Reasons to be cautious: the list starts growing

The Sunday Times (London)

As regular readers of this column know, I have been relentlessly optimistic about the future of the American economy. Not that there is some "new paradigm" that has repealed the business cycle. But there is an improvement in productivity, support for deregulating large swaths of the economy, a general sense of well-being among consumers, a leaner and meaner manufacturing sector, a mobile labor force, an absence of class envy, and an extraordinarily robust entrepreneurial and venture capital sector. Not a bad combination as we enter a new century.

Still, it would be a disservice to followers of these analyses of the American economy not to recognize that something just might go wrong, that a funny thing might possibly happen on the way to permanent prosperity.

Start with the current state of play, summarized in the Federal Reserve Board's most recent survey of its regional members, published late last week. The lead sentence tells it all, "District reports indicate continued strength in economic activity, though there are widespread reports of supply constraints." Translation: the economy may be overheating. Retail sales cooled a bit, but only because consumers couldn't find the merchandise they want on the picked-clean shelves of retailers. Residential construction and housing markets remain strong, although shortages of materials and labour delayed projects and boosted costs. Loan demand is rising. Most significant to Fed chairman Alan Greenspan, the report notes, "Widespread labor shortages persist in virtually every district...". Little wonder, since claims for unemployment insurance are at a ten-year low.

Add in unit labour costs that jumped in the last quarter, a return to double-digit increases in health care costs, and rising oil prices. If ever there ever was a prescription for a rate increase when the Fed's monetary policy committee meets on August 24, that is it. True, prices show little sign of taking off. But Greenspan says it is the Fed's job to preempt inflation, rather than to wait until it rears its ugly head. And Washington rumour has it that he would not be displeased to see share prices fall until the Dow drops another ten percent, to, say, 9600. That, he is said to believe, would cool consumer spending sufficiently to slow the economy's growth to a sustainable 2.0-2.5 percent.

Such a slowing might begin to rein in the country's burgeoning trade deficit. Which brings us to the second stumbling block on the road to continued rapid growth. America has been serving as consumer of first, last and only resort for the goods of stricken economies in Asia, and for the static economies of Mexico, Canada and Europe. The world sends its output to us, and we send the world bits of green paper decorated with pictures of American presidents. Not a bad deal for America, so long as it lasts.

But some policy makers worry that the world's appetite for presidential portraits is limited, and that as the European and Asian economies recover, which they seem to be in the process of doing, overseas holders of dollars will decide to cash them in for euros, or yen. This will cause the dollar to fall, raising the price of the imports on which Americans are now feasting, and permitting domestic manufacturers to raise their prices as competition from imported goods becomes less intense. Allan Meltzer, a professor at Carnegie-Mellon University and chairman of the committee that shadows the Fed, expects more expensive imports to contribute to a rise in the inflation rate to three percent in the near future.

This would force the Fed to raise interest rates, and not by only a little, if it is to prevent a herd instinct from turning a normal fluctuation in exchange rates into a massive flight from the dollar.

That higher interest rates will slow the economy no one doubts. Recent increases--dictated by investors who are more nervous about the reemergence of inflation than the Fed has thus far been--have already slowed down applications for new mortgages. Higher rates also make it more expensive for consumers to carry credit card balances, and to buy new cars with bank financing.

Perhaps even more important, higher interest rates make it attractive for investors to dump shares and buy bonds. And it is the run-up in share prices that has aroused the animal spirits of consumers, investors and entrepreneurs. A stock market sell-off, induced by and combined with higher interest rates, might just send consumers out of the malls, shops and car showrooms.

Add one more ingredient: the opening of the political silly season in America. Democrats and Republicans are engaged in a heated debate about how to dispose of the forecasted surplus in the federal budget. The President wants new spending programmes; the Republican congress wants large tax cuts. Meanwhile, in the quiet, unobserved committee rooms in which budget bills are drafted, congress has already spent the portion of the surplus that is not needed to meet the nation's retirement obligations to its baby-boomers. As this budgetary drama unfolds, the markets are certain to become a bit more nervous, as the future course of fiscal policy becomes difficult to forecast.

Not that monetary policy will be any easier to predict. Greenspan is coming under fire from former conservative allies such as Steve Forbes, the billionaire inheritor of his father's magazine empire, and now a candidate for the Republican presidential nomination. Campaigning in Iowa, Forbes needs the votes of the state's drought-stricken farmers. Generally saddled with mortgage and other debt, these farmer-voters favour low interest rates. So Forbes and other Republicans on whom Greenspan could in the past rely for political support for anti-inflationary monetary policies, now have moved over to the populist camp.

An overheated economy bedeviled by labour shortages that are bound to trigger wage increases, rising interest rates, a falling dollar, lower share prices, higher import prices, and increased uncertainty don't make for continued economic growth. That's the dark outlook for America, say some prognosticators. Let's hope that I'm right and they're wrong.