John Rapley - Foreign FocusSO FAR this year, the American economy is off to a good start. When the economy sank into a mild recession last year, aggravated by September 11, the Federal Reserve Board rode to the rescue by aggressively loosening money supply. Injecting vast amounts of liquidity into the economy, the 'Fed' stemmed the stock market slide and shored up consumption.
Of late, however, the slide appears to have resumed, as reflected in the slumping stock market. While some indicators point to a continued rebound, others hint that consumer sentiment is finally starting to show the impact of rising unemployment and declining share values.
Beneath the strong output figures, the American rebound looks fragile. In the 1990s, interest rates fell on the back of declining inflation, itself restrained by low labour costs. But while workers saw few fruits of the boom in their wages, they made up for it with cheap credit, which they used to fuel both consumption and investment. By crowding onto the stock market, they drove up share values and thereby enhanced their own wealth (at least on paper).
The soaring stock market then attracted foreign capital by the truckload. Hundreds of billions of dollars flowed into the US each year, further enriching Americans. Moreover, steady demand for US securities drove up the dollar's value. This, in turn, restrained inflation, giving rise to the much-vaunted new economy: rising growth amid slowing inflation, an almost unprecedented phenomenon.
At the time, some commentators warned that it was too good to last, based as it was on borrowed money. While the federal government reduced its deficit, American households pushed their debt loads to record levels. Still, for as long as returns on their investments remained so good, the strategy appeared sensible.
But did asset values rise too high? Arguably, the future of the American rebound hinges on the answer to this question. Traditionally, stock market analysts calculate the value of a given company's stock by dividing its total earnings by the number of outstanding shares. Using this figure, they then calculate the ratio between the share price and the earnings per share. Historically, the average price-earnings ratio on the US market hovered around 15. During the boom, it rose above 30; on technology shares, it flew into the stratosphere.
To traditionalists, therefore, the US boom was nothing but a bubble economy, similar to Japan's in the late 1980s. Given the state of the Japanese economy since its bubble burst, that analysis was ominous.
However, the so-called new economy theorists, encouraged by the Clinton administration, argued that the old rules had changed. They suggested that globalisation and new technology had so revolutionised productivity that future earnings would outstrip historical averages. These future gains were thus priced into asset values. In other words, assets were fairly valued.
For as long as this confidence was sustained, the boom could last. The market's slide over the last two years reflects merely the effect of reduced earnings, for price-earnings ratios remain largely unchanged. In other words, investors have anticipated a sharp rebound in corporate profits as the economy gets going.
HEDGING THEIR BETS
The problem is, profits have yet to bounce back. Despite rising growth and productivity, corporate America is still struggling to make money. As a result, investors, particularly foreigners, appear to be losing faith in the new economy.
If the productivity gains fail to continue in the future, one of two things will happen. Either earnings will slide or inflation will rise. Apparently mindful of this, investors have been hedging their bets, withdrawing money from the stock and bond markets and placing it in gold, thereby driving up interest rates.
Should these trends continue, and most importantly, should foreign investors continue repatriating their money from the US, the situation will grow dire. Already, the dollar has been sliding. As it does so, inflation is likely to rise. This will drive up interest rates, leaving overloaded US households at serious risk. As they pare spending and curtail investment, the stock market may well crash and the economy sink back into recession.
That is, unless the US government can persuade the world that the new economy was not just a mirage. To date, though, market behaviour seems to indicate that investors are judging that the 1990s boom involved some irresponsible enthusiasm.
John Rapley is a Senior Lecturer in the Department of Government, UWI, Mona.
