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Bulls and Bears

Mises Daily: Monday, January 15, 2001 by

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Hans F. Sennholz

There is a great division among economists over where the American economy is headed.  Essentially, they are divided into three different schools of thought: the pessimists who believe that the economy is bound to sink into a long and painful recession; the optimists who believe that the former are doom- and-gloomers overreacting to a few negative indicators; and those who are straddling the fence because they don't know which side to come down on.  All three camps obviously view the economy through different theoretical glasses that color their analyses and outlook.

Some optimists point to the fact that the American economy has weathered a devastating storm in 2000 and, therefore, is bound to do well in the coming months.  Every conceivable obstacle has been erected and every combination of events has been leveled at the equities market. 

Yet, the economy continues to grow and the markets, though shaken, are holding their own, despite several interest-rate hikes by the Fed, oil prices over $35 a barrel, natural gas at $10 per MCF, many commodity prices falling, real-estate prices skyrocketing, scores of dot-com companies failing, taxes rising and savings fading, civil war in Israel, war with Yugoslavia, and even a presidential impeachment. To withstand all such disruptions and trillion-dollar corrections is to reveal exceptional strength, which is bound to come to light in the coming months.  For these optimists, experience apparently is the only teacher who, in their judgment, is preferable to any number of theories.

Other optimists are convinced that the Federal Reserve, under the Chairmanship of Alan Greenspan, will avert any panic and avoid a recession.  The Fed and nearly all other central banks, they assert, have become "Keynesians" who may not believe in Keynesian doctrines, but they do not know what else to do.  As long as the consumer price index does not move up sharply, they will expand their credit.  But it is unlikely that they will succeed in reflating the old tech bubble; instead, they may create new bubbles, which will be in weapons and raw materials, such as
oil, natural gas, platinum, palladium, and even copper. 

The weapons bubble will build on the growing danger of war in the Middle East and on the anti-American hostility of Iran, Iraq, Syria, Libya, North Korea, Pakistan, Afghanistan, and the Sudan.  In short, the profusion of geopolitical crises and the Fed's return to Keynesianism make these observers rather optimistic in financial matters, expecting great changes in 2001 and numerous opportunities for alert investors.

The Keynesians in the camp of optimists echo their teacher: John Maynard Keynes (1883-1946) who sought to give scientific justification to a policy of vigorous government intervention.  His economic doctrines conquered the free world during the 1930s and have shaped the economic policies of scores of governments ever since.  While Keynes was preoccupied with a depression-ridden world, his modern disciples usually endeavor to make the national economy grow faster. 

In the footsteps of the master, they call on government to increase production, incomes, and jobs through the wise use of three important policy tools: taxation, government spending, and money management.  They feature government spending which, they believe, enjoys the characteristic of a "multiplier," that is, it generates an increase in income that is a multiple of the original government spending.  In the world of Keynesianism easy money assures full employment and government spending by officials and politicians multiplies the people's income.

In the optimists' camp the Keynesians argue with the "Monetarists" who, on the foundation of overwhelming empirical evidence, hold to a version of the old quantity theory of money and re-emphasize the importance of monetary policy.  They never tire leveling devastating criticism at official monetary managers for having caused disastrous recessions through gross mismanagement of the money.  They point to a long list of Federal blunders which, in their judgment, have increased in frequency in recent years.  There was the crash of 1987, the bear market of 1990, the bear market of 1994, and the 1997-1998 financial crisis abroad. 

The present situation is most precarious, they believe, because the Fed made the monumental mistake of raising interest rates several times in recent months.  But as soon as the Fed cuts its rates, big rallies and visible improvements are bound to follow.  On January 3, 200l when the Fed lowered its rates by one-half of one percent, they applauded.  In the hope that the Fed will continue to lower its rates, the Monetarists are happily turning optimistic again.

The Wall Street Journal's semiannual survey of 54 economists arrived at a consensus growth forecast of just two percent for the first half of 2001  and three percent thereafter.  All economists expected the Fed to lower interest rates, which should lay the foundation for stronger growth in the future.  But they differed on the very nature of the present difficulties.

One party viewed them as a mere reflection of a brief technical adjustment of the economy; the other party saw fundamental changes due to rising interest rates, the energy shock from rising oil, natural gas and electricity prices.  They pointed to the slowdown in technology spending, stock-market woes, a budding credit crunch, even the colder-than-normal weather. 

Nevertheless, forty-nine economists foresaw continuous economic growth; only four expected the American economy to contract in the first quarter of 2001.  Thirty-five economists faulted the Federal Reserve for raising interest rates too much.  Twenty-three warned that tight money would trigger a recession this year, fourteen hinted at the troubled stock market, and ten at rising energy prices. 

It is significant that not a single Wall Street economist expressed his disappointment about the massive credit expansion that spawned the economic boom of the 1990s.

Some analysts in the fence-party camp are convinced that the information technology has created a "New Economy" which fueled the great boom and may also affect a decline.  They are unclear on whether it will lead to a painful recession or facilitate a soft landing and a speedy recovery.  The present downturn, they assure us, differs from others in the past in three important ways. 

First, the stock market, which at its peak at the end of 1999 recorded a stock value of 181 percent of gross domestic production (GDP), may significantly affect the economy on account of its sheer weight and importance.  Stock prices, which traditionally responded to economic expectations, now may actually influence expectation and guide economic activity. 

Second, the new technology may prove to be a double-edged sword.  It caused corporate America to make heavy investments in computers, software, networks and Internet infrastructure.  In a downtrend some such investments may prove to be excess investments that are abandoned.  The period of heavy investments may be followed by a period of scanty commitments. 

Finally, the rapid productivity growth in recent years provided employment for ever more workers.  If growth should slow, companies could shed workers in large numbers.  Unemployment would soar, even if the economy should stay out of recession.  A sharp fall in jobs would mean a fast decline in consumption, which would decelerate the most powerful economic engine.

Moreover, because the new technology provides business with instant knowledge of sales and earnings, business is likely to react faster in cutting back in a downturn.  In short, having never experienced a New-Economy recession, some fence-party analysts are bracing for some difficulties but are refraining from calling a recession.

The camp of the pessimists, just like that of the optimists, consists of a number of parties that agree on the basic trend of the economy - a downward direction, but disagree on the reasons for their pessimism. There are the "market realists" who point to experience as the only reliable teacher.  They know that the stock of great old companies sells for under 30 times earnings; paying 200, 300, 400 times earnings for that of newcomers is sheer folly. 

Even after the conspicuous decline of the Nasdaq in 2000, there are still many companies the stock of which is selling for 100 times earnings and more.  Such prices are fever-driven speculations that are bound to be corrected painfully.  "Never buy into a business that is unable to compete in the real world," they advise their followers.  The Nasdaq fever is like the great California gold rush, they explain; fewer than 1 in 10,000 prospectors ever struck it rich.  But the companies that brought the people to California or sold them picks, shovels, and groceries made enduring fortunes.

Other "realists" point to a potential credit crisis that is casting its shadow over the economy.  Throughout the financial boom the leading banks freely extended their credits to many new enterprises that now face difficulties.  Apparently, suffering from the high-tech fever, they readily financed new ventures at high rates of interest, but then, in order to maximize their returns, failed to set aside the necessary reserves covering the high risk.  In just 12 months ending in September 2000, the debtor default to the Bank of America, for instance, rose from $3.3 billion to $4.4 billion, but the Bank's specific reserves declined throughout this period. 

The Bank management obviously accepted the talk of a permanent transformation of the American economy through the Internet, as did many regional banks.  Their stockholders are bound to pay the price for this exuberance.  Moreover, the whole tech industry now faces great difficulties raising capital at any rate.  The banks' generosity has turned into the opposite, a policy of scantiness and closed pockets.  In the junk bond market, interest rates have risen already to 14 percent, a level they briefly reached in the 1990-91 recession.  

A real "credit crunch" is threatening on the horizon, which would gravely encumber the American economy.

Congressman Ron Paul, a keen observer of the Washington scene, points to glaring examples of the credit bubble waiting to be pricked.  The government-sponsored financial institutions Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) show $33 billion of shareholder equities with $1.07 trillion worth of loans.  Similarly, commercial debt barely amounted to $50 billion in 1994; today it is ten times higher, exceeding $551 billion.  When the bubble bursts because of debt default, the economy is bound to flounder, no matter how the Fed may attempt to prevent it.

A few pessimists apply psychological understanding to their analyses of the economy.  They distinguish between several psychological phases of a bear market and economic decline.  In the early phase only a few knowledgeable analysts and investors perceive a maladjustment of various markets and, therefore, begin to withdraw.  Public enthusiasm may turn into doubt and suspicion.  In the second psychological phase, into which the economy is now moving and which usually is the longest, business conditions deteriorate and stock markets go down.  Public doubt turns into investor despair.  In the third and final stage, the economy readjusts and recovers although the public refuses to believe it.

These analysts expect the American economy to turn down rather quickly, which should surprise most observers, including the governors of the Fed. As the decline accelerates, the disaster in the technology industry and Nasdaq is likely to turn into calamity for most other industries and the Dow, including the blue chips.  At the present, the Dow is still selling at 20 times earnings and yielding a paltry 1.6 percent.  Such prices and yields are characteristic of bull market tops rather than bear market bottoms.

During the economic decline the Fed can be expected to fight it "tooth and nail."  It undoubtedly will expand money and credit at unprecedented rates in order to stimulate and revitalize the markets.  And, in old Keynesian fashion, the U.S. Government will boost its spending in order to stem the decline.  Unfortunately, all such policies merely render the needed readjustments more strenuous and thus prolong the recession.  They help finance and carry the maladjustments instead of allowing them to be corrected promptly.

The psychological analysts in the camp of pessimists often draw conclusions similar to those drawn by Austrian economists who differ from all others in their search for the ultimate economic causes.  They disagree especially with the Monetarists who believe that "exceedingly tight monetary policies" cause depressions and that sufficient monetary ease assures prosperity. 

In contrast, Austrian economists are convinced that the propensity of officials and central bankers to inflate the currency and expand credit leads to unsustainable structural maladjustments that need to be corrected sooner or later.  In fact, they contend that the magnitude of the maladjustments accumulated during the credit expansion predetermines the length and severity of any recession.

Kurt Richebacher, a German banker espousing Austrian economic theory, compared the present excesses in valuations, money and credit expansion, and economic fundamentals with those of 1929 when the stock market was about to crash and the American economy sink into the Great Depression.

In September 1929, the price-to-earnings ratio of listed corporate stock stood at 13.5 - at the beginning of 2001 the S&P 500 hovered at 24, the Dow Industrials at 29, and the Nasdaq still exceeded 100.

Between 1925 and 1929 the stock of money (M3) increased by some 10 percent - between 1995 and the end of 2000, it grew by a stunning 55 percent, more than five times the estimated growth of GDP.

The expansion of credit during the 1920s exceeded that of the stock of money by a large amount.  But it does not compare with the credit explosion since 1995.  While GDP expanded annually by some $500 billion, the volume of new credits swelled by $1.4 trillion in 1997, $2.1 trillion in 1998, $2.25 trillion in 1999, and an estimated $1.8 trillion in 2000.

This growth of credit occurred at a time of lowest rates of savings and biggest trade deficits.  Moreover, persuaded by the notion of great corporate efficiency due to the new technology, many American corporations reduced their liquidity to finance acquisitions and stock buybacks.  They purchased shares yielding minuscule returns with borrowed money costing 8 to 10 percent; this strategy is a clear signal for corporate disappointments to come.

Current economic fundamentals make poor reading in every respect. Corporate profits are virtually flat although the economy has been growing at astonishing rates.  But this growth has been financed by a massive expansion of debt by both corporations and private households.  The feverish equity markets generated a psychological wealth effect that stimulated the credit creation.  A crash would soon turn the wealth effect into a poverty effect, which would depress economic activity.

This writer agrees with the reasoning of his Austrian colleagues.  But he is at a loss about some of the conclusions they draw from their theories. Kurt Richebacher, for instance, comes to the conclusion that "the stock market crash was the most important, immediate cause" of the Great  Depression.  Surely, we readily agree that the crash generated a "poverty effect" which depressed consumption and promoted savings.  But that's no cause of depression. 

On the contrary, while the consumers' goods industries may feel a pain of readjustment and the producers' goods industries may stagnate for a few months, the new savings tend to reduce interest rates, which may hasten the needed readjustment.  The rapid recovery from the post-World War I decline (July 1920-July 1921) clearly demonstrates the point. Surely, all readjustments are painful and take time; they entail business losses, capital writeoffs and temporary layoffs.  They may lead to short recessions, but are incapable of enmeshing a market economy in a long and deep depression.  Only government intervention can turn a market readjustment into a Great Depression.

President Herbert Hoover and the Republican Congress managed to do just this when they enacted the Hawley-Smoot Tariff Act of June 1930 which raised American tariffs to unprecedented levels.  It practically closed U.S. borders and caused the immediate collapse of the most important export industry, American agriculture.  In the depression that followed, the U.S. Congress struck another blow which shattered all hope of recovery. 

The Revenue Act of 1932 doubled the income tax, raised estate taxes, and imposed several new taxes.  When state and local governments faced shrinking tax collections they, too, joined the federal government in imposing new levies.  In 1933, in Hoover's footsteps, President Roosevelt placed the government in the driver's seat.  The National Industrial Recovery Act led to the development of codes of prices, wages, hours, and working conditions.  It pursued the old daydream of prosperity through less work and higher pay.  And finally, we must not overlook the Wagner Act of 1935 which took labor out of the courts of law and raised the costs of labor, which again deepened and lengthened the Great
Depression. 

Only when more than 10 million able-bodied men had been drafted into the armed services in World War II, unemployment ceased to be an economic problem.  And only when the purchasing power of the dollar had been cut in half through vast budget deficits and currency depreciation, did American business manage to adjust to the oppressive costs of the Hoover-Roosevelt Deals.

It is unlikely that the George W. Bush Administration will repeat the fateful blunders of the Hoover and Roosevelt Administrations.  We know of no plans for closing American borders, for doubling the income tax, codifying business activity, or significantly boosting the costs of labor. Guided by Keynesian and Monetarist thought, both major parties undoubtedly will want to inflate more, create credit at faster rates and, above all, increase government spending.  But contrary to Keynesian and Monetarist doctrine, such measures may actually hamper the business recovery. 

Massive budget deficits and near-zero interest rates may actually impede economic activity, as the Japanese recession throughout the 1990s so clearly demonstrates.  Or they may precipitate an international run from the U.S. dollar, which would rekindle the price inflation of the 1970s and 1980s.  Blinded and dulled by Keynesian and Monetarist thought, the politicians in power probably will act as they always have acted: they will spend and spend and make matters worse.

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Hans F. Sennholz, Emeritus Professor of Economics at Grove City College, is an adjunct scholar of the Mises Institute. Send him mail, and see his Mises.org Archive and his Personal Website.