Equity market players, particularly the high rollers who concentrate in the Nasdaq, have become their own worst enemy. Their continued irrational exuberance may turn out to be the factor that keeps the U.S. economy from successfully making a mythical “soft landing.”
There is a Catch-22 here. Highly leveraged new economy companies, and the investors who hold their stock, have the most to lose if the U.S. economy ever falls into a mean recession. Dozens, perhaps hundreds, are fated to bite the dust if the economy really turns south.
A more gradual slowdown, even one reaching the two consecutive quarters of declining output that economists use to identify a recession, will give them a lot more time to tighten belts, reduce their leverage and generally batten down the hatches.
There is considerable evidence that sort of adjustment is already in the works. Most recent economic indicators, including factory orders, new home construction, retail sales and the indexes of leading and coincident indicators now tabulated by the Conference Board, point uniformly to slowing of economic growth. The revisions to earlier flash estimates of third-quarter growth released late in November were slightly downward, indicating that growth of output was slowing already in the July-to-September period.
Contrary to media gloom and doom, this evidence of slowing is not bad news. The economy had been growing at a pace history tells us is unsustainable. History also tells us that in the late stages of a boom, everybody gets a little punch-drunk. Consumers spend more than they really should, taking on too much debt.
Businesses invest in new machinery and facilities that may not pay for themselves just because things have been good for so long and the cash is there. Banks loan money imprudently simply because the memories of past defaults and write-offs have become too dim.
Long-distance running provides a good analogy. Many of the runners who set the hottest pace in the first kilometers off the starting line end up in the bottom tier of finishers. The guy who blazes past you as if you were standing still at Mile 3 is likely to be standing painfully hunched over by the side of the road an hour later, while the more disciplined runners continue to motor on along.
Economic history shows the same lesson. Flashily rapid growth tends to end earlier or more violently. Slower growth can go on longer, and any eventual slowing is less wrenching and less prolonged.
Monetary policy involves long lags from the time changes in the money supply are made to when they really start to bite. “Don’t fire until you see the whites of their eyes,” was sound advice at Bunker Hill but is bad in central banking.
Fed Chairs Arthur Burns and William Miller tried that tactic in the 1970s and ended up with their positions overrun and the wounded bayoneted by rampant inflation. The Federal Open Market Committee knows this and was right to start ratcheting up rates at a time when there was no evidence of rising price levels.
Greenspan and other FOMC members also know that they should not keep their foot on the brake pedal until the economy comes to a dead stop. The chairman recognized that in his speech last Wednesday to a group of community bankers. Anyone who has followed his record over the past 13 years should not be surprised by his observation that the Fed may ease at some point if slowing continues.
But that acknowledgement should not motivate traders to bid up stock prices by 10.5 percent in a single day. In the long run, equity values need to rest on realistic expectations of long-term earnings, not on a bet that the Fed will pump enough liquidity into the economy to keep all boats afloat.
And in the long run, consumer spending will have to rest primarily on the bedrock of higher productivity, rather than on the wealth effect of households looking at the appreciated value of their 401k accounts and deciding they don’t need to save so much for retirement after all.
Greenspan and other FOMC members have said repeatedly that it is not their job to decide what is the appropriate level for equity markets. They are right. But the Japanese experience, when in the late 1980s the Bank of Japan was far too lax and let an expanding money supply flow into equity and real estate markets with catastrophic results, has to be in the back of everyone’s mind.
That is the crucial irony. The more Nasdaq traders respond with unbridled buying to any hint of Fed easing, the longer it will take for that easing to occur. The less willing traders are to accept a moderate slowdown as healthy and inevitable, the more likely the slowdown will be harsh and will grind through their new-economy portfolios like a diesel powered wood chipper.
© 2000 Edward Lotterman
Chanarambie Consulting, Inc.