The advance second quarter Gross Domestic Product estimate, released by the Bureau of Economic Analysis Friday, showed the quarter’s growth at 2.5%, lower than expected while the price index for gross domestic purchases increased at a 4.0% annual rate, higher than expected. The market responded by soaring into the stratosphere, in the belief that the lower GDP growth would cause the Fed to pause in its rate tightening. Hope really does springs eternal in the stock market’s breast!
On closer inspection, the details in the BEA release confirmed pessimism not optimism. Real GDP figures for 2002-05 were revised down by 0.3% per annum, while the price index was revised upwards by 0.2% per annum – thus we weren’t as rich as we thought we were, productivity growth was lower than we thought, we were already suffering more inflation than we thought and monetary policy was in real terms significantly looser than we thought.
There’s really no way to get around the fact that if inflation keeps on rising, interest rates will eventually have to follow, to a level high enough to bring that inflation down again, regardless of what the U.S. economy does. If the economy went into a severe recession, inflation might drop because the price of domestic inputs would decline (as would commodity prices if the world shared in the recession) but the experience of the late 1970s demonstrated pretty conclusively that even with quite a sharp economic downturn, if interest rates remained at a low level in real terms, inflation would rebound as soon as the economy stirred again into life.
If as Wall Street seems to expect, the Fed pauses in its increases in short term interest rates, while inflation continues to ratchet upwards, the effect is a continuing loosening of monetary policy. However this won’t produce continued economic expansion, for two reasons.
First, after several years of loose money and proliferation of private equity funds and hedge funds, all aggressively seeking deals, some of the investments that have been made with the readily available money will turn out to have been turkeys. Like the overexpansion of telecom bandwidth in 1999-2000, let alone the dot-com speculations of those years, the turkeys will take some time to reveal themselves, but as expansion continues, the rate of turkey production will increase until, even without monetary tightening, the collapsing turkeys will produce an overall loss of confidence.
For an example of an easy money collapse, you can go back to the British secondary banking crisis of 1973. Monetary policy remained loose throughout that year, the British economy continued expanding, and “secondary banks” financing real estate continued expanding as though there was no tomorrow. In October 1973 the first Middle Eastern oil crisis took place, an external event with no obvious connection to British real estate (and beneficial in the long run to the British economy because North Sea Oil was shortly to come on stream). The result throughout the fourth quarter of 1973 was a series of collapses of secondary banks, as the optimistic assumptions on which they had been lending were seen to be false and confidence leaked away. By the time in December 1973 that rumors began to circulate about Midland Bank and National Westminster, two of the country’s four large retail banks, the boom was over, even though monetary policy was not tightened until well into the following year.
A second effect of the rise in nominal interest rates the Fed has already implemented, even though it represents little or no monetary tightening in real terms, stems from simple arithmetic. Although in real terms a 7% home mortgage with inflation at 5% is no more burdensome than a 4% home mortgage with inflation at 2%, in cash flow terms it’s far more difficult for a borrower to handle, since the required monthly payment (including principal repayment) is about 40% higher.
Over a long period, inflation increases the borrower’s income and maybe the value of the property, but in the short term the burden is considerably increased, maybe to the point where it is unmanageable. Thus even if real interest rates remain low, the affordability of housing decreases, and demand for housing diminishes. Given the aggressiveness with which speculative building has taken place, this can only result in a housing glut, and at least a moderate fall in house prices, which will in turn produce defaults and bankruptcies of its own. Once inflation gets going, even loose money cannot sustain a housing bubble forever.
As well as the downbeat GDP figures, and the widening of a new war in Lebanon, the other major event that might have been expected to have an effect on the market was the final collapse of the Doha round of trade talks, and their supposed replacement by a spaghetti of bilateral trade agreements.
There are a number of reasons why all-out free trade, with no tariff or non-tariff barriers of any kind, is probably not desirable – for one thing, it’s not clear that a 10% tariff is any more economically distorting than a 10% sales tax or income tax, and government has to be financed somehow. More economically damaging than moderate tariffs are non-tariff barriers, which produce no revenue and generally distort trade more than tariffs. Even worse are subsidies such as are granted by the United States and the EU to agriculture, which cost money rather than helping to finance government and are thus doubly destructive to the economy.
When there are no worldwide pressures for freer trade, it’s clear from 1930s experience that subsidies, non-tariff barriers and special politically-motivated deals multiply, to the great detriment of world prosperity as a whole. The Doha trade negotiations themselves were far more valuable than any outcome of freer trade that might eventually have emerged from them. Under Doha’s predecessors, tariffs throughout the world were lowered dramatically from 1948 to 1994, resulting in a revival of world trade to its pre-1914 levels and since 1980 a surge in world economic growth that has missed only the heavily protectionist continents of Africa and Latin America.
The alternative policy now to be pursued by the United States, bilateral trade agreements, is directed by politics rather than economics. Countries with which trade agreements are to be negotiated are chosen on foreign policy grounds, and the contents of such trade agreements are determined by a political balance between the wish to favor a particular country and the strength of the lobbies resisting imports of that country’s products.
Thus the U.S.-Australia Free Trade Agreement retains quantitative quotas on Australian beef exports to the United States. The U.S. –Central America free trade agreement retains tight restrictions on sugar imports to the United States, with a quota for Central America that replaces only 1.2% of U.S. sugar production in the first year and a heavy tariff remaining on above-quota imports.
Not only does this spaghetti of agreements impose major costs on businesses doing business in several countries (particularly as it is matched by an equivalent spaghetti of bilateral agreements with other major economies) but it also does little to free up trade, mostly diverting trade from low cost producers to higher cost producers with which the United States has an important political relationship. The process of negotiating FTAs is free-form; the results are politically predetermined.
The Doha round offered only a modest chance of approaching the optimal world trading system, one of low and uniform tariffs and no non-tariff barriers or subsidies, but they did at least offer some hope of a reduction in the world’s greatest economic distortion, agriculture subsidies, just as the 1994 Uruguay Round of trade talks has finally, more than a decade after it was signed, more or less disposed of textile quotas. Thus the collapse of this generally benign system is an economic disaster, which is likely to reduce world economic growth by a measurable percentage, thus losing us all hundreds of billions of dollars.
It’s an interesting question what form the cost of increased protectionism will take. The speed of globalization will be lower than it would otherwise have been, but that may have little effect on employment, at least in rich countries. It is unlikely, absent other major errors, that we will see a major trade-induced world depression on 1930s lines. Most likely, the most visible effect of the protectionism will come in higher inflation as prices are propped up by producer-oriented deals and cartelization, while price-reducing trade enhancements like the opening of the world textile and garment markets fail to appear.
This week thus contained important bearish news, both for the short and long term. However over the week as whole, the Dow Jones Index increased 3.2%, its best week since November 2004, while the Standard and Poors 500 Index increased 3.1% and the Nasdaq Composite Index increased 3.7%.
The Efficient Market Hypothesis states that stock market prices include the effects of all information, short term and long term, to produce a valuation that is minute by minute rational, so that it is impossible to achieve superior returns through superior understanding. Once again, we have had a week that proved what utter twaddle this is.
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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.)