Barrons, October 28th, 2002
Deja Vu All Over Again
By EDWARD YARDENI
The similarities between 2000-02 and 1990-92 are eerie. A president
named George Bush was in the White House then and now. Saddam Hussein
was Bush enemy No. 1 then, and is again. Both the current and previous
decades started with very short and moderate economic downturns. Both
were followed by lackluster economic recoveries, with weak employment
growth. Indeed, the pattern of initial jobless claims now and then looks
remarkably similar. In the early 1990s, the banking industry was a mess.
Today, the Tech Wreck is the major structural problem in the economy.
In both periods, the Federal Reserve lowered the federal-funds rate
dramatically and kept it low for some time. The central bank's key
overnight rate plunged from 9.8% during the middle of 1989 to 3% by
August 1992, and it remained at this level through the beginning of
1994, when the Fed started to tighten again. At the end of 2000, the
fed-funds rate was 6.50%. It dropped to 1.75% by December 2001, and it
is likely to remain at this level through most of next year. A
combination of easy money and time revived the economy by 1994. Easy
money and time should do so again over the next couple of years.
Both now and then, Americans were concerned about going to war with
Iraq. Tactical weapons of mass destruction were viewed as a potential
threat to American soldiers. U.S. troops face the same dangerous
scenario today if they attack Iraq. Of course, after 9/11, Americans are
more fearful of our vulnerability to terrorists at home.
The relatively quick victory in the Persian Gulf War helped to revive
consumer confidence, but consumer spending remained lackluster during
the first half of the 1990s. This time, consumer spending has been more
robust because solid gains in productivity have boosted real pay per worker.
Also, record low mortgage rates are supplementing consumers' purchasing
power by reducing monthly payments and increasing "cash-outs" of
residential equity. Fannie Mae reports that an estimated $1.4 trillion
of mortgages will be refinanced this year, up from $1.1 trillion last
year. Furthermore, both this year and last, homeowners took out an
estimated $100 billion of equity.
The early 1990s marked the end of the Cold War. If the U.S. can deliver
a quick and decisive resolution of the Iraq problem, then the so-called
clash of civilizations might be aborted quickly. President George W.
Bush seems to believe that the most dangerous terrorists are sponsored
and supported by states such as Iraq and Iran. If so, then a decisive
win in Iraq -- through diplomacy or military means -- could have
enormously positive geopolitical consequences for Americans, who might
rightly feel less alarmed about the potential for future attacks like
9/11 and more confident about the future.
My hunch is that the administration has concluded that a successful
outcome in Iraq also might be a good way to revive the global economy.
Oil prices are likely to fall significantly, possibly to less than $20 a
barrel, if Iraq is free to export more oil. This could provide a
substantial cut in the "oil tax" and stimulate global economic growth.
The most significant difference between now and the early 1990s is that
deflation is a more significant risk. After the end of the Cold War, I
developed a simple War & Peace Model for inflation. A glance at the
Consumer Price Index in the U.S. since 1800 strongly suggests that wars
are inflationary and peace times are deflationary. This makes sense to
me. Power is concentrated in the government during wars. Markets tend to
be monopolized, protected, subsidized, corrupted, and inflation-prone.
Power shifts to business and consumers during peacetime as governments
negotiate free-trade agreements to gain access to foreign markets.
Markets around the world become more competitive and prone to deflation.
Since the end of the Cold War, deflationary forces have been offset by
easy monetary policy. However, these forces weren't defeated and were
actually reinforced when China joined the World Trade Organization at
the end of last year. The Bank of Japan ran out of basis points to fight
deflation when the official bank rate was dropped to near zero in the
late 1990s. The Fed has only 175 basis points left.
Japan's gross domestic product implicit price deflator has been falling
modestly for the past several years. During the second quarter of this
year, it was 6.1% below its second-quarter 1997 peak. The U.S. inflation
rate -- based on the yearly percentage change in the GDP implicit price
deflator -- is down from 4.2% at the start of the 1990s to only 1.1%
currently. The implicit price deflator for nonfinancial corporations has
been deflating, showing a drop of 0.6% during the past four quarters --
the first such negative comparison since the data were first collected
in 1958.
The weakness in pricing is depressing the growth in nominal GDP in both
Japan and the U.S. Nominal GDP growth has been mostly negative in Japan
since 1998. In the U.S., it remains positive but relatively weak, with a
gain of only 3.3% over the past four quarters through the middle of this
year. This means that top-line growth for many businesses is very
challenging.
Deflation is a very unstable and potentially dangerous economic
environment. Macroeconomists, particularly monetarists, believe it can
be overcome by pumping up the money supply. I am not so sure. I believe
that it is a consequence of increasingly competitive markets resulting
from peace, free international trade, industrial deregulation,
technology, and productivity. The end of the Cold War was Big Bang I for
deflation. Big Bang II occurred when China joined the WTO last year.
China has a population of 1.2 billion people. Even with effective
population control measures, China's population rose by 100 million
during the past 10 years. By some estimates, 20 million people per year
leave the rural villages of China looking for construction and
manufacturing jobs in the urban areas. In the U.S., the number of
manufacturing jobs is only 17 million in total! Before the end of the
decade, the Three Gorges Dam project will open up the Yangtze, China's
longest river, to large container ships. That will open up a vast
interior area of China, including 350 million people, to global trade.
The consequences are likely to be mostly deflationary.
Above, I suggested that deflation is inherently a microeconomic problem
rooted in the competitive structure of markets and therefore not easily
eliminated by stimulative monetary and fiscal policies. It also is a
political problem. As the economist Joseph Schumpeter famously observed,
capitalism is a process of creative destruction. But what if
uncompetitive companies remain in business even when market forces make
them unprofitable? They can do so by gaining political support, either
through corrupt means or by claiming that too many jobs will be lost if
they aren't protected by the government.
The result is zombies, the living-dead companies that should be buried
but continue to produce, thus causing deflation in their industry. Japan
is full of such zombies. The U.S. steel industry has zombies, and now so
does telecommunications. WorldCom became a zombie a couple of years ago,
although we only found out about it at the end of June, when the company
disclosed that its earnings had been fraudulently overstated for the
past few years. Now the Baby Bells fear a debt-free WorldCom could
emerge from bankruptcy as an even more voracious zombie to start a new
round of telecom price wars.
If deflation is a structural global problem that defies macroeconomic
solutions, then there are two possible scenarios for the economic
outlook -- sweet and sour. In the sweet version, companies offset the
competitive pressure on their prices with productivity gains. The gains
benefit mostly consumers as wages rise faster than prices. As long as
consumers spend their real income, productivity continues to grow and
the overall economy continues to prosper. Individual companies can
prosper and be very profitable in this scenario, but they also can go
out of business if they fail to stay ahead of their competitors.
In the sour version, competition is so intense that profits are
depressed, forcing companies to slash their payrolls in desperate
attempts to cut costs and boost productivity. Consumer confidence falls
as the jobless rate rises. Consumer spending is depressed by the
worsening employment situation and perceptions that there is no rush to
buy when prices are falling.
Of the two scenarios, I believe the first one applies today. I think it
will continue to prevail over the next few years. Could inflation be the
surprise? The War & Peace Model suggests that might be the outcome only
if the conflict with Iraq and Islamic terrorists leads to a global clash
of civilizations. In this unhappy scenario, inflation would be the least
of our worries.
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Edward Yardeni is chief investment strategist for Prudential Securities.
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The Marxism list: www.marxmail.org
- Re: War and deflation Louis Proyect
- Re: War and deflation joanna bujes
- Re: War and deflation Michael Hoover
