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Market Shots

2/21/01

b42267.jpg (23059 bytes) Last Friday we got industrial production numbers that indicate the manufacturing sector of the economy is contracting, and producer price numbers signaling higher inflation. Today, the CPI came in higher than expected. Traditional economic analysis suggests that prices and economic activity move in the same direction, but the stagflation of the 70’s and the high growth, low inflation 80’s and 90’s disproved that tenet. Unfortunately, we may be experiencing a reprise of stagflation. Certainly the stock market is acting the way it did in the 70’s—going down.

Economics would be easy if everything could be explained by a few simple Keynsian or monetarist equations. Unfortunately, the real world is constant change and shifting variables. An important determinant of economic activity is liquidity—how much monetary juice sloshes around the system. The standard response to economic and financial crises by central bankers and other policy makers for at least the last fifteen years has been to inject liquidity into the financial system until the problem recedes. Greenspan stepped up when the stock market crashed in 1987 and 1998, when the savings and loan crisis threatened the economy in the late 80’s and early 90’s, and even when Y2K posed a potential, but not realized, threat in 1999. The Japanese have driven their interest rates to zero in a vain attempt to revive their economy. The IMF and World Bank administered numerous bailouts to insolvent sovereign borrowers in Latin America, Southeast Asia and Russia.

So far there has been enough monetary fingers, the dike hasn’t broken, and the world’s economy hasn’t collapsed. However, the financial system suffers from a massive surplus of liquidity. Economies burdened by surplus liquidity are generally characterized by booming investment, strong economic activity, rising prices for fashionable asset classes, and overall euphoria. It may seem like the distant past, but that description matches conditions in the U.S. as recently as eleven months ago. One of the few ironclad laws of economics is the law of diminishing returns. Each additional monetary unit injected into the financial system produces less economic stimulus than the previous one. Keeping the global economy afloat has required successively larger monetary rescue operations, and the time between crises is shrinking. In other words, we’re getting progressively less bang for our bucks, yen, ECU’s, IMF special drawing rights, etc. Last March, equity prices became too distant from economic reality—the world had enough Internet startups, semiconductor plants, hi tech office parks, 10,000 square foot homes, $50,000 SUV’s, trendy Italian cafes featuring $25 pasta and $5 lattes, and so on, and the whole thing collapsed of its own weight.

What happens now? Economic activity contracts as surplus capacity, production, and employment, resulting from the boom’s excess investment, driven by excess liquidity, is eliminated. Such a process implies downward pressure on prices, but this time may be different, because the monetary stimulus applied the last fifteen years has been so disproportionate to the growth rate of the world economy. Although a lot of paper stock market wealth vanished into thin air, some people took profits that were never reinvested, and that money has to go somewhere. One month’s numbers aren’t necessarily a trend, but the PPI and CPI could be confirming last year’s increase in inflation from the previous year. Plentiful liquidity may be finding its way into the real economy.

If the economy is entering a period of stagflation driven by excess liquidity, lowering interest rates will be worse than useless as a remedy. It will do nothing to eliminate speculation and unprofitable investment, and it will exacerbate inflationary pressures. While investors focused on the economy and equities, the Clinton administration managed to sneak in a lot of regulations that both raise costs and decrease overall production, further exacerbating both the stag and the flation problems. The Bush administration will try to reverse some of Clinton’s last minute executive orders, but it’s difficult for Republican administrations to conduct the kind of line by line review of regulations and agency budgets that would be necessary to cut spending and streamline the federal bureaucracy. Republican appointees fight rearguard opposition from the bureaucrats and their friends in Congress and the press. Although the bureaucracies operate in the shadows, as we’re finding out in California, their activities can have profound, and costly, consequences. Stay tuned, and let’s hope the economic statistics reverse themselves. The 70’s demonstrated that stagflation is no friend of financial assets.

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