Nonsense on stilts

Samuel Brittan, FT, May 13, 1999

Most of the rationalisations for the Wall Street boom were foreshadowed in the run-up to the 1929 crash.

Whatever Wall Street's immediate reaction to the long-awaited departure of Robert Rubin as Treasury secretary, it will not stop talk about the so-called "new paradigm". This is supposed to allow a combination of economic events previously regarded as impossible, but which only fuddy-duddies now deny.

The new paradigm used to be known - with justifiable cynicism - as the Goldilocks scenario. It has three elements.

First, it is said, the US economy can now be run with a much lower level of unemployment than before without generating rising inflation.

Second, it is suggested that there has been a pronounced upward shift in the underlying growth rate.

And third, Wall Street is supposed to soar to ever greater heights.

The first assertion - that the US can now be run with a tighter labour market than previously supposed without inflation taking off - is probably justified.

The second - about a higher underlying growth rate - is more dubious.

The third - about Wall Street's ability to reach the stratosphere - is nonsense on stilts.

Alan Greenspan, the chairman of the Federal Reserve, has reminded us how Fed forecasts have chronically overestimated inflation and underestimated real growth.

Unemployment has fallen to lows normally associated with rising wage costs and accelerating inflation, according to nearly all models. Yet wage inflation has never seemed more subdued.

Even this most plausible part of the paradigm can be exaggerated. For there have been some favourable once-for-all influences on the inflation rate, arising from falling commodity and oil prices and a rising dollar. These may give a misleading idea about quite how far the sustainable rate of unemployment has fallen.

According to Goldman Sachs, the recent rise in energy prices will be sufficient to bring about a blip in the US inflation rate from 1½ per cent to over 3 per cent this quarter, and a more lasting rise to 2½ per cent or more. Another abnormality is the strength of the investment boom, which has produced the rare coincidence of a tight labour market and a large margin of excess capacity.

It is, in any case, nonsense to conclude that fundamental economic rules need rewriting. Those who say this do not know what these rules are. The estimates made of - forgive the jargon - the Non Accelerating Inflation Rate of Unemployment or Nairu, are simply rough guesses. Even if valid, they apply only to limited periods.

There is no reason in basic theory to expect the Nairu to be unchanging. Milton Friedman, one of its inventors, has always refused to guess its level. As Mr Greenspan said: "Neither the fundamental laws of economics, nor of human nature on which they are based, have changed or are likely to change."

The validity of the new optimism about underlying growth depends somewhat on what you mean by "underlying". Mr Greenspan sang the praises of the information technology and related revolutions. But he then pointed out that they are less important than technological revolutions around the turn of the last century, leading to the introduction of the automobile, the aircraft, the telephone and the beginnings of radio.

Charles Jonscher, who is an acknowledged IT expert, remarks on the lack of evidence that IT has increased US productivity growth (Who Are We in the Digital Age?, Bantam Press). Indeed, the average annual growth of business output per hour in the post-1992 business cycle has been less than in the years between 1954 and 1975.

Mr Greenspan believes that the new technologies have indeed brought an unexpected increase in output over the last few years. But he considers it invalid to project this increase into the future. For we do not have the knowledge to distinguish between a once-for-all jump, and a change in trend.

Now I come to Wall Street itself. Even if equity prices do not crash, the US boom is highly vulnerable. For American consumers - the much vaunted saviours of the world economy - have stopped saving, and have been running down their financial balances.

This cannot go on for ever. It only appears sustainable on the basis of a continuing rise in equity and other asset prices, which is creating the illusion of wealth.

Surveys of equity analysts show expectations of 13 to 14 per cent annual rises in corporate earnings continuing. But if these represent real profits, and not just a resumption of inflation, they are absurd. For the average annual growth of nominal gross domestic product is barely 5 per cent. If any component of GDP continues to grow faster than the total, compound interest alone suggests that it would eventually account for almost the whole of GDP.

The return of near double-digit growth of broad measures of money over the past year also needs attention. It could be passed off as an aberration if it were an isolated development. But combined with so many other symptoms of an asset price bubble it is beginning to look ominous.

Some Wall Street bulls fall back on the big drop in bond yields, which has not been reversed by the recent setback. They say that these justify higher price to earnings ratios because they reduce the rate at which future profits are discounted. But Andrew Smithers, the London investment manager, has spoiled the party by pointing out over a long period there is no correlation whatever between bond yields and price-earnings ratios.

To me, most striking of all are comparisons to the 1920s. Just as there are optimists today who talk about the Dow Jones Industrial Average rising from 11,000 to 20,000 or 30,000, their forebears in the 1920s spoke about a new era of everlasting prosperity.

The rise in the Dow Jones between 1924 and 1929 was very similar to the rise from 1994 to date.

Consider the recent story about a truck driver who gave a lift to a man in a dark suit.

The man in the suit asked the driver if he ever invested in stocks. He replied that not only did he do so, but that he had been able to buy a tropical island with the proceeds.

This is the modern equivalent of the cab drivers making fortunes in the 1920s, and driving only as a hobby.

Of course, in talking about 1929, it is important to avoid the error of identifying that crash with the Great Depression. That came rather later - and was only partly the result of the 1929 Wall Street crash. The crash was followed by a moderate recovery that gave way to further and larger downturns, reaching a bottom only in 1933.

One hopes that the Fed has learned enough to prevent a 1929-style crash being followed by a 1930s-style contraction in the money supply and economic activity. But it is doubtful if it can avoid at least some check to growth - or even outright recession - in such circumstances.

This is the first time that I recall expressing a view on stock markets anywhere. But if the pundits in any field seem to be living in a fantasy land one must say so. This applies whether they are military pundits making unrealistic claims for the results of bombing, or stock market gurus projecting what Tim Congdon of Lombard Street Research rightly calls "a crazy boom" for ever.

No one knows know whether the break will come within one week, month, one year, or five years. We must hope and pray that any Wall Street crash comes after some combination of the euro-zone, Japan and the emerging countries can take over from the US the task of being the locomotive for world expansion.

Meanwhile let us recall the remark of that stock market authority, Bernard Baruch, that no one ever lost his shirt from taking a profit.

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