularly low.
As of last November, the personal savings rate dropped unprecedentedly into negative territory, dipping to –0.8 per cent of disposable income. Compare that to late 1994, when the personal savings rate stood at 6.6 per cent, and to an average over the previous 45 years of 8.5 per cent.
This plunge in savings reflects the extraordinary disparity between income and spending. Since 1995 consumer spending has gone up by 4.4 per cent annually, much faster than the 3.3 per cent increase in personal income. Never before have Americans lived so far beyond their means.
The recent boom became self-fulfilling. Americans, buoyed by an unswerving belief in the future, piled into the stock market, eschewing saving for short-term speculation. As the market rose, so too did people’s wealth, leading them to spend more.
The correlation between the Nasdaq, consumer spending and confidence is quite startling. The Nasdaq began to tank in March and American consumers duly stopped spending in late summer.
Company bosses also bought into the spending craze. Huge increases in technology and telecom investment were seen as the only way to ensure profits.
Many employees find themselves with brand spanking new computers with ludicrously huge capacity, when all they need are word processors. This idle excess capacity is the new economy’s equivalent of the old economy’s empty factories. Now such gluttony smacks of economic indigestion: corporate America’s eyes are bigger than its stomach.
So who financed this binge? Unfortunately, the rest of the world did so. We readily gave our savings to the Yanks to allow them blow our cash on four-wheel drives, condos, internet startups and high-capacity PCs.
The net result of all this is that the US owes the rest of the world a fortune. The account deficit (which measures the amount of our money they are blowing) is increasing by $1 billion per day and now totals 4.4 per cent of GDP. Never before has the US had such an overdraft. Ten years ago the current account was in the black.
Thus, the prosecution concludes that, without confidence, the emperor has no clothes and the dollar will plummet as the US economy contracts, exerting a deflationary squeeze on the rest of the world. Internally, debt deflation will grip the US and the experience of post-boom Japan of the 1990s is the most likely outcome.
In this regard, any bounce in stock markets is that of a dead cat, and further Fed rate cuts are selling rather than buying opportunities. Quite a compelling case.
The defence acknowledges some of the prosecution’s points, but suggests that the events of 1998 provide the blueprint for what will happen in 2001.
In October 1998, as a response to a liquidity crisis in the US banking system, the Fed cut rates three times in quick succession. The markets rallied and confidence returned, propelling the US economy forward.
The defence would go so far as to indicate that the new economy and the productivity miracle are still very much the story of the day, and there is no reason to panic. It argues that the US is strong, healthy and nowhere near recession.
In fact, many in the defence team, led by Mr Greenspan, suggest that it is the financial market itself that has panicked. If they are right, today represents a fantastic opportunity to buy stock at bargain basement prices. Yet I don’t see many buyers out there.
On balance, with inventories rising rapidly, debts building and a credit crunch possible in highly leveraged companies, it looks like the prosecution’s case is far more persuasive. Retribution from the financial markets, particularly currency markets, will be swift and exacting.
Now that the emperor has been exposed without his undies, it will be difficult for confidence to re-emerge. One thing is certain: next time Mr Greenspan cuts rates, the initial Pavlovian stockmarket rally will be less euphoric.
Over the coming weeks we should expect to see the dollar sliding, US stocks continuing downwards and US financial commentators becoming more pessimistic.
This leaves us, the 51st state, exposed to the chill wind coming in from the Atlantic with little or nothing to protect ourselves.