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Can the Boom Last?

July 31, 2000

Hans F. Sennholz

One of the great economic puzzles of our time is the international
strength of the U.S. dollar, the huge U.S. trade deficits notwithstanding.

Many observers view the situation with alarm and expect the exchange rate
of the dollar to fall soon under the weight of an unfavorable balance of
trade. Others look upon the situation with pride and confidence that
American productivity has risen permanently, thanks to great technical
progress in the information industry. Novel technology will allow the
rapid economic growth of recent years to continue, they believe, and
counterbalance all dangers of price inflation and dollar depreciation.

The puzzle of the strong dollar points straight at the related crucial
question of whether the American boom will end without tears.
Professional opinion on the odds for a happy ending is divided. Most
analysts are convinced that Alan Greenspan and his fellow governors of the
Federal Reserve System will manage the party and allow it to continue
indefinitely.

A few skeptics emphasize many adverse conditions and expect
the worst; they dispute especially this faith in the wisdom and power of a
few wise men over the economic lives of millions of people. It is
well-nigh impossible, they contend, to execute a soft landing of an
economic boom that is the longest since records began more than a century
ago.

Shortly before his passing in 1914, the eminent Austrian economist, Eugen
von Böhm-Bawerk
, addressed himself to the puzzle in his essay on "Our
Passive Trade Balance." He called attention to the movement of capital.

The flow of goods and services may be affected and even controlled by the
flow of liquid capital. A net influx of capital tends to facilitate the
importation of goods and services; a net outflow of capital brings about
the opposite.

As long as a country attracts foreign capital, he said, its current
account, which covers imports and exports of goods and services, tends to
be "unfavorable" and its currency remains strong. A country that loses
capital for any reason tends to have a weak currency, which in turn
promotes exports, reduces imports, and generates a "favorable" balance of
trade. As economic conditions deteriorate and liquid capital leaves a
country, its current account balance tends to be "most favorable."

Recent economic events in Southeast Asia seem to confirm Böhm-Bawerk's
observation. Throughout the 1980s and most of the 90s, Malaysia,
Thailand, Indonesia, Singapore, South Korea, and Taiwan enjoyed strong
currencies while suffering large balance- of-payment deficits. A massive
influx of American dollars and Japanese yen facilitated growth rates that
were the envy of the world. But although their currencies were strong,
pegged to a basket dominated by a strong U.S. dollar, large balance-of-
payment deficits led to concerns about the stability of the exchange rates.

By early 1997 the influx of foreign capital had brought a remarkable
increase in economic growth and wealth which was the envy of the world.
The central banks freely created and exchanged their national currencies
for dollars, yen, pounds, and marks seeking investment opportunities. The
expansion of national currency together with the influx of foreign
exchange not only facilitated the importation of more foreign goods,
generating large trade deficits, that is, "unfavorable" current accounts,
but also engendered feverish asset inflation.

High yielding debt
instruments and appreciating real estate attracted ever more foreign
newcomers whose funds sustained the given exchange rates despite the
soaring trade deficits.

The boom inevitably came to a painful end when excess liquidity and
massive malinvestments, especially in real estate, caused foreign
withdrawals which soon accelerated and turned into panicky runs. The
central banks aggravated the runs by extending credit even further in
their effort to rescue overextended banks and financial companies. The
runs soon depleted the dollar reserves and, when the pegged exchange rates
could no longer be maintained, caused the rates to plummet. By the end of
1997 the Malaysian ringget was down by 25 percent, the Indonesian rupiahby
33 percent, the Thailand baht by 37 percent, with the Singapore dollar
losing 9 percent of its exchange value. The South Korean won soon fell
over 35 percent against the dollar,
and even the Japanese yen weakened and fell to a low of 127 to
the dollar.

Throughout Southeast Asia price inflation mounted and
interest rates soared as stock markets plunged and economic expansion
ground to a halt.
The situation may be comparable in the United States. Surely, the
American economy is by far the largest in the world, but the United States
also is the largest debtor with the largest trade deficit.

The U.S.
dollar is the world's most popular currency, having taken the place of
gold ever since President Nixon took the United States off the gold
standard in 1973. But it also is the most overextended currency in the
world with some $572 billion in circulation and a money stock (M3) of more
than $6.7 trillion presently rising at an 8.9 percent annual rate.(July
12, 2000). Unknown trillions of dollars held in banks outside the United
Stats (euro dollars) are commonly used for settling international
transactions.

Surely, the American economy looks very dynamic and the
value of the stock market is the highest in U.S. history, but the private
economy is incurring the biggest financial deficits since the Second World
War. The country is suffering record current account deficits with net
external liabilities now exceeding 20 percent of GDP and rising.

Wall Street may be celebrating the decline in government deficits, but
other debts continue to grow by leaps and bounds. According to the Fed's
Flow of Funds, household debt (mainly home mortgages) is growing at an
annual rate of 9.25 percent, total household debt as a share of personal
income now exceeds 103 percent. Business debt is soaring at a 10.5 rate.
Corporate debt of non-financial firms is rising at a 12 percent rate, the
fastest in more than a decade.

While some of these debts are going into
new investments, much is spent on share buybacks. In short, corporations
are going into debt to boost their share prices. Margin debt in the stock
market is growing faster than any other type of credit. In 1999 it soared
by 46 percent, now exceeding $206 billion, which is the highest in U.S.
history. Unfortunately, if this growth of debt should come to a halt, or
merely slow down, it may break the fever of the boom and usher in the
readjustment.

Rising debt is not the only threat to the economic boom. Derivatives are
the single greatest danger, especially to financial institutions. These
are options, futures, and options on futures which are highly leveraged
speculation on virtually everything: interest rates, stocks, stock
indexes, and foreign currencies. Even bonds and mortgages may yield
derivatives as they are split into the interest-only portion and the
principal- only portion. American commercial banks, brokerages, and
insurance companies are the primary source and traders in derivatives now
exceeding $35 trillion. What would happen to derivative players if the
markets should suddenly begin to readjust, if interest rates should rise
suddenly or price inflation should return in force?

The American economy is in its 10th year of cyclical expansion, which is
the longest on record. A grave risk in this setting is a sudden fall in
share prices, a bear market, which would evoke a dramatic fall in consumer
confidence and demand. Since consumption is driving more than two-thirds
of American production and growth, a sharp decline of consumer demand
would soon lead to a decline in production, which may trigger an
international run from the dollar. In order to stem such a run and
attract enough foreign capital to cover the current account deficit of
more than 4 percent of GDP and carry external liabilities of more than 20
percent of GDP, the Federal Reserve would have to raise its rates. But
such a raise at a time of falling stock prices and falling output would
soon aggravate the decline and lead to a painful recession. The present
pleasant scenario of rising productivity and income, high stock prices and
a strong dollar would soon turn into the opposite - falling productivity
and income, falling stock prices and a weak dollar, declining imports,
rising inflation, rising interest rates, and rising unemployment. The
longest economic boom in history would give way to a long recession.

In the face of growing economic difficulties public opinion may demand
that the Fed lower its interest rates in order to redress the decline.
Politicians and government officials may add their weight to an active
countercyclical policy of easy money and massive deficit spending. But
such a reaction by the world's biggest debtor and spender would only
aggravate the situation. Even if foreign investors would patiently
refrain from withdrawing their funds from the United States but only
hesitate to invest new funds, the trade deficits would cause the dollar to
plummet with all the dire consequences.

The dangers of a looming recession, together with a weakening dollar,
would present the Fed with the choice of two inevitable evils. Compelled
to choose one of the two, the Fed may raise its rates in order to defend
the dollar but thereby aggravate the recession, or it may lower its rates
in order to stimulate the sagging economy but thereby weaken the dollar
and engender more price inflation. Whatever the Fed's choice may be, it
will incite the wrath of the public and forever tarnish its sterling
reputation.

Many knowledgeable investors are convinced that the American stock market
is already in its early stage of cyclical readjustment. They know that,
at 28 times record earnings, stock prices are rather lofty and the market
may have entered a stage of "distribution" of large holdings. They are
pointing at the Dow Jones Industrial Average having topped out on January
14, 2000 at 11,722, the NASDAQ on March 10, 2000 at 5,048, and the S&P on
March 24, 2000 at 1,527. They are bracing for the next stage of the bear
market: a precipitous decline.

The U.S. dollar in 1999 and 2000 may have received special support and
strength from the unexpected weakness of the euro, the single currency of
eleven European countries. While the low euro enabled several European
countries to achieve an export- driven economic recovery and sizeable
current-account surpluses, these were dwarfed by the magnitude of capital
outflows exceeding $150 billion in 1999, driving the euro irresistibly
lower and boosting the U.S. dollar.

Two political forces that are as unstable and unpredictable as politics
itself are gnawing at the purchasing power of the euro. The European
Central Bank is conducting an expansive policy which obviously exceeds
that of its primary competitor, the Federal Reserve System. Comparative
interest rates tell the story. At the present (July 21, 2000), the Fed
discount rate stands at 6 percent and the Eurodollar rate at 6.69 percent;
the euro rate is quoted at 3.75 percent. The American prime rate is given
at 9.5 percent, the German rate at 4.25 percent. Last year at this time
German banks charged 2.5 percent, American banks 8 percent. This rate
differential alone points in the direction of the flow of funds.

While
the ECB's own target rate of expansion is said to be 4.5 percent per year,
which hopefully will maintain price stability, its actual increase of the
stock of money has exceeded six percent ever since its inauguration on
January 1, 1999. Its governors seem to be guided by oldfangled Keynesian
thought which ordains the desirability of credit expansion for most
economic ailments. The other cause of euro weakness is rooted in the
primitive ideology of welfarism which creates large armies of paupers on
public assistance and workers on unemployment rolls. Great rigidities of
the euro-zone labor market impose high costs on investors. They have to
cope with very high social security taxes which finance unfunded,
government-dominated pension systems. Many currency dealers are convinced
that there is no hope for the euro as long as European governments are run
by "unreconstructed socialists."

It is hardly surprising that under such
institutional conditions most European economies are stagnating with
hundreds of billions of euros seeking to escape.
Many billions find their way to Wall Street.
This situation is bound to draw to an end as soon as European thought
leaders finally tire of the stagnation and unemployment and demand
far-reaching economic reforms. This day will come because of the close
interdependence, interplay, and interchange of European and American
thought. When European policy makers finally embark upon reform the euro
will come into its own. The U.S. dollar may then be found to be greatly
overextended and the overdue economic readjustment will not be far behind.

Our Fed managers and their numerous devotees are fully convinced that the
Fed has the power to prevent a painful recession. But having generated
the boom phase with easy money and credit, how can it be expected to avoid
the inevitable readjustment?

Throughout the long history of the Fed,
the governors invariably have sought to prevent the readjustments with
ever larger bursts of credit expansion and, once enmeshed in a recession,
sought to rekindle the boom with easy credit. Unfortunately, this
merry-go-round, which characterizes all federal administrations from
Herbert Hoover to Bill Clinton, has reduced the value of the U.S. dollar
to a fraction of its original value.

Alan Greenspan and his fellow governors obviously are impressed by the
apparent benefits of the "new economy" with its high-tech innovations and
boosts in productivity. And they seem to be unsure of the enormous wealth
effects of the stock market on consumer spending. Surely, they have
increased interest rates in quarterpoint and halfpoint stages, seeking to
stem consumer demand without stifling the expansion. But the
maladjustments that are visible in the financial markets continue
undiminished.

The high-tech revolution undoubtedly makes human labor more productive. Powerful computers and the Internet enable many corporations to increase
their profits by cutting costs. They may economize the use of labor,
eliminate middlemen, reach new customers, control inventory, manage
delivery, and perform many other functions; but they necessitate heavy
capital investments which entail high capital costs. Analysts estimate
that computer and Internet-related efficiencies may add some two percent
to annual corporate earnings in the United States. They will add little
or nothing to business earnings in many developing countries in which the
high costs of capital exceed the costs of labor to be saved.

Such modest
expectations obviously do not support stock prices that set all-time
records. They cannot for long sustain the bull market which measures
Internet success in hundreds of percentages. Moreover, they even cast
doubt on the genuineness of the "new economy."

"The new economy" of the 1990s reminds the historian of two previous "new
economies" that bred much confusion and ended in upheaval. The first
"new economy" made its appearance during the roaring 1920s with soaring
equity prices and negligible unemployment.

President Coolidge and his
fellow politicians proudly identified with the prosperity. And again
during the 1960s President Kennedy's "new frontier" and his involvement in
the Vietnam War ushered in a "new economy" with economic growth that
lasted eight years, with both inflation and unemployment at their lowest
levels in years. President Johnson boasted about his economic
achievements when he left office in 1969. We know that the following
decade brought double-digit inflation, a deep recession, an energy crisis,
and general political turmoil. If the previous "new economies" are
indicative of the true nature of economic newness, we must brace for much
pain and stagnation to come.

The economic maladjustments due to many years of monetary manipulations
by the Federal Reserve System are the prime source and mover of the
inevitable readjustment. Once the market structure no longer reflects the
unhampered choices of all participants, the readjustment is unavoidable.

In the end, the laws of the market always prevail over the edicts of
political controllers and regulators. They even reign over the wishes of
a few central bankers. Surely, government officials and central bankers
have the power to lessen or aggravate the stresses of readjustment as they
have the power to interfere with the economic lives of their nationals.

They may reduce their burdens of government and allow the readjustment to
proceed quickly and efficiently. Unfortunately, they tend to make matters
worse and prolong the readjustment with ever more political intervention
such as monetary expansion and deficit spending.

The Japanese government managed to turn a readjustment that began in 1990
into a decade of deep depression the end of which has not yet come in
sight. This example and many others make us fearful that the U.S.
Government will turn the coming readjustment into a long and painful
recession. Political intervention is ill-designed for soft landings.

------

Hans F. Sennholz, professor emeritus at Grove City College, received a second PhD under the direction of Ludwig von Mises. Professor Sennholz has his own website, from which this essay is reprinted: Sennholz.com. You can send him MAIL.


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