Opinion pieces and speeches by EPI staff and associates.
THIS PIECE WAS POSTED TO VIEWPOINTS ON FEBRUARY 17, 2000.
Are the economic warning signals flashing yellow?
by Christian Weller
Weakness and volatility in the stock market has spooked investors. The fear on Wall St. is that market sentiment will shift, a herd mentality will take hold as everyone makes a mad dash for the exit, and the long boom in stock prices will end in rapidly falling stock prices.
The history of financial crises suggests that this particular fear is unfounded. While shifts in market sentiment do occur, economies rarely experience a financial crisis unless the economic fundamentals are weak.
That does not mean, however, that the U.S. has nothing to fear. Economic booms do not last forever. As the end of a boom approaches, early signs of growing weaknesses can be found among the good news on employment and growth. Warning signals begin flashing yellow in the months before a crisis, giving policy makers enough time to avert trouble — if they recognize the signals and take appropriate action.
The macroeconomic characteristics of fragile economies are remarkably consistent. Economies become more likely to experience financial crises when growth is based on a credit expansion that follows from overly optimistic expectations by banks. In particular, real credit growth is fueled by booming stock and real estate markets, and by capital inflows from abroad that are both attracted by rising stock and real estate prices and are a prime contributor to that rise. More capital inflows, meanwhile, cause an overvaluation of the currency, and a widening trade deficit, which they in turn help to finance. A growing trade deficit spells trouble for an economy as industrial production slows. In other words, while the financial sector is expanding, the real economy shows some strains.
Real and financial sectors grow apart domestically. The growth of stock prices slows while the gap between credit growth and industrial output increases. International trade and finance relationships also come unglued. In particular, the currency appreciates and the trade deficit balloons.
The danger is that, despite apparently strong growth in economic activity and employment, the economy is financially fragile. It faces the very real possibility of a sharp decline in its currency and an unraveling of the dynamics that previously propelled its growth. Capital inflows are replaced by capital outflows and foreign funds are withdrawn from the U.S. stock market. Share prices fall, as do real estate and other asset values. The trade deficit is suddenly unsustainable. The country finds itself on the horns of a dilemma. Either a financial crisis is allowed to unfold, or the Fed raises the interest rate sharply to prop up the dollar and the real economy goes into a nose dive and income and employment fall.
It sounds eerily like the United States. Are early warning signs flashing?
The growth of the stock market is slowing. Investors reaped average returns on stocks of well over 20% from 1994 to 1998. In 1999, the market recovered in the fourth quarter after a sluggish performance in the first three where the rate of return has been close to 6%. The third quarter has been an especially sobering experience, with an almost 3% decline in stock prices in September alone and a sharp fall the week of October 11. Similarly, since the beginning of the year, the Dow Jones has fallen by 1,000 points within two weeks, and only begun to recover slowly.
Another yellow light is a widening gap between the growth of credit and the growth of industrial production. Industrial production grew by less than 3%, compared to the same month in the previous year, for eleven out of the past twelve months. This is a marked slow down compared to growth rates at or above 5-6% in late 1996, 1997 and the early part of 1998. In contrast, commercial bank loans are outpacing growth in the real economy. Loans have increased from 33% of GDP in the first quarter of 1993 to 38% of GDP in the second quarter of 1999. In addition to growing commercial loans, there is a particularly worrisome trend in debt that is used to fund stock purchases — so-called margin debt — which has increased four-fold since the beginning of 1993.
The dollar has appreciated since May 1997 and remains overvalued, despite the recent decline against the Yen. As a result, U.S. exports are not competitive on global markets, and imports are available to Americans at bargain basement prices. Not surprisingly, the trade deficit has spiraled out of control. The trade deficit has grown from $37 billion in 1992 to $164 billion last year. In the first seven months of this year, the trade deficit already exceeded that record and reached $169 billion.
The warning signs are there. We can reassure ourselves that the U.S. is different — after all, it is not an emerging economy or a small, industrialized nation. Perhaps it can sustain a slow down in the stock market boom, a credit expansion fueled by capital inflows, an overvalued currency, and a ballooning trade deficit. Perhaps.
But perhaps not. What to do, though? One possibility would be for Treasury secretary Larry Summers to negotiate a new Plaza agreement with our trading partners to bring down the value of the dollar. Like the agreement reached at the Plaza Hotel in 1985, it would engineer a soft landing for the overvalued dollar and gently let the air out of the stock market bubble. To avoid rapid capital outflows, though, such an agreement needs to be combined with capital controls. If this is too drastic a regulatory step, the Fed could lower interest rates instead. This would translate into real wage gains that would both spur domestic output, and lower the credit exposure of US households. Since real wage gains would cut into corporate profits, lower interest rates should also help to slowly deflate the stock market bubble.
The alternative is for Americans to bet on our continuing good fortune. If we lose this bet, we will face a financial crisis, a serious recession, or both.
[ POSTED TO VIEWPOINTS ON FEBRUARY 17, 2000 ]
Christian Weller is an economist at the Economic Policy Institute in Washington, D.C.