First, the Bad News . . .
October 18, 2002
by Irwin Stelzer
“You don’t worry enough,” chides my sometime colleague, Jim Haskel. The Goldman Sachs vice president, himself a natural-born worrier, feels that I haven’t been giving enough weight in these columns to the dark side of the economic news, what he calls “the vulnerabilities.” Fair enough. So here’s a dose of gloom.
We begin, of course, with the stock markets. The third quarter saw share-price averages post their biggest three-month decline since the fourth quarter of 1987. All in all, Americans have watched about $8 trillion in wealth go down the drain as share prices engage in what seems an endless search for a bottom. Many analysts feel that such losses are already discouraging business investment and will sooner or later cause consumers to rein in their spending.
It is that sustained spending that is a two-edged sword. It has kept the economy moving forward in spite of a massive slowdown in business investment. But American’s appetite for imported cars, television sets, trainers, and T-shirts has created a current account deficit that is now approaching 5 percent of GDP. Most economists think that an imbalance of that magnitude between imports and exports inevitably leads to a run on the currency of the importing—some would say profligate—nation.
So far, the United States has avoided more than a minor decline in the dollar by attracting sufficient inward investment to offset the massive outflow of dollars. Europeans’ withdrawal of funds has been matched by increased inflows from Asia. But if share prices continue to fall, foreigners may tire of holding dollar assets. If they do so suddenly and in a major way, the dollar may fall so far and so fast as to force the Federal Reserve Board to jack up interest rates to increase returns on dollar assets. That would, of course, abort the halting economic recovery now underway.
Consumer spending creates another problem—record borrowing. Haskel points out in a memorandum to me that the cost of servicing private debt is now running at about 14 percent of disposable income, the top end of the historic range. Should interest rates rise, the cost of carrying that massive pile of debt—now equal to more than 100 percent of disposable income, compared with about 75 percent in 1990—will soar, forcing consumers to rein in spending.
Indeed, there is some evidence that Americans are already getting more cautious about parting with their money. Housing starts have declined for three months. Auto sales fell sharply in September. And mighty Wal-Mart and America’s fourth largest retailer, Sears Roebuck, both reported sales that fell below their expectations.
If a rise in interest rates did force consumers to stay out of the shops, the current recovery could come to a screeching halt, especially because such an increase would also put an end to another source of consumer funds, the refinancing of mortgages. Consumers have been withdrawing equity from their homes by refinancing at such a rate that the ratio of their remaining equity to the market value of their homes has fallen to 55 percent, according to a study by Dean Baker of the Center for Economic and Policy Research (CEPR). That’s down from an average of 77 percent way back in the 1950s and 68 percent in the 1980s. In short, homeowners’ ability to engage in a few more rounds of refinancing to get their hands on ready cash is decidedly limited. Indeed, Baker goes further, “If [house] prices decline nationally by an average of . . . 22 percent, . . . with the low current ratio of equity to value, many homeowners will be left with mortgages that exceed the value of their homes.” The dreaded negative equity.
There is worse news. The rising defaults, already rearing their ugly heads (a record 1.23 percent of all mortgages are now in the foreclosure process), will “place serious stress on a banking system that already is suffering as a result of several major corporate bankruptcies,” concludes the CEPR study. And that was written before federal regulators reported last week that problem loans held by syndicated lenders had increased for the fourth consecutive year, before European and American investment banks announced that they would write off a record $130 billion in bad loans this year, and before Douglas Flint, HSBC’s finance director, warned of the “systemic implications” of the problems faced by Germany’s Commerzbank.
As with all economists’ stories, there is an “on the other hand.” The dollar won’t fall if other nations’ economies remain unattractive to investors. Indeed, since this summer the dollar has been gaining on both the euro and the yen as prospects for recovery in Germany and Japan grow dimmer by the day. And if the dollar does drift down, that will stimulate exports and make imports more expensive, reducing the trade deficit and increasing the pace of domestic manufacturing. That’s what floating exchange rates do.
As for consumer debt, a study by William Natcher, an economist at Cleveland’s National City Corp., points out that because more Americans own their own home, it is not surprising that mortgage debt has risen. But mortgage payments by homeowners are replacing rent payments by these former renters. Correct the data for that fact, and the average share of household income consumed by mortgage payments, 5.94 percent, is no larger than it was in 1995, and below the 1991 peak of 6.5 percent.
Similarly, the rise in credit card debt is due in part to a change in habits rather than to increased recklessness, with consumers using their cards where once they used cash in order to gain free air miles and other premiums.
As for the banking system, fear not. Fed chairman Alan Greenspan says that U.S. banks have “impressive earnings and balance sheets” and are “quite healthy.”
So Haskel is right: you are entitled to a dose of bad news. Now that you have it, weigh it against the facts that when this year ends the economy will have grown at an annual rate of some 3 percent, not far from its sustainable limit, and that America remains the envied world leader in the thrusting entrepreneurialism that is the key to long-term prosperity.
This article appeared in London’s Sunday Times on October 13, 2002, and is reprinted with permission.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.