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09.01.2001

US : Renewed Fears of a Crash

The US Federal Reserve Board’s decision to cut interest rates by half a percentage point on January 3^rd has taken most observers by surprise. This is even though several analysts had suggested that the Fed may have to take some such measure in order to prevent a further recessionary slide, as the US economy finally slows down after a seemingly endless decade-long boom. There are several reasons for the surprise.
 
First, the decision came close to four weeks before the next meeting of the federal open market committee, which meets periodically to review monetary policy and decide on interest rates. The last time a similar decision was taken in an emergency meeting was when the financial crises in East Asia, Latin America and Russia threatened a global financial collapse.
 
Second, the reduction comes in the wake of a six increases in short term interest rates from close to 5 per cent in June 1999 to 6.5 per cent in May 2000 (Chart 1), and therefore marks a change in direction. Further, the one-shot 50 basis points reduction was uncharacteristic of the Fed, which has, in recent times, preferred gradual changes of a quarter of a percentage point at a time in the interest rate. The move signaled not just a change in direction, but a sharp reaction as well.

Finally, the cut has been justified by the Fed in terms that indicate that it saw the action as necessary to forestall a slump. To quote the Fed’s announcement: “These actions were taken in light of further weakening of sales and production, and in the context of lower consumer confidence, tight conditions in some segments of financial markets, and high energy prices sapping household and business purchasing power.” In a feeble effort to boost confidence, however, the Fed went on to assert that “to date there is little evidence to suggest that longer-term advances in technology and associated gains in productivity are abating”, even though the information currently available suggests that “the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future. “
 
No one can deny that the US economy, which entered a record-breaking tenth year of continuous growth in February last year, has been running out of steam since the third quarter of 2000. Having grown at an average rate of well above 5 per cent in the year stretching between the third quarter of 1999 and the second quarter of 2000, US aggregate output growth slowed sharply to 2.2 per cent in the third quarter of 2000, and is expected to be even lower in the final quarter of last year (Chart 2), figures for which would be available by the end of January.

However, while these annualized quarterly growth rates are among the lowest recorded in recent times, they would have normally been seen as a necessary correction to the marked and prolonged boom in the US economy, which has brought unemployment rates down from 7.5 per cent at the beginning of the 1990s to 4 per cent last year (Chart 6). In fact, the Fed’s actions that continuously raised interest rates over the year ending May 2000, indicated that it wanted to apply the breaks on an economy that was growing too fast, even if without spurring inflation.
 
The puzzle therefore relates to the reasons why, despite this long history of more than satisfactory growth, Alan Greenspan and his colleagues found the need to intervene as strongly as they did at what seems to be the beginning of a downturn whose lifespan is still uncertain. Judged by its own reasoning, the proximate cause for the Fed’s knee-jerk reaction seems to be its perception that underlying the downturn is a waning of consumer confidence and the prospect that rising energy prices may sap consumer purchasing power.
 
The focus on consumption stems from the fact that the US boom has indeed been consumption driven. During the years 1997-99, accelerating growth was accompanied by a sharp increase in personal consumption expenditures, led by consumer expenditures on durable goods (Chart 3). These were the years when the deficit in the United States government’s turned to a surplus, and American exports lost out in world markets while imports invaded domestic markets, taking the current account deficit on the US balance of payments to close to a record annual $400 billion.

In any other economy in the world, such indicators would have been associated with real economy recession. But in the US, this has been an integral part of the prolonged boom which has been strongly associated with private sector spending well in excess of its income, and more than counteracting the effects of the newly emerged budget surplus. Growth was clearly being led by consumption, not by export surpluses or government spending, and any waning of consumption growth would imply recession in the absence of alternative stimuli.
 
As Chart 4 shows, during recent quarters, the annualized growth of consumption expenditure has remained at around the 5 per cent level and durable expenditure growth has been remarkably buoyant. Not only has the growth of such expenditures slowed in the second and third quarters of 2000, but evidence of trends in consumption expenditure in recent months (Chart 5) point to a substantial deceleration in overall personal consumption expenditure growth and a collapse in durable consumption expenditures. Thus, even if the downturn in the US is recent, it stems from factors that appear to stifle the principal stimulus to growth in the miracle years of the late 1990s.

However, the view that this occurs because the increase in energy prices have sapped purchasing power cannot wash, because the consumption fest in the US has hardly been determined by real incomes. What has been more crucial is the willingness of the average American to dip into potential savings to finance consumption, resulting in a gradual decline in the household savings rates in the US to negative levels.
 
Credit, equal to net dissaving, has been the trigger for the consumption boom that has driven growth. If the more recent figures on consumption expenditures point to a waning of consumer confidence, the explanation must be found in the growing unwillingness of the average American to borrow her way to a good life today at the expense of greater security tomorrow.
 
Till recently, this peculiar consumerism of the American was attributed to the wealth gains which American households had registered because of the boom in US stock markets. It is widely known that the US is unique in terms of the width and depth of the equity culture in the country.
 
According to recent Surveys of Consumer Finances, a household survey conducted under the auspices of the Federal Reserve Board, the number of share owners in the US increased by approximately 32 million since 1989 and 1998 and 15 million since 1995 to touch 84 million in 1998. While stock ownership through self-directed retirement accounts and through equity mutual funds were the two largest contributors to the growth in share ownership, between 1995 and 1998 even direct share ownership increased. By 1998, the probability that an individual between the age of 35 and 64 owned some shares stood at above 50 per cent, with the figure standing at 62.4 per cent in the 35 to 44 age group.
 
During the years of the stock market boom, which began at the end of 1994 and lasted till the end of 1990s (with one major glitch at the time of the financial crises of 1997-98), this wide prevalence of stock ownership resulted in a substantial increase in the wealth of American citizens. The consequent “wealth-effect”, which encouraged individuals to spend because they saw their “accumulated” wealth as being adequate to finance their retirement plans, was seen as a major factor underlying the consumer boom and the fall in household savings to zero or negative levels.
 
Similarly, the reverse process is also seen to be operative at the moment. Thus, the recent slowdown in consumption growth is seen as the result of a downturn in stock markets that has made the consumer increasingly reticent in parting with his income for consumption rather than investing it in assets for the future.

This argument certainly carries some weight, but it still needs to be used carefully, because the intensity of the stock market downturn in 2000 varies depending on the index that is being looked at. It is indeed true that the collapse of the internet boom and overinvestment in technology markets has resulted in a sharp fall in the value of technology stocks. Thus the NASDAQ composite index, which reflects movements in such stocks, which rode a wave to cross the 5000 mark in March last years, had fallen by more than 50 per cent to around 2400 by the end of the year (Chart 7).

However, movements in the NYSE composite index (Chart 8), while in part a mirror image of the NASDAQ (reflecting movements into and out of ordinary stocks when technology stocks perform poorly or well), fluctuated within a much narrower band and registered on average a rising trend throughout much of 2000. Of course it is true that even the NYSE was on a declining trend towards the end of last year.

Given these differences in movements in technology stocks and stocks as a whole, the strength of the “wealth effect” in terms of its impact on consumption would depend on the extent to which shareholders were exposed to technology stocks. There are two reasons why such exposure could have been high.
 
First, managers of mutual and pension funds may have been driven by the lure of quick speculative gains from technology stocks to adjust their portfolios, so as to accommodate a larger volume of such shares. This would obviously result in a much larger fall in the net asset values of their holdings by the end of the year.
 
Second, although shareholding is widespread in the US, the concentration of shareholding tends to be substantial as well. According to the Survey of Consumer Finances, not only did direct and indirect holdings of shares by households (as opposed to various kinds of corporate entities) account for only around 69 per cent of total share ownership, individuals with an annual income of $100,000 or more a year, who accounted for 17.7 per cent of all shareowners, held 63 per cent of shares held by the household sector. Not surprisingly, the volume of trades by this category of shareholder was also higher.
 
It is to be expected that these shareowners, who are in the market largely with capital gains in mind, would have a larger share of risky technology stocks in their portfolio. It is in their case that the “wealth effect” would have been more prevalent, resulting in a sharp increase in consumption demand for durables and luxuries of various kinds during the stock market boom.
 
Not surprisingly, it is durables expenditure that drove the consumption boom as well as led the subsequent slowdown in consumption. A journalistic depiction in the Financial Times, London, of the recessionary mood in the United States titled “Fifth Avenue wealth effect” captures this aspect of the fall in consumer confidence as follows:
 
“Decisions that will determine whether the world economy heads for a hard landing were taken this week - not in the White House, at the US Federal Reserve or on Wall Street but on Manhattan's Fifth Avenue. New York's premier retail street, where Christmas shoppers can buy silk teddy bears from Salvatore Ferragamo for $205, is undoubtedly where you would find Santa Claus if he were a New Yorker. It is also the place to gauge how far recent stock market sell-offs, profit warnings from leading US companies and tens of thousands of job cuts have damped the exuberance of the American shopper. After a decade of unparalleled economic growth, fuelled by a huge increase in borrowing, American household saving is at its lowest level. If consumers decide that lean times lie ahead, spending can be expected to fall sharply. Economic slowdown, even recession, could then follow. The signs this Christmas are that this is exactly what is happening. Retail analysts warn of the toughest trading conditions for a decade.”
 
The waning of consumer confidence does not, however, tell the full story behind the recession fear. Other factors are at work as well. To begin with, over-investment during the boom years and dampening demand are leading to higher levels of unutilised capacity in American manufacturing industry located both at home and abroad. At the same time, rising costs (driven among other factors by the increase in oil prices) are squeezing profits further.
 
American companies are responding to this situation by downsizing massively. According to media reports, the Chicago-based international outplacement firm Challenger, Gray & Christmas has estimated that monthly layoffs among top US corporations tripled from 44,152 in November to 133,713 in December, with the bulk of the rise coming from retailers and auto companies. The US Labor Department has also reported that initial weekly claims on unemployment insurance rose to 375,000 in the week ending December 30, which is their highest level since July 1998.
 
With jobs under threat, the fall in consumer confidence induced by the decline in the NASDAQ has been aggravated by consumer fears that incomes earned today may disappear tomorrow. The question then is whether the reduction in interest rates and further such reductions expected by analysts, would be adequate to stall the deceleration in the growth of consumption and output. It is widely accepted that if at all a decline in the cost of credit would directly spur consumption and investment, this would occur only with a considerable time lag.
 
Indeed, it may be the case that such a step, by further fuelling expectations of a coming recession and associated job loss, would actually have the contrary effect of reducing consumption rather than increasing it. Thus, a similar measure in Japan in the recent past, when interest rates were slashed to near zero in the effort to revive consumer spending, actually led to increased personal savings and further reduced consumption, as consumers identified this as an attempt to ward off recession and reacted by trying to safeguard future incomes. Retail sales in Japan have been declining for 45 months in succession. Since consumer spending there accounts for 55 per cent of GDP, the impact on the Japanese economy has been obviously adverse.
 
This “liquidity trap” element in interest rates would have been easily understood several decades ago; the recent obsession with finance as somehow independent of the real economy has meant that this insight is now less obvious to monetary policy makers.
 
Hopes of any indirect positive consequences of the interest rate cut - through a revival in stock markets - were quickly dashed when, after a rise in the NASDAQ immediately after the Fed’s announcement, the index resumed its decline the very next day. The Fed therefore has little to bet on other than the so-called “headline” effects of its decision. It is now argued that consumers convinced that the Fed would not allow a slide into recession would resume their shopping spree. In reality, few are convinced that the Fed can do very much to revive either the stock markets or the economy, paving the way for expectations of a recession to become self-fulfilling.
 
In the circumstances, the only hope for the US economy today stems from the possibility that its new President would quickly implement promises of massive tax cuts and opt to reflate the economy with higher expenditures. Democratic opposition to tax cuts is waning in the face of the threat of recession. And Republicans have been known in the past to flout their own opposition to larger government expenditures once they are in government.
 
It is expected that the independent Congressional Budget Office would place the estimated budget surplus over the next 10 years at $6,000 billion. This does provide President Bush with some leeway to push ahead with tax cuts and larger expenditures without generating a budget deficit that the American media and its people have been taught to dislike.
 
But there are dangers inherent in such a move as well. Though unemployment is rising now, it still is placed at just 4 per cent. Given the current context of high and rising fuel prices, strong reflationary initiatives could stoke inflationary pressures forcing the Fed to revert to its obsession with controlling inflation above all else. Making the American miracle of the 1990s last is unlikely to be easy, if at all possible.
 
Predictions of the likely future aside, recent events have clearly put paid to two myths that have dominated discussions on American growth in recent times. First, they have damaged if not demolished the argument that the productivity benefits flowing from the information and communication technology revolution have changed the nature of capitalism, rendering a combination of high growth, low unemployment and low inflation the rule than the exception.
 
Second, they have forced votaries of the idea that capitalism works best when markets are left alone, to make the case for or actually initiate drastic State action. Everybody looks now to Alan Greenspan, at the Fed, and President Bush, at the White House - both free market ideologues - for concerted action aimed not at sustaining the heady boom of the late 1990s, but at preventing a crash by paving the way for a soft landing. But as is characteristic of markets, such expectations can easily be belied.