Are Happy Days Here Again? Don't Bet on It

The fact is, no one knows where the U.S. economy is going.

The vast majority of forecasters are saying the recession is over. They say the decline has ended, the Federal Reserve has provided substantial stimulus, and the upturn is upon us.

The Bush administration's point of view coincides with this positive outlook, and the stock market seems to certify that good times are here.

Unfortunately, this conclusion may be premature. And there's danger that it may prevent the government from doing what is needed to turn this economy around for the longer term.

Remember, all the Pollyana pundits are the same ones who first said there would be no recession (a "soft landing" was the cliche at the time) and then argued that the downturn would be short and relatively painless (which is also proving to be incorrect).

Therefore it makes sense to look at the darker side of the argument.

Negative Case Is Compelling

Weakness in the actions of the government, the Federal Reserve, and the stock and bond markets suggest that the economy might be headed for an extended period flat performance.

Let's take government first. Its lack of action to prevent the economic downturn represents a major departure from the activities of the past 60 years.

Virtually all governments in the Western world concluded in the 1930s Depression that the theories of British economist John Maynard Keynes were correct.

Mr. Keynes argued that to end recessions, governments had to stimulate their economies by all available measures. This ultimately came to mean lowering interest rates and stimulating money supply.

A Stress on Consumption

What is more important, however, is that Keynesian theories sought to stimulate consumption.

First the government would buy things. It was also expected to hire people, thereby stimulating higher individual incomes and more consumption of goods and services. Business would benefit by providing the wanted goods and spending money on its own. The economy, benefiting from increased activity in all sectors, would rise.

The negative aspects was that the government was expected to create mammoth deficits in order to achieve its goals. Money was to be given away - through unemployment insurance and Social Security and welfare payments - in part to stimulate consumption.

In essence the government would borrow in the hope that when the time to pay up came, the economy would be so strong that repayment would present no problem.

Economists, businessmen, and politicians therefore argued that it made no sense to follow the prescriptions of Keynes and his school.

But the heads of government, who discovered that these theories worked, followed them to the letter - though sometimes spurning them in public.

Ronald Reagan, Jimmy Carter, and Richard Nixon were all elected on platforms of cutting government spending and restraining deficits. When in office, however, they bowed before the Keynesian altar and created record deficits. Not one of these men wanted to test new approaches if it meant disrupting economic activity.

The Bush Difference

George Bush is clearly different, however. For whatever reason, he has spurned the Keynesian approach. In the midst of this surprisingly strong recession, he is offering no stimulus.

The U.S. government is attempting to balance its budget and reduce the deficit. State and local governments are raising taxes at record rates, and tens of thousands of public employees are being fired. (Ultimately, hundreds of thousands may get the ax.)

The government is attempting to reduce its purchases of things (note the defense cutbacks) and is actively reducing after-tax worker incomes. It is even pursuing free-trade talks with Mexico; free trade might have long-run benefits but would certainly cost our country jobs in the short run.

It appears that the U.S. government feels no pressure from the current economic downturn and is doing nothing to offset it. In fact, one might argue that Washington is taking actions to accelerate the slide by depressing after-tax incomes and consumption.

The Fed Enfeebled

Perhaps in recognition of this fact, the Federal Reserve has been unusually active in attempting to turn the economy up.

Domestic money supply as measured by M2 is rising at an acceptable 4% rate (far faster than real economic output) and at times in the past six months the monetary base has been gunned at 20%-plus rates. The federal funds rate has fallen from close to 9% to below 6%, and the discount rate has been cut three times in the past 12 months.

The actions of the Fed are meant to provide funds at low price so that the economy will have liquidity and grow.

However, it is quite possible that the Fed is now irrelevant. There are a number of reasons for this:

* The Fed has shrunk dramatically as an actor in the international money markets.

In 1970 required reserves in the banking system were $28.1 billion. M2 was $625 billion. The Eurocurrency market, according to Eugene Sarver in his excellent book "The Eurocurrency Market Handbook," was $110 billion.

Today required reserves in the banking system are $23.5 billion (down $4.6 billion), M2 is $3,385 billion (up $2,760 billion), and the Eurocurrency market is possibly $7,000 (up $6,890 billion).

All this means that in 1970 the Fed controlled required reserves equal to 8.6% of domestic money supply - and domestic money supply was 5.7 times the size of the international money market. Today the Fed controls required reserves that are 0.7% of domestic money supply, and domestic money supply is less than half the size of the international money market.

The Fed has become a very small tail trying to wag a very big dog.

* The actions of the Fed are not affecting the long-term cost of money.

Before the three discount rate cuts of of the past 12 months, the long-term Treasury bond rate was approximately 8.30%. Today this rate is over 8.50%.

There are many reasons why the long-term rate is not declining. The most important is that higher returns are available elsewhere, in the huge international money markets. A second is that the need to pay back the huge Keynesian deficits built up over the past 60 years is coming at a time when the economy is weak and does not have the money.

* The Fed's actions to stimulate liquidity in the system are being thwarted by the actions of bank regulators, who are castrating the system, destroying its ability to generate funds.

The demand for more capital as a percentage of assets in banking companies inhibits their ability to use the new funds generated by the Fed.

The constant threat to remove Federal Deposit Insurance Corp. insurance from some bank deposits and to abandon the "too big to fail" doctrine is forcing the banks to increase their liquidity by not making loans and buying Treasury securities or other cashlike items instead.

Dismantling the Thrifts

However, Congressional and regulatory actions are going even further to ensure that there is little federal or monetary stimulus to the economy.

In the past, the housing industry was expected to show strength when the economy weakened. This was because funds would flow into the S&Ls to be lent to builders and because Fannie Mae would borrow sizable amounts of money to lend into housing with Federal Housing Administration guarantees.

Now, of course, the S&L system is being dismantled. Furthermore, Fannie Mae is being told to increase its capital-to-asset ratios. So it, along with Freddie Mac, may be proportionately less able to lend.

And, of course, the FHA is losing money. Thus the stimulus that housing traditionally provides in a weak U.S. economy is not being provided.

Why then is the stock market so strong?

The answer is simple. The market thrives on excess fund flows. When the economy is weak, the new monies created by the Fed and those funds not being used by the economy float into financial assets. This is why the stock market always rises before the economy and is considered to be a leading indicator; it gets the money first.

However, even the stock market must obey the rules of rate of return. If investors believe they will earn a higher return by investing elsewhere, they will do so. The available funds will flow out of stocks, into bonds or foreign securities.

To determine the rate of return on the stock market versus the bond market at present, one must compare the earnings yield on common stocks with the yield on long-term bonds.

To make this calculation, divide the current price of the S&P 500 into the expected earnings for that index of stocks in 1991 ($23 to $25 by 375). The resulting yield is the expected return on common stocks - at present 6.1% to 6.7%.

This number is much too low in comparison to the 8.50%-plus available on Treasury bonds. Thus without some series of developments to lower bond rates or kick up earnings, the stock market is vulnerable.

This is not good for the economy either. A strong stock market creates a mechanism for corporate fund-raising. High returns in this financial sector also lower the pension funding costs of large corporations.

The government is taking actions that could reduce spending, lose jobs, and cut incomes. The Fed is becoming increasingly irrelevant. The capital-generating capability of the stock market may shut down if prices tumble.

Why then is everyone so sanguine? The outlook could be far worse than is currently imagined?

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