The Pulse of Capitalism

Issue 99-3, October 1999

Reviewing the Nineties

Political spokesmen are agreed on one point: we are enjoying the best of economic conditions with low inflation, low unemployment, rising incomes, stable interest rates, etc. They seldom if ever inquire into the factors that have produced these results, or whether they will continue to produce them. In this study we will attempt to probe them.

The Monetary Backdrop

The year 1990 marked the high point of the last business expansion and was followed by a year of recession and several years of slow growth. The causes of the downturn were the collapse of commercial real estate values and the savings and loan industry. To combat these problems the Federal Reserve reduced required reserves by more than fifty percent or $16 billion, and the Federal government expanded $152.6 billion in direct costs to liquidate insolvent S&Ls. These actions provided the monetary background for the present expansion.

Real GDP is the most comprehensive measure we have of overall economic activity. The data above show the real substantial growth that occurred during the nineties. Under the concept of a flexible money supply that responds to the needs of business, the M-3 measure should have grown at roughly the same rate as real GDP. In fact, both M-3 and non-financial debt grew about twice as fast, while reserves required to safeguard bank deposits were reduced by one half. The monetary throttle, despite words to the contrary, has been pretty wide open.

Output

The 32.8 percent rise in industrial production through 1998 was more than one-third higher than the rise during the 1980s. Manufacturing, particularly durable equipment, led the rise whereas mining was unchanged, and utilities increased about 13 percent. New construction (in current dollars) fell in the early nineties but then recovered, led by residential construction which reached a new high in 1998. Commercial/industrial and government construction also increased as the decade progressed.

Much of the impetus for this activity has been due to the sharp 65.2 percent increase in real gross investment. During the 1980s this indicator rose 25.7 percent. The fastest growing segment has been producers durable equipment - information processing equipment, industrial equipment, and transportation and related equipment. Total residential structures also rose strongly. Computers and advances in communications equipment have changed business practices throughout the economy. These developments, along with strong consumer demand, led to the high output gains of the nineties.

The Inflation Puzzle

Inflation has been the obsession of market commentators in the 1990s. First, the economists were enamored of the "non-accelerating inflation rate of unemployment" which they assumed to be about 6 percent. Now, along with Alan Greenspan, they focus on the "employment cost index", assuming that further rises will cause producers to raise prices automatically. Market observers, of course, see any sign of inflation as a signal for higher interest rates and a threat to stock prices.

The real question is why we continue to have consumer price inflation. First, we have experienced a decline of 13.1 percent in commodity prices. Second, producer prices have not risen since 1996 and rose only 9.6 percent during the decade. Third, we have worldwide competition from other developed countries with unemployment rates close to 10 percent. And fourth, industrial production rose 32.8 percent since 1990 even though employment in manufacturing was lower in 1998 than in 1990. In other words, industrial productivity rose about 33 percent since 1990. If this gain had been shared with consumers, it, along with falling commodity prices, should have resulted in lower prices at the consumer level, But, in fact, they rose 24.7 percent.

One suspects that this result has little to do with the preoccupation of economists with such things as "tight labor markets". For example, medical care costs rose from an index of 162.8 to 242.1 or 48.7 percent during the period. Likewise, advertising expenditures rose from $129.6 billion in 1990 to $200.8 billion in 1998. Competition at the retail level increasingly takes the form of competitive advertising, not direct price competition. All of which blurs the "invisible hand" of classical economics that determines prices and wages in free markets.

Employment

One of the pleasant surprises of the nineties has been employment growth which has been almost twice as large as population growth and which has resulted in a commensurate decline in unemployment. Virtually all (97.6%) of this increase has been in services producing industries. Almost all services experienced growth, but retail trade, business services, health services, and social services/membership organization added the most jobs.

This growth in services employment appears to be somewhat limited to the U.S. The Euro-11 group of countries had an average unemployment rate of 11.3 percent in April, while Canada had an 8.3 percent rate. The reasons for this divergence are not clear. Obviously the proliferation of services reflects rising affluence. As wealth increases, people expand their lifestyles with bigger homes, more vacations and entertainment, more consumption of personal and household goods, etc., but this does not answer the more fundamental question of why this should occur at this time in the U.S.

Financial Developments

Financially, the nineties have been a period of falling long-term interest rates and rising stock prices. Both reflect the high growth rate of the money supply: 44.3 percent for M-3. This high growth rate substantially exceeded both real GDP growth and consumer price growth. In addition to this domestic stimulus the U.S. experienced a net $998.6 billion inflow of foreign capital. The result has been substantially lower interest rates and higher stock prices. The classical definition of inflation, "too much money chasing too few goods", has been limited principally to financial markets.

Foreign holdings of U.S. Treasury securities and currency increased $1.0 trillion during the nineties while holdings of other U.S. securities rose $1.6 trillion. These increases include price appreciation. In a broad sense, this inflow reflects weakness and lack of investment opportunity in other countries, with the U.S. seen as a safe haven. Western Europe has been the largest supplier of the funds.

The great unanswered question as the nineties draws to a close is how long these trends can continue. Short term interest rates are currently 2.60 in Euro-11 compared with 4.89 in the U.S. If the inflow of foreign capital slows or reverses, U.S. rates could rise quickly. It is interesting to note that when the Japanese economy slowed, short term interest rates fell to virtually zero whereas, when the less developed countries' economies declined, their interest rates soared. The difference apparently was due to the degree of dependence on foreign capital. Which way might the U.S. go?

The earnings-price ratio for the S&P 500 index is now below 3 percent compared with 6.47 percent in 1990, and the dividend-price ratio is now 1.21 compared with 3.61. Will shareholders continue to boost these valuations? One key is corporate profits which rose to a new high in first quarter 1999 after five quarters of no growth. Unless there are further quarterly increases, there wil be no logical reason for investors to continue to boost stock prices.

The nineties began in recession after the S&L commercial real estate collapse. A combination of reduced reserve requirements and government bailout restored liquidity to the banking system and launched a new credit boom. The boom was stimulated by a strong upturn in nonresidential fixed investment, especially information processing and related equipment. These stimuli, along with an inflow of foreign capital, supported employment growth in services and high consumer spending. Along the way (to the surprise of politicians) the government deficit was eliminated, helped by an accounting change that recognizes government saving. It is on that note that we approach the beginning of a new millennium.

The first half GDP growth rate was somewhat improved in Canada and Japan, but three countries - Germany, Japan, and the UK - experienced rates of 1.2 percent or less. Industrial production increased in Canada and the U.S. but declined in Germany, Japan and the UK. Retail sales volume was higher except in the U.S. where it was still very strong, and in Japan where it was still negative.

Consumer prices rose slightly in Germany and declined in Japan; they continued to increase in the other three economies at recent rates. Japan now has an unemployment rate higher than the U.S., an unprecedented relationship in the postwar world. Britain's rate has increased while Canada's and Germany's have fallen. Short-term interest rates have trended lower, including the Euro-11 which has fallen from 3.90 percent to 2.69 percent as of September 22. The U.S. rate on that date was almost as high as the British. Stock indices advanced strongly in the first half, led by the Japanese. During the third quarter, however, most experienced declines. The New York stock exchange index on the basis of 1995=100 is now over 200.

The U.S. current account imbalance grew to $80.7 billion in the second quarter. As recently as 1993 it was only $85.3 billion for the entire year. Britain's balance also worsened. By September, the Japanese yen had risen to 104 per U.S. dollar. But overall against major currencies, the dollar was little changed.

Real gross domestic product increased 1.6 percent in the second quarter, down from 4.3 percent in the first. This was the slowest rate since second quarter 1995. The decrease was attributed primarily to slowdowns in consumer and government spending and investment, and to slower inventory accumulation.

Industrial production has risen every month since January, led again by durable goods production. Capacity utilization, after falling in 1998, was little changed. Manufacturers' new orders continued to rise at the same rate as in recent years, but new construction expenditures fell in the second quarter after rising in the first. The contracts index has been flat since April. Real gross investment also rose strongly led by producers' durable equipment.

Manufacturers' and especially retail sales were quite strong in the first half. The inventory-sales ratio for manufacturing and trade fell while the retail sales ratio rose slightly. These gains reflect continuing increases in per capita personal consumption expenditures.

Employment in services continued its strong growth whereas employment in goods production fell 162,000 from January through August, indicating that the "tight labor market" is entirely in services.

National income rose at an annual rate of $81.4 billion in the second quarter after rising $139.2 billion in the first. Real per capita disposable income rose 1.4 percent after rising 2.4 percent; for 1998 the gain was 2.3 percent. Real weekly earning rose 1.3 percent in the first half compared with 2.7 percent in 1998.

Growth of gross saving appears to have decelerated in the first half despite strong increases in business and government saving. The cause, of course, is the reversal of personal saving into personal dis-saving - $62.4 billion for the first half. This is an unprecedented development in the postwar period that began in 1997 and has deepened since; it could exacerbate any future down turns.

The depression in commodity prices continued in the first half, and the index was 83.7 at the end of August with metals at 77.6. The producers price index rose after falling in 1998. Corporate profits rebounded after a fall in the fourth quarter.

The ten-year Treasury rate reached a low of 4.53 percent in October 1998 but was up to 5.97 percent September 4, 1999. The rapid M-3 money supply growth that started in 1995 began to slow in the first half. From a percent change of 11.5 in January (from 6 months earlier), the change fell to 5.3 in July. Federal Reserve open market purchases were close to the pace of last year.

Commercial bank credit has not grown since December, 1998, breaking an uptrend that goes back to the seventies. The slowdown affects several categories but not commercial and industrial loans. While banks have reduced their exposure to consumer credit, overall it grew $46.5 billion in the first half, which is the fastest pace since 1995. The growth of credit market debt, however, slowed from 1998 as the paydown in Federal debt more than offset increases in the private sector. Since 1997, the amount of Federal debt outstanding has dropped more than $100 billion or about 2-1/2 percent.

The trade imbalance on goods and services for the first half of 1999 was larger than for the entire year of 1997. While the deficit on goods has continued to grow, the excess on services has fallen, mainly due to a slowdown in travel, passenger fares, and other transportation.

With direct investment valued at current cost, the negative international investment position of the U.S. increased $271.0 billion or 28.0 percent in 1998. Financial flows accounted for 209.8 billion of the increase, with the remainder due to valuation changes. The net position breaks down as follows: