Vanderbilt Capital Advisors
STRUCTURAL
ISSUES IN THE ECONOMY
"An economic policy, if there had been one in the
Bush administration, would have focused on the real economy, not solely on its
adjuncts such as interest rates. The
administration would have asked why new business starts dried up, killing off
the real engine of economic growth, and it would have found the answer in the
multiple burdens of ever-rising taxes, environmental costs, and regulatory
burdens it heaped on business. It would
also have asked why there was so little real effort to curb the congressional
propensity to waste money.
Instead, Mr. Brady wanted his fellow finance ministers
in
George Melloan,
Wall Street Journal,
Mr.
Melloan is quite correct in his diagnosis of the
failure of the Bush administration's economic policies. This is especially true of the non-policies
of Nicholas Brady, arguably the most ineffectual Treasury Secretary in decades. The truth of this assertion does not derive
from some ideological position on our part as to whether government per se is
good or bad. Rather it stems from a
scientific understanding of the critical if unglamorous role of rational
incentive structures in generating growth in a modern economy confronting
truly global competition. The important
role of incentives is supported not only by theoretical deductions within the
"new" microeconomics of uncertainty and information, but also via
empirical analyses of which nations grow fast, which grow slow -- and why.
This much having been said about the longer
run, we must now focus on the more immediate outlook for the
1.
The
In
the
o Absence
of a classical inventory cycle recovery -- reflecting not only the role of
"just-in-time" technologies in suppressing the classical cycle, but
also the self-validating expectations of the business community for a very slow
recovery;
o Ongoing "slimming" of industry
and of the service sector, creating as it has a nearly unprecedented sense of
gloom in the labor market not only about short-term employment prospects, but
long-term prospects as well;
o Reluctance of financial intermediaries
either to seek deposits or to book loans given the riskless
route to balance sheet recovery by riding today's remarkably steep yield curve;
o Lack of contra-cyclical fiscal stimulus,
especially, when the distress of state and local governments is taken into
account;
o Desynchronization
of the global business cycle, whereby the economies of
o Ongoing determination of consumers and
businesses to repay debt and improve their balance sheets to the
extent possible in difficult times.
Despite the
lackluster pace of growth and the lack of optimism in all quarters, a recovery
does seem to be under way, and we do not expect another recession soon. The very fact that mean growth is low serves
to increase the perceived degree of uncertainty about the reality of
recovery in a somewhat misleading way.
For fluctuations in the values of the various economic indicators around
a low growth mean will inevitably give rise to some negative indicators (e.g. a
one-month decline in some index).
Psychologically, these take a disproportionate toll on the perception
that a recovery is really afoot.
All of the
foregoing structural impediments to vigorous growth have been analyzed
extensively in various publications.
There is one, however, that is proving to be particularly salient and
thus merits special comment.
"Slimming"
and Distress in the Labor Market: We are
not as concerned as the market was about the August employment figures, partly
because of seasonal factors (e.g., school graduates) for which it is
notoriously hard to "adjust".
Instead, what is disturbing to us is the extent to which
"slimming" of middle management continues to take place
notwithstanding the modest upturn in the economy. A continuing rise in official unemployment of
non-salaried employees always characterized the early stages of cyclical
recovery. But what is currently
happening in the ranks of salaried workers has no precedent at all, and in and
of itself all but guarantees that the U.S. recovery will continue to be
sluggish.
Briefly, two
developments in the labor market are particularly noteworthy:
o First, the existence of an extensive network
of middle managers went hand in hand with the rather top-heavy and
"vertically organized" organizations of yesteryear. But with the advent of the new microeconomics
of manufacturing around 1975-1980, everything was to change. Specifically, the advent of the microprocessor, and subsequently of CAD-CAM and digitally
reprogrammable manufacturing equipment made it possible to retool existing
products and introduce new ones in a fraction of the time traditionally
required to do so.
The result: a
dramatic foreshortening of the "distance" between the producer and
his suppliers on the one hand, and the producer and his customers on the
other. In this new environment, with
its premium on fast turnaround, the necessity to flatten the organization's
structure and thus to slim middle management was a foregone conclusion.
o Second, the reality of these structural and
non-cyclical developments in the labor market has dramatically altered the expectational context in which microeconomic
decisions of every kind are made -- ranging from decisions about hiring to
decisions about purchases of consumer durables.
The growing realization that many job losses are permanent creates a
self-validating set of expectations that ripple through the economy.
In this context,
the new research into the phenomenon of unemployment by John Roberts of
Stanford University becomes highly important.
Roberts uses advanced game theory to demonstrate that Keynes may well
have been right and Adam Smith/Arrow/Debreu wrong
concerning one of the most fundamental issues in all of micro and
macro-economics: the logical possibility of an involuntary
unemployment equilibrium.
In such a state,
no equilibrium set of wage rates exists which clears the labor markets despite
an absence of the usual "rigidities" that create unemployment,
such as imperfect competition (e.g., labor unions), an absence of
"contingent markets" to cope with uncertainty about the future,
etc. Keynes argued but did not formally demonstrate, that certain pathological cycles of
self-validating expectations could result in involuntary unemployment of this
kind. Arrow and Debreu
proved formally that this could not happen in the absence of classical
rigidities.
By generalizing
the Arrow-Debreu model, Roberts showed that this need
not be the case. His work is not merely
of theoretical interest. For the
circumstances which can generate an involuntary
unemployment equilibrium in his model mirror precisely those we witness today,
and stem from self-validating expectations of inadequate aggregate demand. This is indeed sobering food for thought.
2.
The Myth of "Policy Coordination" - and Today's Dollar
During the early
and mid 1980s, and culminating with the celebrated "Plaza Accord" of
September 1985, it became widely believed that G-7 governments would
increasingly coordinate their macroeconomic policies in the future. This somewhat fuzzy concept was soon extended
to a prediction that interest rate levels in Japan, Europe and the U.S. would
increasingly move in sync.
However,
monetary policy and interest rates in general are variables that continue to be
determined by largely domestic conditions. In addition, with the desynchronization
of the global business cycle, domestic economic conditions are proving to be
neutrally correlated. As a result,
monetary policies and interest rate levels would go their own way. Conversely, volatile currency movements will
continue to bear the brunt of the adjustment process in a world where monetary
policies are not coordinated.
Events during
the past three years certainly substantiate the above reasoning. The economies of Europe, Japan, and the U.S.
have been very much out of sync, and these domestic economic realities have
precipitated completely uncoordinated monetary policies driven solely by
domestic concerns. Currency movements
continue to bear the brunt of the underlying adjustment process accompanying
divergent monetary policies. In
particular, the recent steep drop of the dollar should be understood almost
solely as a result of German rates repeatedly being driven higher than
expected, and U.S. rates being driven lower than expected. Understanding these dynamics of adjustment
is highly important for investment managers given their increasingly global
orientation.
There is of
course one context where policy coordination is alive and well, and this is within
a given currency bloc, in particular the European Monetary System. We are currently watching a number of
European nations seriously impairing their own economies by adopting
coordinated monetary policies aimed at maintaining fixed exchange rates. Time will tell whether such policies will
continue. We are skeptical that they
will or should given the fundamental differences between several European
nations; Germany and Italy in particular.
3.
Paradox of Slow Money Growth
The U.S. Federal
Reserve Board has eased interest rates 23 consecutive times since 1989. Yet, especially recently, the monetary
aggregates have grown at rates well below target. How can this be the case, and what does it
mean? An answer to these questions
presupposes an understanding that money growth is a variable which must be
interpreted in a proper supply/demand setting.
After all, what exactly is the "growth of M2?" It is nothing other than the rate of change
over time of the point of intersection -- projected onto the "quantity
axis" -- of two price/quantity relationships: the demand curve for money,
and the supply curve. Here then is an
analysis of today's paradoxical situation which results from adopting this
perspective.
Demand for
Money:
M2 has been growing well below 2.5%, the lower end of the Fed's target range of
2.5% - 6.5%. Slow money growth certainly
indicates that consumers and businesses have decided that they do not want to
hold significant cash (or otherwise highly liquid) balances. Why might this be the case, and what do these
reasons protend for the economy? Three stories can be told in this context.
First, the classical monetarist explanation of the choice to hold fewer
liquid assets would be that people simply don't plan to increase their spending
anytime soon, and thus decide to accumulate assets of a non-cash variety. Yet recent and highly interesting empirical
research by Benjamin Friedman and others suggests that in today's environment,
neither money aggregates (such as M2) nor credit aggregates (such as private
debt outstanding) contain meaningful information about the future course of the
real economy. This is particularly true
when the turnover or "velocity" of money is changing as it now is,
for reasons not fully understood.
Accordingly, this first explanation of low money growth is problematic;
the second and third stories are more persuasive.
Second, the extraordinary slope of the yield curve has caused people to
shift funds out of low-yielding liquid assets, and to lengthen their
maturities, shift into stocks, or whatever.
This indeed is true. Evidence
abounds that people have been shocked by below 3% returns on cash deposits, and
have altered the composition of their assets as a result. Note that this second explanation contains no
information about prospective economic growth.
Third, the steep yield curve has caused people to alter the liability
side of their balance sheet as well as to redeploy their assets. Specifically, with longer-term rates
remaining high, the temptation to pay off debt has rarely been greater, and
evidence abounds that people who can afford to do so are paying down debt. This third explanation may portend slow real
growth to the extent people use income (rather than existing liquid deposits)
to retire debt.
Supply for
Money:
The Fed has certainly done its part, especially over the past year, but what
about the banking system? This is the
supply-side question, and it underlies the debate about the existence of a
credit crunch. The evidence suggests
that banks have not done their part.
Rather, they have chosen to exploit today's steep yield curve and
redress their balance sheets in two ways entailing minimum risk.
First, they have not increased the interest rates they will pay on
deposits, thus indicating that they do not want to increase the liability side
of their balance sheet.
Second, they are booking extremely safe assets, either in the form of
purchases of government securities, or else loans to established, credit-worthy
borrowers.
Taken together,
these "shifts" in both the supply and demand curves in the money
market explain the performance of the monetary aggregates.
4.
Postscript on Protectionism and "Industrial Policy"
Just as the
problematic concept of "policy coordination" became fashionable in
the 1980s, so did that of the prospective advent of Fortress Europe, Fortress
Japan, and Fortress North America in the 1990s.
Regional protectionist policies are certainly an ominous possibility as
the end of the millennium draws near.
But here we have another example of a concept which sounds
compelling on the surface, but which may not make sense when scrutinized from a
bottom-up microeconomic perspective.
To understand
this, consider developments in the increasingly important memory chip
industry. It turns out that for
microeconomic reasons utterly unbeknownst to government planners, production of
the next generation 256 megabyte chip will require a staggering $1.25 billion
investment up-front. Daunted by this
figure, IBM, Siemens, and Toshiba deemed it microeconomically
rational to team up and go it together.
In a parallel
deal announced two weeks later, Advanced Micro Devices and Japan's Fujitsu
announced a "strategic alliance" to develop so-called
"flash" chips. Should this be
any surprise? No, not when appraised
from the light of microeconomic logic.
McKinsey and Co. and other consultancies have reported for years on the
rising significance of strategic alliances of just this form.
Here in the
States, people blind-sided by these recent developments and at a loss as to
what they portend include Harvard's Robert Reich -- an architect of the Clinton
economic program. Reich and others are
not business oriented, do not understand microeconomic logic, and are busy
promulgating top-down "industrial policies" designed to bolster U.S.
performance in the coming era of protectionist blocs.
Yet what Reich
and others like him fail to realize is that businesses both small and large are
becoming increasingly impervious not only to national frontiers such as those
within the European Community, but also to the artificial barriers erected by
economists and policy makers around supposed continental trading blocs. In such an integrated global context, any
industrial policy aimed at improving U.S. competitiveness should assume a
microeconomic, bottom-up form. The aim
should be to reduce regulatory, tax and other impediments to investment,
innovation and growth, instead of attempting to promote growth through the
protection and subsidization of industries selected by government agencies.
FED
POLICY
Commentary: Several
paradoxes arise in the context of monetary policy during the present business
cycle. First and foremost is the paradox
of why an unusually strong dosage of Fed easing has failed to kick-start the
economy. The reasons lie in the peculiar
role of structural impediments to strong growth which easier Fed policy has not
been able to offset. The second paradox
concerns why money growth has remained so slow despite aggressively easier
monetary policy. A meaningful answer to
this conundrum requires an understanding of behavior on both the demand and the
supply side of the money market.
Looking forward,
we believe that the Fed will most probably maintain the current Fed funds rate
of 3.25% until after the election. If
there is any further adjustment between now and then, it will be a downward
move to 3.0%. The drop in consumer
confidence recently announced increases the likelihood of this. Yet by winter 1993, we expect economic growth
to be well enough established for the Fed to raise rates back to around
3.5%. This being the case, and with the
election behind them, the Fed will most probably begin to turn its attention to
the dollar. In this regard, it is often
forgotten nowadays that the dollar remains the world's reserve currency, and as
such needs some tender loving care once in a while. Additionally, there are the potential
inflationary implications of a record low dollar. It is for these reasons that we anticipate a
slight tightening at the beginning of the new year.
Uncertainties
central to long bond yields include real GDP growth, the trend in core
inflation, Federal Reserve Board policy (where we expect a slight tightening
after the election or in the winter of 1993), and the magnitude of the
"distrust premium" exacted by today's long-term bondholders.
We continue to
believe that the best watchword for the bond market remains that which we have
used for the past two years: "sticky". By this we mean first, that relatively high
long-term rates have been and will remain the order of the day, reflecting the
existence of the distrust premium, reduced net foreign capital inflows, a low
domestic savings rate, and large net government borrowing. Second, the term reflects the fact that
reactions by the bond market to unexpected news will be lesser and
shorter-lived than was the case in the past.
The events of this past July bear this point out in an informative way. When the arresting June employment number was
released July 3rd, and the Fed concomitantly dropped the discount rate to only
3%, the bond market rallied, much as one would have expected. Yet note the end result: the yield curve
ended up even steeper than before, as the modest 15 - 20 basis point drop
in long-term yields failed to match the 25/50 basis point drop in the Fed
funds/discount rates respectively.
This phenomenon
is important for two reasons. First, it
reinforces the likelihood that long-bond yields will remain sticky. Second, it throws doubt on the classical
"expectations theory of the yield curve" whereby the steepness of the
yield curve today contains significant information about tomorrow's term
structure.
We expect that
the deficit will lie in a $350-$400 billion range during fiscal year 1993. Uncertainties central to the deficit outlook
include real GDP growth, the prospects for significant post-election fiscal
reform (which we believe are slim), further reductions in defense spending, and
further surprises in deposit insurance outlays.
Post-Election
Fiscal Reform: The June defeat of the Balanced Budget Amendment has not
completely eliminated the prospect of serious fiscal reform. Indeed, the most important legacy of Ross
Perot's presidential campaign may be his deficit reduction program - widely
acclaimed as the best such program to be set forth in several years. The possibility that either remaining
candidate would adopt such a program should not be completely discounted. The beginning of a new term and new Congress
would be a promising time for such a dramatic measure. Nonetheless, any paring of the deficit of
this magnitude would mobilize every conceivable special interest group to
oppose it, and even if the new president were to propose such measures, changes
for enactment remain slim.
Defense Cuts: The House has
now passed a defense spending bill $25 billion lower than Administration
proposals, and legislators such as Senator Sam Nunn have called for
far-reaching armed services restructuring to reduce inter-service duplication
and reduce costs even more. Nonetheless,
despite the appeal of reduced military spending, members of Congress are all
too well aware of the economic impact of such cuts on their home districts in a
weak economy and may be expected to oppose them regardless of the nation's
larger needs for fiscal discipline.
Deposit
Insurance Costs: Most of OMB's $70 billion reduction of the estimated fiscal 1992
deficit stems from lower deposit insurance (and associated "bailout")
costs. Some $20 billion of this results
from the effects of lower interest rates, and another $50 billion from
Congress' failure to provide new RTC funding.
The latter should increase future deposit insurance costs once
spending resumes. MHII believes further
overruns are likely in 1993 as interest rates rise slowly and many regional
real estate markets remain weaker than expected or planned for.