Henry Kaufman: No clear road for the world economy
Forecasting the world economic outlook has rarely been trickier. Japan is floundering in stagnation, Europe is headed into a similar mire and even the US seems destined for deflation. Henry Kaufman, the Wall Street economist and financial consultant, offers his views on the state of the US and world economy. As he sees it, one word sums up the challenge for policy-makers and forecasters at the moment – “imponderable”. –
The economic outlook is precarious. We face too many imponderables whose consequences are impossible to quantify as precise statistical estimates of future business and financial behaviour.
One large imponderable is the impact of the war on terrorism on the economy and financial markets. Another is the backwash of the huge financial excesses of the past decade. A third great imponderable is the question of whether government policies on terrorism and financial excess will be effective.
Despite these uncertainties, I suspect that we can avoid a double dip in the economy. On the other hand, a sustained economic lift of cyclical proportions seems unlikely. Consequently, it is likely that the economic path adopted will continue to have a sobering influence on business and financial markets.
As for the first great imponderable – the war against terrorism – no one can really estimate how long it will last or its cost. We have seen economic ripple effects of significant proportions from the attacks of September 11. If there is another major attack, what will the scale of its impact be on our society and economy?
At the same time, we are edging towards war with Iraq. Historically, war has proved to be disruptive for business and financial markets. One thing is clear, however: the federal government’s role as defender of national security – and thus its involvement in the economy and financial markets – has grown significantly in the past year. This stands in sharp contrast to the prevailing view in recent years that the role of government should be reduced.
The many revelations of financial excesses – a second great imponderable of our time – have certainly been startling. But it is important to consider the impact of official responses to these excesses on business and financial behaviour. In an effort to prevent this kind of disaster from recurring, regulatory officials have been busy promulgating new rules of conduct and behaviour. As these rules take effect, corporate boards are bound to tighten their oversight over corporations.
Outside auditors, the audit committees of boards and inside auditors will all scrutinize the accuracy of reported financial information much more carefully. For their part, credit rating agencies are likely to respond with greater alacrity to changes in the credit quality of borrowers.
The Securities and Exchange Commission has given notice that it has become a tougher supervisory organization. Finally, the new regulations will sharply reduce the influence of sell-side stock analysts.
In the long term, these changes will improve transparency, the quality of reported corporate earnings and confidence in the economic democracy of the United States. But in the shorter term, they will restrict economic growth to an imponderable degree.
Even as regulatory officials work to minimize financial excesses in the future, US business continues to live with the grim legacy of excesses from the previous decade.
The financial condition of non-financial business corporations is worse now than at any time since the end of World War II. There have been more downgrades than upgrades of corporate debt for nearly a decade now. The total value of outstanding junk bonds is growing more rapidly than the growth of investment-grade obligations.
While quite a few businesses have improved their liquidity by funding liabilities, many were forced to do so by market constraints. The volume of outstanding commercial paper, which at its peak in 2000 totalled $3.6 billion, has been reduced to $1.8 billion (or 50%) largely because investors questioned the credit merits of issuers.
The funds to pay off this large run-off came mainly from new bank loans and bond issues. This will result in higher borrowing costs that will show up on corporate income statements during the next 12 months. These financial constraints will act to inhibit the normal process of cyclical recovery in capital outlays. Unfortunately, there are other restraining forces as well.
One is the muted recovery in profits which seems quite likely. Most businesses in the US and elsewhere have little or no pricing power, reflecting in part the absence of strong order books and huge excess capacity.
As corporate investment languishes, consumption is a more positive force for private sector strength. But will consumption remain robust? That depends largely on fiscal and monetary policies and, in turn, the impact of these policies on stock prices.
It also depends on the employment situation, which unfortunately will remain sluggish as businesses – strapped for cash and experiencing meagre profit gains – continue to rein in labour costs. It is, however, quite obvious that households have ample access to credit and are not crowded out of the market.
What about business corporations? They crowded themselves out in earlier years through overleveraging and poor earnings. In this respect, the financing pattern of both business and the federal government during record years is very revealing.
In the so-called halcyon days from early 1997 to late 2000, business debt increased at an annual rate of nearly 10%, while the debt of the federal government contracted by nearly 3% annually. Thereafter, business debt grew by an average of 3.6% a year, while federal debt expanded by 4.8%.
It seems clear that economic policy-makers erred, not on the fiscal side, but rather by their unwillingness to recognize and take action to limit the extremely liberal credit practices in the private sector, which in turn underpinned the irrational exuberance in the credit market.
The key government challenge for the immediate future is not the budget deficit. Rather, policy-makers need to pay greater heed to expenditures, and be willing to raise taxes when real resource constraints threaten economic instability. That has been the weakness of fiscal policy all along. But that does not mean that fiscal sterility should prevail.
As for monetary policy, two aspects have recently stood out. There is little doubt that the Federal Reserve’s substantial easing over the past few years helped stem the slide in the economy. But how much can it do to mitigate the ill effects of the financial bubble’s collapse?
Declining interest rates have sharply reduced housing financing costs, encouraging households to buy new homes and take out cash by refinancing their existing mortgages. Home-owners are now better informed about movements in mortgage interest rates, and better able to borrow more quickly, thanks to the growing automation of mortgage applications. In addition, households have become more willing to borrow a higher proportion of the appraised value of their homes than in the past.
Given current economic prospects, the Fed appears to have some leeway to provide additional financing incentives for households by additional reductions in the federal funds rate – which in a slow-growth economy tends to lower rates along the entire yield curve.
But there are complicating factors. Regardless of what the Fed does, the rapid rise in housing prices may be over. That, in turn, would eliminate one source of housing monetization. In addition, the growth of household debt has been large and probably cannot be sustained in a period of subcyclical economic growth.
The yield on 10-year government bonds may continue to fall, but its positive impact on mortgage financing may be weaker than normal. For one thing, the mortgage industry probably lacks the capacity to handle another avalanche of applications with the same speed and efficiency that it showed in the past few years.
More than that, another wave of refinancing will introduce a level of volatility into the mortgage market that will make it somewhat more difficult to hedge mortgage positions.
Mortgage market investors may also prove to be less willing to write new fixed-rate mortgages at the new, very low rate levels. They may view these new low yields as temporary and hold out for them to rise.
To be sure, the recent recession has been mild in historical terms. Monetary and fiscal stimuli have had positive effects, on households and elsewhere. The most recent round of monetary easing has even encouraged financial intermediaries to increase their holdings of securities. Given all this, it is easy to accept a “so far, so good” attitude. But economic policy-makers still face considerable challenges.
A particularly vexing question is how long the Fed will sustain its accommodating posture if asset values remain in a narrow trading range. If investors begin to expect a monetary policy reversal, they will respond negatively.
Will the Fed not reverse its stance until it is confident that the economy and the markets are on a firm footing? Or will it act as soon as inflation begins to move higher again? It will be hard for our central bankers to resist the temptation to jump the gun in this regard.
Some also believe that the monetary options will soon be limited by weaknesses of the US dollar in the foreign exchange markets. I doubt that this will retard US monetary policy anytime soon.
The US dollar will not be challenged in any significant way in the near future. For one thing, investment opportunities are not very attractive elsewhere. Economic growth in Europe is stumbling and is at best anaemic in Japan. The key economies of Latin America are in trouble again.
Both in Japan and on the European continent, fiscal and monetary policies are caught in a quagmire, and strong political leadership is lacking. Of course, the US dollar would suffer seriously, as would leading economies throughout the world, if the United States were to retreat – or were forced to by war – from its broader responsibilities as global economic leader.
But I do not envisage that happening, whether we go to war with Iraq or not.
Henry Kaufman
Henry Kaufman is president of Henry Kaufman & Company, a firm specializing in investment management and economic and financial consulting. He previously worked for 26 years at Salomon Brothers.
