In 4th Century BC Syracuse, Damocles was the court sycophant who wished to change places with the wealthy tyrant Dionysius, and discovered that to do so involved having a sword suspended over his head by the finest of horsehairs, since Dionysius was in permanent danger of assassination. Likewise those who designed today’s U.S. economy sought to create an era of permanent prosperity; only in 2006 will we come to notice the slender thread by which hangs the prospect of economic catastrophe.
Like Damocles seeking wealth, economic policymakers of the last decade have wished to create a world in which economic growth is continuous, capital is always freely available at low interest rates and high price-earnings ratios, government can cut taxes and spend as it chooses with no adverse effects and trade deficits are a matter of no consequence because of a world “savings glut” none of which fortunately has to be contributed by Americans.
Like Damocles, their dream has been unrealistic, and has ignored the dangers and long term costs of such an approach. In the case of the U.S. economy, there has been more than one self-delusion, and there is thus more than one such sword.
Monetary policy is the most obvious area in which Damoclean dreams of steady growth and low interest rates are in the process of being interrupted by reality. Fed Chairman Alan Greenspan has allowed M3 money supply to grow at more than 8 percent per annum for a decade, while disguising the resulting inflation with spurious claims of productivity miracles and redefinitions of price indices so they do not include the items whose price is currently rising. Fed policy gained an additional boost Thursday when November’s consumer price inflation dropped once again below 4 percent on a year on year basis. This will be seen as the temporary blip it is when December’s figure is announced, since oil prices have stopped dropping and December 2004 consumer price inflation, which will fall out of the comparison, recorded a 0.4 percent drop.
In 2006, we can expect further rises in “headline” consumer price inflation, as the world oil market continues tight and creeping protectionism removes some of the benefits the U.S. consumer has gained from the opening up of China. Judging by its most recent statement Tuesday, the Fed is contemplating ending its tightening moves at a Federal Funds interest rate below 5 percent. Certainly incoming Fed Chairman Ben Bernanke’s reputation suggests that he will want to do this, though even his favorite and much massaged statistic of “core” consumer price inflation is now above his maximum plausible target of 2 percent and is still rising. A peak of 4½-4¾ percent in the Federal Funds rate is not what any reasonable person would call a tight monetary policy at a time when consumer price inflation is running around 4 percent per annum. At some point, the Fed will realize this, or more likely the bond markets will, and the resulting denouement will not be pretty.
Bernanke’s ostensible reason for resisting tight money, the “wall of savings” that he purports to see in the international economy, which removes from the U.S. consumer the need for any savings at all, always appeared pretty spurious. It was pushed further into unreality this week by new statistics showing that the Chinese economy was around 20 percent larger than had previously been believed. Apparently small scale service industries had not been properly counted by the cumbersome statistics collectors of the Chinese government. Thus China’s savings rate (savings are measured fairly accurately because Chinese savings, like Chinese citizens, are prevented from escaping the country by draconian controls), which had been thought to be around 45 percent is currently around 35 percent, somewhat below its historical average. The “wall of savings” argument always looked thin; in reality the world is suffering from a damaging wall of excess liquidity, mostly created by the Fed, with some help from the European Central Bank (real interest rates close to zero) and the Bank of Japan (even nominal interest rates zero, at a time when the Japanese economy is recovering rapidly.)
International trade is another area where the U.S. administration and economic commentators have taken the Damoclean approach. Far from worrying about the U.S. payments deficit, now around $800 billion per annum, they trumpet the inflow of funds from Asian central banks and Caribbean based hedge funds that finances it. Worriers are informed that the flood of Chinese imports to the United States which form a large part of the deficit increase (the net U.S. trade deficit with China alone is now around $20 billion per month) reduces U.S. consumer prices and is an all-around boon to the U.S. economy, since the Bank of China, by investing in Treasury bonds with a real interest rate close to zero, is allowing the deficit to be financed almost entirely without pain.
The sword of Damocles is the apparent shift by Asian central banks in November towards selling Treasury bonds. Their replacement as investors in the Treasury bond market, Caribbean-based hedge funds trying to pick up a “carry” trade profit by buying Treasury bonds yielding 4½ percent and financing with short term yen at a cost near zero, are financially suicidal in the long run once the yen begins to rise again against the dollar. Their suicide will doubtless be reflected in a spiraling drop in the dollar and the Treasury bond market, even as Boston Red Sox owner John Henry, according to the Boston Globe a participant in this trade, attempts to satisfy his shareholders with some temporarily redundant infielders (Cayman Islands Red Sox, anyone?). Hedge Funds were the flavor of the year in 2004 and the place-to-put-silly-money of the year in 2005; they will doubtless be the disaster of the year in 2006.
The U.S. budget deficit, apparently under control in the $300-400 billion range, is another Sword of Damocles. Apart from the well advertised demographic doom represented by the retirement of the baby boomers starting in 2008, two other factors have artificially depressed the deficit: very low real interest rates (reducing the interest cost on Treasury borrowing) and very high corporate profits (bringing unexpectedly large corporate tax payments.) As these factors go into reverse, and as the U.S. economy enters recession (as it must inevitably do at some point) the deficit will increase rapidly, as it always does in recessions. Starting from a base of $300-400 billion, it will quickly spiral out of control; the $750 billion level at which it becomes difficult to finance is not that far away. Wasteful government spending will turn out not to have been cost free, after all.
The final Sword of Damocles overhanging the world economy is the current state of the world’s capital markets and real estate markets. Price-earnings ratios are high, based on earnings that are both at a cyclical high and inflated by low borrowing costs. Spreads between Treasury bonds and junk bonds are exceptionally low, and bear little relation to the historical default experience of high risk bonds. Argentina has been allowed to return to the capital markets, even after stiffing its creditors less than 4 years ago. House prices have soared for several years in succession, not only in the United States and Britain but also in smaller, less well developed real estate markets such as Spain and South Africa. Gold, traditionally a leading indicator of future trouble, is at double its 2000 low and its highest price in 25 years.
All these are to be expected in an era when liquidity has been so great for so long, and their return to earth can also be expected. What has not been seen before, and is very much to be feared, is the economic consequence of them all returning to earth simultaneously. The Federal Reserve believed during the 1990s that there was no “wealth effect” from inflation in the stock market; as of 2003 they had revised their view to a belief that the wealth effect was about 4 percent, in other words, for every $100 the stock market dropped, consumption would drop by about $4 per annum. With leverage in the U.S. housing sector now so great, there must clearly be an equivalent albeit smaller wealth effect for housing, maybe 2 percent. An international bond market collapse will similarly produce a wealth effect, partly from the drying up of credit availability for many borrowers.
In total therefore, if we assume a 50 percent drop in stock prices from a current U.S. market capitalization of around $15 trillion and a 20 percent drop in house prices from a current total U.S. housing stock value of around $30 trillion, the annual negative “wealth effect” on consumption in the United States alone would be 4 percent x$7.5 trillion plus 2 percent x $6 trillion, or $420 billion per annum, just under 4 percent of Gross Domestic Product. In addition, we can anticipate a further $200 plus billion decline in consumption from the ending of mortgage refinancing takeouts, plus something extra from the international bond market. From “wealth effects” alone therefore, the United States can expect to lose around 18 months’ economic growth at the current rate.
That makes a total of four Damoclean swords over the U.S. economy, even without considering any possible adverse effects of uncontrolled illegal immigration, an Al-Qaeda outrage, a major default or minor war in the cesspit that Latin America is becoming or a surge in world protectionism resulting from the effective failure of the Doha round of trade talks. It’s thus unlikely that we’ll make it through 2006 unscathed.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.