T H E L O N G A N D S H O R T O F T H E C R I S I S O F C O N F I D E N C E
-- Rajeev Dhawan
Director of the Robinson College of Business
Economic Forecasting Center
The local newspaper recently ran a cartoon that showed a person named "Economy" falling down from the top of a skyscraper with Alan Greenspan standing by, dressed in doctor's garb, giving the downward-hurtling patient a clean bill of health! The stock market has lost almost $7 trillion in market value since its peak in March 2000, with share prices declining very rapidly in the last few months. Large companies or their CEOs are falling like dominoes, and accounting scandals have caused a crisis of confidence that is taking its toll on both consumer confidence and capital spending plans. So is there a disconnect between what the most powerful policy maker in the world perceives about the future of the economy and the reality?
Notice that I only question the health of the economy and not the strength of the ongoing recovery or the sanity of the stock market. The fundamentals of our economy are good, and that is what matters for sustained growth in the long run. Currently, we have a very accommodating monetary policy, unlike that of the double-dip recession of the early 1980s. There is no Paul Volcker ratcheting up interest rates to sky-high levels in order to break the back of potential inflation. Thus, the Fed is not engaged in a desperate gamble to build its credibility by leveraging the economy's sanity. Also, there are no OPEC-engineered oil price hikes, as was the case in the fall of 1973, which coincided with booming economies all over the world adding to inflationary pressures. At this moment, the Fed's credibility is a given with Wall Street, which is significant as it relates to the efficient functioning of credit markets.
Our fiscal policy is also very accommodating when it comes to defense spending and other outlays. Yes, fiscal deficits have returned rather ominously, but the culprit here is the lower capital gains tax collections caused by a teetering stock market rather than out-of-control politicians with their pork-barrel projects. Since the Great Depression, experience has taught us that hesitancy in government spending can deepen downturns while reckless extravagance in good times (as seen during the Vietnam War) can cause the inflation monster to rear its ugly head. It is hard for us to imagine that this wisdom will vanish overnight, although politicians are known to surprise us with their "brilliant" acts. However, what saves us from these follies is that monetary and fiscal policy are joined at the hip - a lesson that has been learned well by the Treasury and the Fed over the years. Chances of fiscal mismanagement by politicians are low as a result.
There is, however, short-term trouble on the horizon, e.g., the strength of the recovery. This recovery is proceeding as we predicted earlier - volatile and tending to go two steps forward and one step sideways. Current gyrations in the stock market will cause consumers to pull back and CEOs to cut back on hiring and capital spending. However, the long-term interest rates are still low and continue to fall, keeping the housing market afloat. The next wave of refi's will add consumption dollars and lower the debt burden while the profit margins take their time to recover. I expect job growth to begin in earnest in early winter after the stock market has stabilized by fall. The dollar has weakened considerably in the past few months, which is a welcome relief for our exporters, who have been hurting since the Asian crisis strengthened the dollar.
So where is the stock market headed? The Enron and WorldCom debacles along with other accounting scandals call for revaluations of stocks since both historical and future earnings estimates are revised downward. This is the short-run response until the system stabilizes after the crooks are weeded out and, guilty are punished. Efforts have already begun, and if the individual investor hangs in there, the economy will survive this turmoil. The amended caveat in the post 9/11 economy is that, barring new major terrorist attacks and an implosion of another large corporation, we will be back on track by early next year. The big issue involves the prognosis for the market in the long run. Here we turn to tenets of finance theory.
Efficient market theory implies that a market's price-to-earnings ratio (P/E) tends to revert to its mean value following deviations. Empirical research indicates that when prices adjust not earnings, the P/E ratio returns to its equilibrium value. Thus, what we are seeing now are the implications of the reversion to the mean tendency. In layman's terms, the leftovers from the bubble of the late '90s are being mopped up. There is room for price correction to go further, but the chances of seeing even high single-digit returns seem slim. Now, will this ongoing price correction cause long-term damage to the economy? There was no economic crisis in the aftermath of the Dutch Tulip mania or the Railway stock mania of England in the 1840s. But the crash of 1929 and the bubble bursting in the Japanese economy in the 1990s were followed by serious economic pain. On the other hand, the bursting of the South Sea bubble was painful, but the 1987 stock market correction wasn't. Using history here is no better than flipping a coin. I am, however, optimistic as I am following the sage of Omahašs advice that to forecast, one needs to supplement history with onešs own perception of the future. In my view, the fundamentals for the economy are strong for the reasons stated in this article.
