The Post-Bubble US Economy

The US economy has gone through a very interesting period over the last twenty years or so. There was a period of expansion that lasted for ten years, the largest ever recorded by an industrialised country. So much so that allegedly a ‘new economy’ emerged with rules, which were different from what, traditionally, had been known. The stock market produced enormous gains, especially so in the areas of Technology, Media and Telecommunications. Beginning March 2000 the stock market simply collapsed. The optimism surrounding the ‘new economy’ vanished with it, followed by pessimism. In fact, beginning March 2001 the US economy entered a period of recession. This prompted the Fed and the US fiscal authorities to pursue expansionary policies. There were no less than 13 reductions of the Fed Funds rate between the early parts of 2001 and mid- 2003, along with expansionary fiscal measures. The surplus in the government budget, created during the expansion, turned into a deficit and a higher government deficit is expected in the near future, especially in the second half of 2004.

On 26 November 2001 the National Bureau of Economic Research declared that the US economy’s recession had begun in March 2001. The expansion had lasted for ten years and it was one of the longest ever recorded by any industrialised country. In the fourth quarter of 1999 the US growth rate reached 7%, the highest in the 1990s. Unemployment fell to a 30-year low (3.9% by April 2000), the rate of inflation was low (averaged 2.5% throughout the whole of 1990s), faster growth in productivity was recorded, and faster growth in real wages. All these factors helped to reduce poverty and stabilise wage inequality (Temple, 2002). More recent data (see Council of Economic Advisors, 2004, table A33), though, reveal that this is true only for the years 1998–2001. The stock market also produced massive gains, so that by the late 1990s the price/earnings ratios reached record levels in the whole of the twentieth century. Every year between 1995 and 1999 the US stock exchange Standard and Poor’s Composite Index (S&P 500) produced an annualised total return (including dividends) over 20%. By the end of that period, the performance of the stock market was concentrated in the stocks of large companies and of growth companies (those that had been delivering strong growth in earnings per share and were expected to continue to do so), especially so in the areas of Technology, Media and Telecommunications (TMT). The Nasdaq Composite Index, which was a heavy representative in technology shares, reached the level of 2000 for the first time during 1998 and peaked to 5048 on 10 March 2000.

Headline consumer price index-inflation (CPI-inflation) peaked at 3.7% in June 2000 and bottomed at 1.1% two years later, in June 2002. It rose steadily to 3% by March 2003 and subsided to 2% by October 2003. Core CPI-inflation, which is preferred by the Fed and taken more seriously than the headline measure in formulating monetary policy, peaked at 2.8% in November 2001 and has declined steadily to 1.3% in October 2003 (see Figure 3.1).¹ Although the Fed, on numerous occasions in the last three years, has expressed fear of deflation the question arises as to what would happen to inflation now that the economy shows signs of robust growth. Is the fear of deflation justified? Or, is the Fed, as the cynics would argue, using the excuse of deflation to keep interest rates unduly low and help the personal, corporate and government sectors get rid of their debt through inflation? Would inflation remain low in the current recovery? When should the Fed tighten monetary policy, if it is to keep up with its hardly won reputation as the guardian of low inflation?

Reported earnings in the second half of the 1990s showed a dramatic improvement in profitability, which was interpreted as the reversal of the long-term decline in US profitability. However, National Income Accounts did not confirm this argument at that time, which financial markets ignored entirely. The ‘governance crisis’ that ensued confirmed that creative accounting was mainly responsible for that interpretation. Consequently, the question of whether the US economy is still characterised by long term declining profitability is pertinent. A further question is whether this decline might reverse itself with the current recovery. The alternative interpretation would be that any improvement might be temporary in view of the US long-term trend of shifting production overseas. We address these issues in this chapter.

In the first year of the current recovery investment grew at the worst-ever anaemic pace. Both short- and long-run factors contributed to it. However, in the second half of 2003, following the end of the Iraq war, both the short-run and long-run factors that affect investment have improved. The current accommodating stance of fiscal and monetary policy is probably sufficient for the economy to be booming at the time of the presidential election in November 2004, as there is sufficient momentum already built in. The long-term risk to investment stems from the fact that the current US Administration is not willing to take the risk that the economy would only be growing at the rate of potential output in 2004 as investment growth may be very subdued by then. It is, therefore, considering yet another fiscal package to stimulate the economy in the run up to the presidential election. Although such package would ensure that the economy is booming at the time of the election, it will raise long-term interest rates even more and will foster the forces that would ultimately weaken investment in 2005 and beyond. Hence, the long-term risk to investment would not dissipate by the introduction of yet another fiscal package. Instead, it would increase such risk.

The importance of the housing market and residential investment was highlighted by OECD (2000b), suggesting that ‘In the United States… the contribution of real estate developments to the current economic expansion has been emphasised recently’ (p. 169). In fact, it is argued that ‘Over the 1996–99 period, the growth of housing wealth in excess of income growth in the United States may have contributed 0.4 percentage point to the total drop of the household saving ratio of some 2.4 percentage points’ (p. 179). The same OECD study concludes that ‘The link between house price developments and movements in aggregate demand suggests that monitoring developments in property markets can provide a useful input to the setting of economic policy’ (OECD, 2000b, p. 181; see also, Greenspan, 1999).¹ The boom of the housing market since the burst of the equity bubble has raised some concerns. Greenspan (2004c) emphasised the importance of ‘preventive actions’ which ‘are required sooner rather than later’ in order to ‘fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated’ (p. 4).² Especially so, since ‘the existence, or even the perception, of government backing undermines the effectiveness of market discipline’ (p. 4). It is, therefore, suggested that ‘the GSE regulator must have authority similar to that of the banking regulator’, but also ‘GSEs need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and nonmortgages, that they hold’ (p. 5).

In the second half of 2003 consumption rebounded because of an improved outlook for the corporate sector, higher confidence because of lower geopolitical risks and in view of the new round of tax cuts and higher government deficit. The short-run factors that affect consumption improved over the same period, and expected to remain buoyant in the course of 2004. Employment prospects are much better, inflation will remain subdued for a while and real disposable income growth will remain buoyant. Moreover, further gains in the property market and recovering equity prices mean that the imbalance of the personal sector has narrowed, in spite of higher indebtedness that stands at an all-time high. Hence, the outlook for consumption in 2004 has markedly improved. However, there are still long-term risks to consumption, especially so if growth in 2004 turns out to be strong, boosted once more by easy fiscal policy. Interest rates would rise and would undermine the outlook for the corporate sector, which would adversely affect the short-run factors that affect consumption. In addition, higher interest rates would adversely affect the long-run factors that affect consumption. Higher rates would threaten to lower both house and equity prices once more. In this case the personal sector imbalance would widen once again and this time it may lead to retrenchment by households that may even develop into recession in 2005, unless, of course, sufficient government deficit is in place. Slow growth in 2004 is preferable than fast growth, as none of these risks would materialise.

The buoyancy of the US economy since the end of the Iraq war and the spectacular recovery of exports in the US, the euro area¹ and Japan, and we refer to them as (G-3) in what follows, in the third quarter of 2003 have raised hopes of a US-led world recovery. The OECD index of leading indicators has continued to rise and this heralds further strengthening of (G-3) exports in the months ahead. However, the conclusion of a world recovery over a longer horizon depends on the strength of the US economy and the extent of previous changes in competitiveness. In this respect, the US and Japan have gained competitiveness in the last two years, while the euro area has suffered a great loss. However, if the US economy were to grow as fast as potential output in the next two years, then the world economy would recover.² Such growth would be sufficient to offset previous losses in competitiveness and allow the euro area to enjoy an export-led recovery. Steady growth in the US at potential output is preferable to fast growth in 2004 and weak growth in 2005, but with the same average, because the world recovery would falter. The implication is that domestic demand in the euro area and Japan should be boosted by accommodative economic policy. Although the same effect can be achieved by easy fiscal policy in the US, this may not be desirable at this phase of the US business cycle.

The finance of the huge US current account deficit has so far been met very easily, as the residents in the Rest of the World (ROW) have been willing to lend the US the necessary funds to cover this deficit. This process has turned the US into a serious net debtor to the ROW in the last twenty years. However, the debt is in US dollars and there are no immediate good reasons why residents in the ROW should lose their confidence in the ability of the US to service this debt. There is a risk, though, that ROW residents may lose their appetite to hold US assets, if they continue to suffer huge losses on their holdings of US assets. As we argued in Chapter 1 above, during September and October 2003 there was a temporary drop in the desire of foreign investors to accumulate US assets, but this was restored subsequently. The risk that foreigners may, at some point in time, lose their appetite implies that it would be better that the US should balance or, at least, reduce its current account deficit. The dollar is on declining trend and that would help the current account deficit, because the economy is operating with spare capacity and needs to boost its exports to foster the recovery.

Bond yields are likely to rise gently this year, thereby causing a threat neither to equities nor to an overvalued housing market, as inflation is likely to dissipate for most part of 2004 and the Fed might delay its monetary tightening. In spite of market worries, both bonds and equities are near their respective equilibrium. However, there are serious risks to financial markets and the economy as a whole from fiscal policy turning once more easy in 2004. The Fed, then, would have a difficult job in keeping the economy on a sustained path to recovery. With strong growth, above potential, the Fed can afford to wait before tightening, as growth is likely to decelerate in 2005 and inflation is likely to remain muted. But the Fed would be forced to tighten more aggressively after the presidential election. Bond yields will rise in 2005 but not to levels that would undermine the housing market. The victim might be the equity market with prices falling precipitously revisiting the March 2003 levels, if the slowdown of the economy were sharp.