Pushing On A String… Or A Spring?

In the few days since the tragic September 11^th terrorist attack on the United States, we have been deluged by analyses of that event’s implication for world order and democracy. Some were insightful, others would have benefited from the better perspective afforded by passing time. In any event, there is not much I can add to the debate on that front, except to join in the universal mourning of victims of this barbaric act.

Most of this paper was actually written before September 11^th, and experience has taught me not to dismiss rashly the impact of a sudden, unforeseen event on prevailing economic scenarios. In the present case, however, it seems to me that, after some unavoidable short-term disruptions to the economy and the likeliness of exacerbated market volatility, policy and individual reactions to the deplorable shock of the last few days are likely to reinforce our earlier conclusions, rather than undermine them.

Even before last week’s tragedy, the world’s central banks had been struggling with both cyclical and structural impediments to economic growth. The Bank of Japan, caught in a well-publicized deflationary spiral, has lost its ability to jump-start Japan’s economy. The European Central Bank’s impotence, until recently, had been partially masked by booming U.S. demand and a weak euro. But it is now clear that it is paralyzed by an introspective search for identity amid political infighting. And now, experts and financial paparazzi alike have been questioning the wisdom and effectiveness of The Federal Reserve itself.

A recent Business Week report typically read: “Greenspan in a bind. His efforts to revive the economy have failed to do the trick”. At CNBC (known here as the M&A Channel, for Myopic & Amnesiac), anchors who had all but taken personal credit for the NASDAQ bull market, were quick to blame the Fed as soon as the bubble burst. Observing that seven interest rate cuts had produced no visible improvement in the economy, one anchor person asked in near-hysterical tones: “What’s going on, here?”

This was all the more striking because, until recently, the media had built up Mr. Greenspan into a demi-god who could do no wrong. Some weeks ago, asked if he was concerned about the high levels of consumer debt, a TV economist answered, typically enough: “Don’t worry about the consumer. The Fed will take care of the consumer”.

So, what has been going on here?

Part of the answer is that – at least since the 1960s -- central bankers never have been quite as powerful as outsiders wished them to be. Another part is that whatever power central banks did have has been severely eroded in recent years.

Monetary policy works principally through the banking system, which can extend credit many times the amount of reserves injected into it by the central bank. In the past, that multiplier effect could be estimated with some precision. But, as I have argued for some time, this mechanism has progressively been loosened by the growth of other forms of intermediation, with the result that the traditional tools of monetary policy have lost a great deal of their precision and effectiveness. Both direct access by borrowers to increasingly efficient, creative and far-reaching financial markets and the growing use by banks of derivative instruments and debt securitization techniques that insulate them from the Fed’s actions, have made the conduct of monetary policy akin to fine-tuning a carburetor while wearing boxing gloves. In other words, chances have increased that monetary easing and tightening both will overshoot their goals.

So, paradoxically, just as the media were building up Mr. Greenspan into a demi-god, he was being increasingly restricted to jawboning the financial markets in order to steer the U.S. economy – not to mention to orchestrate an occasional global bailout.

In addition, to the extent that monetary policy still does work, it is particularly difficult to assess what its targets should be. The reason is that the 1990s boom affected different sectors of the economy very unevenly.

Some sectors were flooded with huge capital inflows that led to excessive spending and investment, and ultimately, huge overcapacity, as in fiber optics and cellular phones. Other sectors, however, spent the bubble years of the past decade struggling to preserve cash flows and fighting global overcapacity for their products due to recessions in emerging markets and lukewarm economies in Europe and Japan. As a result, what appears to have been a huge capital spending boom on an aggregate level was really a combination of serious under-spending in the so-called “old” economy and wild over-spending in the “new”. To the extent that the Fed’s role, at least in part, is to avoid excesses in the economy through the use of undiscerning macro tools, it is faced with a real conundrum.

In the consumer sector other problems make a precise setting of monetary goals difficult. The 1990s boom in asset prices (stocks, bonds and housing) has had a significant impact on consumers’ economic behavior, although no one really knows how to measure that link.

Recent studies, however, are beginning to shed some light on how stock market gains may have caused the surprising resilience of consumer spending in the past year. In particular, Goldman Sachs points out to households’ capital gains realizations, as opposed to gains in net worth from the appreciation of portfolios. Realizations topped $500 billion, net of taxes, in each of FY 2000 and FY 2001. This is about 7.5% of disposable income whereas, prior to the mid-1990s, such realizations rarely exceeded 2%. Goldman Sachs estimates that consumer spending is boosted by 15 cents for each dollar of realized gains, as opposed to only 3 cents for each dollar of increase in net worth. If they are right, the recent high rate of realizations may explain the lack of negative wealth effect so far in the recent bear market -- even if stock sales were not initially motivated by a desire to spend.

It has also been pointed out that “cash out” home mortgage refinancing has been used, at least in part, to ease households cash flows, since increased debt could be serviced at little pain thanks to lower interest rate charges and longer repayment schedules. Douglas Lee, of Economics From Washington, estimates that 10% of all outstanding mortgages have been refinanced since late 2000, while Goldman Sachs, again, points to indications that an unusually large proportion of recent refinancings have been done at interest rates that were close to those on the prior mortgages. The only motivation for such refinancings, they say, could only be to “cash out” some portion of the accumulated equity in one’s home.

And herein lies one of the Fed’s problems. Now that it is trying to stimulate the economy, consumer demand, which did not respond as expected to higher interest rates, may be slow to respond to monetary easing. Home refinancing activity has begun to roll over, while cracks in home values have been showing up in some regional markets. In addition, the recent stock market decline must have eliminated many capital gains realization opportunities. As a result, tax cuts may only prevent a sharp decline in consumer spending in coming months, rather than giving it a strong boost.

Finally, as a backdrop, ISI group monitors series showing the three-year growth in consumer spending and the five-year growth in capital spending. When growth in real consumer spending reaches a 5% annual rate over any three-year period, it tends to fall toward less than 2% in ensuing three-year periods. We exceeded the 5% mark during the year 2000. For capital spending, when the five-year growth exceeds a 6% annual rate, it also falls toward less than 2% in ensuing periods. The five-year growth of real capital spending reached an unprecedented 11% in 1998-2000.

Since consumer spending and capital expenditures account for three-quarters of the country’s Gross National Product, it looks like Fed policy would have been swimming against the tide in the next few years in any case. But there may be further complications.

As we said before, for the monetary policy process to work, banks must be not only able but also willing to lend. In addition, of course, businesses and consumers must be willing to borrow. Early into a recession, however, all these participants typically are keener to rebuild their balance sheets, after the excesses of the preceding boom, than to assume more financial leverage.

Banks, for example, tend to use additions to their reserves to buy government bonds rather than lend to the private sector. Aggressive cutting of short-term interest rates by the central bank produces a positive yield curve, which allows banks to make a profit simply by lending risk-free to the government at interest rates higher than their cost of funds. Typically, banks also use such periods to write off bad loans extended during the boom.

Meanwhile, businesses and consumers, too, are more likely to save and repay debts by using any free cash flow to buy treasury bills, CDs or money market funds.

During this process of balance sheet repair, new liquidity resulting from the central bank’s easy-money policies thus tends to flow into financial markets, pushing interest rates down and – eventually – the stock market up. This explains why, historically, stock market recoveries have started in the deep of recessions, before the demand for funds from businesses and consumers dry up some of the excess liquidity created by central banks’ actions.

Until September 11^th, despite the media outcry, the process had been unfolding more or less normally. U.S. banks had cut down on lending, while their over-stretched business customers were busy shedding assets and delaying capital expenditures to repay loans. Consumers, with some delay afforded by unusually high capital gains realizations, had also begun to save more, as indicated by very large inflows into money market funds. Only the timing of this financial restoration seemed a bit more stretched out than in the past – for reasons discussed earlier.

This probably would not have led to excessive concern, were it not for the example of Japan’s demonstrated inability, even with aggressive monetary easing and zero interest rates, to stop that country’s deflationary spiral. Throughout Asia, other central banks are facing similar problems, with bad loans originated in the mid-1990s boom still plaguing financial institutions and crippling lending. With Europe’s central bank until recently satisfied to operate under the umbrella of America’s boom, even a remote risk of Federal Reserve impotence has made the media and some experts unusually jittery about the prospect of a global recession.

Fortunately, monetary ease is not the only instrument of economic policy. In the United States, despite the politically motivated (and somewhat paradoxical) outcry by Democrats, the early elimination of the budget surplus for both policy and cyclical reasons will serve as a much-needed stimulus in the next few years. Now, of course, there is much less opposition to aggressive fiscal stimulus than existed before September 11^th. In Europe, various tax-cuts scheduled to take effect in the coming year should have a similar effect. Even in Japan, the Koizumi administration offers the first real hope of dealing with the banks’ mountain of bad loans, thus restoring some effectiveness to the Bank of Japan’s monetary easing. Finally, there are signs that long-term international capital flows have been trickling back to other Asian countries and, if this trend continues (as we expect), it will likely have its traditional and important stimulating effect on local economies.

All in all, prior to September 11^th, the “W-shaped” bottom which we had been forecasting in recent papers had been unfolding. Unless the global economic and financial system evidences much more severe flaws than have already been well documented, we were confident that the world’s economies would eventually turn around. True, the global turnaround would likely seem tame compared to the boom years of the late-1990s, and its exact timing remained elusive. But it would take place, with important implications for investments.

Now, however, there is an added risk. Experts worry that the recent terrorist shock will have shaken consumer and business confidence enough to produce a much faster and deeper fall in consumption and investment than had been anticipated. I tend to disagree. Hours after the attacks on New York and Washington, I received a short but very timely paper from Global Financial Data on the historical behavior of the stock market in the wake of severe, unforeseen political shocks. Feeling that all investors would need some historical perspective, I immediately posted it on our web site (see: The Historical Impact of Crises On The Financial Markets). In summary, crises usually do have short-term disruptive effects, but their long-term impact tends to be either neutral or, often, positive.

Less than four days after the World Trade Center disaster, I attended a wedding. All the guests, many of whom had gone to great effort to attend, shared a yearning for normalcy and signs that life was going on. There was true enjoyment, occasionally interrupted by tears for the missing ones, but also enhanced by a great feeling of togetherness. Life, all said and meant, must go on. Several guests, as well as myself, actually encouraged their wives to tear themselves away from the TV’s chronicling of the individual tragedies brought about by the disaster and “go shopping”. Normalcy of a kind will return, but with a new, stronger will to regroup and rebuild – a new sense of common purpose. We may well enter a war-like economic environment in the United States, as has been suggested, but such an environment will be accompanied by greater sense of civics and determination than the country has known in a long time. We believe the economy will, eventually, benefit from that new psyche.

To go back to economic policy, let’s use another automotive analogy. When your car gets stuck in a patch of soft soil and you rev up the motor to try and get some traction, one of two things is likely to happen. Either your wheels sink deeper into the soft soil (the automotive equivalent of a deflationary spiral, which we do not anticipate on a global scale), or you suddenly get traction. When the later happens, you often get more traction than you had expected.

Even before September 11^th, the world’s leading central banks had been following very aggressive monetary policies, illustrated by record rates of increase in liquid assets. Large central banks typically increase their assets by first creating new money at the push of a button, which is their privilege, and then using that money to buy monetary instruments from the banks or other financial institutions. Until now, in the current cycle, record increases in central banks’ assets had often not produced commensurate increases in national money supplies. This lack of traction, as we explained, was due to banks’ unwillingness or inability to lend and to the lack of demand from the financially healthy elements of the private sector. In addition, most government budgets remained in relatively restrictive modes.

My expectation was that, if the economies remained sluggish, monetary policies would become even more stimulative, while fiscal policy (tax cuts or government spending programs) would soon become significantly more speculative – to provide the traction that was not forthcoming from the private sectors.

Now, with the additional uncertainty created by the terrorist attacks of September 11^th, I believe that this scenario, in fact, has been reinforced. Specifically, the economic bottom is likely to be both accelerated and accentuated, but so will offsetting policy actions by major governments and central banks. With the global economy looking even more vulnerable in the short term, there will be more money and government spending than I had anticipated, and traction is likely to reappear sooner, rather than later.

One often-overlooked fact is that, when the world is in recession, global Gross National Product continues to grow at rates of 1% to 2% per annum – as opposed to 3% to 4% during more normal periods. The reason is that many younger countries have very strong demographics, so that overall consumption can continue to grow even when GDP per capita stalls or even declines. During the global boom that preceded the onset of the Asian crisis, in 1997, much capacity was built in traditional industries in the anticipation of continued growth at rates in excess of 5%. This capacity was still being completed when the Asian crisis got under way, leading to global overcapacity and declining prices for many products – particularly basic materials.

Now, with the leading world economies likely to take further actions to stimulate economic activity, existing surpluses of many goods will be depleted faster, and prices for many commodities and basic industrial products will likely start rising soon. This will mark the onset of recovery for the “old” sectors of the world economy.

As we were preparing for the re-opening of the U.S. stock markets, late last week, our investment committee decided to enter buy orders for many shares at price limits below recent market levels, in order to take advantage of an early sell off should it occur. Not only do many “value” stocks face a better future, but any sell-off may also provide an opportunity to buy shares of outstanding companies at prices that only become available in exceptional times. We believe that many of the experienced investors at other quality investment firms were doing the same. In times like these, unemotional contrarian thinking and a strong sense of value can be a long-term investor’s best assets.

As America mourns its losses, we must look to the future. Trials such as the present one have always brought out the best in Americans. Already, we can sense the country’s incredible capacity for mobilization in the face of adversity. The solidarity across races and religions stands as a symbol of what America is all about. To paraphrase Carl Friedrich, in most nations, to be a citizen is a fact. To be American is an ideal.

^©Tocqueville Asset Management LP. All rights reserved.
September 17, 2001

The information contained herein has been obtained from sources believed to be reliable and to the best of our knowledge is complete. The validity and completeness however cannot be guaranteed by Tocqueville Asset Management. Nothing herein constitutes investment or any other advice and should not be relied upon as such. This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities. Any reference to past performance is not necessarily a guide to the future. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication. The opinions expressed in this document are those of Tocqueville Asset Management as of the date of the writing and are subject to change.