The major preoccupation of markets and policy makers as we move toward the eighth year of a U.S. economic expansion seems to be an almost morbid obsession with how it will end. Actually, the boom could end in two quite different ways. Most warnings--particularly from Federal Reserve Chairman Alan Greenspan--are about what may be the less likely of the two. The end may come not from the emergence of inflation and the Fed's reaction to that, but from a growth of investment faster than demand can increase to absorb the resulting enlarged capacity to produce goods and services.

Europe's policy makers, particularly Germany's Bundesbank, have eschewed concerns about employment growth in favor of ensuring that Europe's new currency, the euro, will be born as a hard currency and have thereby raised further doubts about an eventual solid recovery. Asia, meanwhile, is locked in an increasingly grim struggle with a deflation that the area might wish to export through currency depreciation.

Unconventional Wisdom

To put this scenario in sharper focus, consider the following affronts to conventional wisdom. Despite a low saving rate and, at the beginning of the decade, relatively high budget and current account deficits, the United States has been by far the most prosperous industrial country during the 1990s. Its success has been approached only by countries such as Italy, Spain, and the United Kingdom, which, in 1992, committed the unpardonable sin of allowing their currencies to depreciate when the strictures of the European exchange rate mechanism became too binding.

Perhaps the biggest affront to the conventional wisdom of how countries grow is emerging in Asia. Asia's high saving rates and rapidly rising investment along with its legendary work force--said to work long hours willingly for low pay--have mimicked the journalist's caricature of what industrial countries somehow should do to grow faster. In 1997, however, Southeast Asia and probably China are demonstrating, as the Japanese did in the late 1980s, that it is indeed possible to save too much and to invest too much.

Saving means forgoing current consumption to finance the purchase of real assets or financial assets that promise a future return so as to compensate the saver for forgone current consumption. The saving must, however, be channeled to investment opportunities that deliver an attractive rate of return to reward the saver. Simultaneously, if the saver accumulates claims denominated in a national currency, the central bank must ensure that those claims maintain their purchasing power so that the saver, and not just the investor to whom the saver has lent, receives some rewards.

One of the greatest satisfactions about the 1990s is the way that America's powerful investment-led recovery has silenced the legions of Cassandras who, in the 1980s and much too far into the 1990s, wrung their hands about America's low national saving rate. How many articles were hapless amateur economists forced to read about America's twin deficits, the budget deficit and the current account deficit, and the dire consequences that would result from their existence? Talk about twin deficits is redundant since the current account deficit measures the shortage of national saving relative to expenditure, including the government sector. The implicit rebuke of the twin deficits was that nations with deficits do not save enough. Not saving enough suggests an inability to forgo current consumption for future returns--hence the endless nattering about the fate of America's future generations.

What has actually occurred during the 1990s is that a deregulated and vibrant American economy has generated more investment opportunities than American savers have chosen to finance. The resulting capital inflow, which must occur when national spending exceeds national income, has contributed to a rise in America's capital stock and thereby to an investment-led recovery that so far has produced remarkably high growth rates without inflation. In this sense, America in the 1990s is behaving like a developing country with a surfeit of investment opportunities that results in a capital inflow mirrored by a current account deficit. Naturally, if the capital inflow were to cease, given the net supply of dollars resulting from America's current account deficit, the dollar would depreciate, and U.S. interest rates would rise.

If the United States becomes an unattractive place to invest, the capital inflows will slow. But how many countries in Europe and Asia would like to see a weaker U.S. dollar and higher U.S. interest rates, with the United States relying more heavily on export growth to extend its current expansion? Most of the world's economies are happy to see their currencies depreciate against the dollar. Europe's tepid expansion is export led and therefore would surely be interrupted by a weaker dollar. Asia is experiencing a sharp rise in excess capacity, which would only be made more acute if the United States, by allowing the dollar to depreciate, began to export an incipient deflation engendered by a cessation of capital inflows.

The Paradox of Thrift

Large parts of the industrial and developing world are now encountering something that markets and policy makers have not seen for over sixty years: the paradox of thrift. According to the paradox of thrift, some savers seeking a high return by forgoing current consumption and selecting good investment projects are duly rewarded. If, however, everyone tries to increase savings at once, the quality of available investment opportunities gradually begins to fall, and, after an exhilarating investment-led recovery, overinvestment results.

Overinvestment appears when projects generate a stream of returns insufficient to compensate savers for forgone current consumption. When investment projects begin to disappoint, it is too late to remedy the paradox of thrift because the capital stock purchased by those investment projects is already in place. The costs have been incurred, and the lenders that supported the investment projects must be paid. The capital cannot be laid off since it is, in effect, owned by the investors; it must be either be shut down (in which case, it loses money) or used to produce goods in hopes that they may be sold for some positive price. If too many disappointed investors attempt to sell goods at any price, disinflation and eventually deflation result, and unemployment rises as companies that have redundant capital attempt to minimize their costs. The paradox of thrift and the resulting symptoms of overinvestment are becoming more and more evident in Southeast Asia and are reemerging in Japan and China.

In a world where the paradox of thrift is being played out, an economy that generates a surfeit of investment opportunities relative to its domestic saving capacity becomes a magnet for foreign investment. In the United States, the current account deficit, the mirror image of net capital inflows, has risen gradually toward two percentage points of the gross domestic product, or about $150 billion per year.

Greenspan's Warnings

Against a background of possible global excess saving and its deflationary implications and a U.S. economy that continues to combine strong growth with low inflation, with the latter related to global excess capacity, Greenspan's October 8 warning of future inflation to the House Budget Committee caught markets by surprise. The Fed chairman's return to the role of traditional central banker, threatening to take away the punch bowl before the party gets too wild, sharply contrasted with his more benign interpretation of America's remarkable economic performance in his testimony before Congress in July.

Said Chairman Greenspan, "Job growth slowed significantly in August and September, but it did not slow enough." He added, "Thus the performance of the labor market this year suggests the economy has been on an unsustainable track." Greenspan went on to say that "financial markets seem to have priced in an optimistic outlook characterized by a significant reduction in risk and an increasingly benevolent inflation process." The Fed chairman suggested that stock price earning multiples are at levels "not often observed at this stage of economic expansion." Greenspan's desire to temper the enthusiasm in financial markets was underscored by an even more pointed comment: "It would clearly be unrealistic to look for a continuation of stock market gains of anything like the magnitude of those recorded in the past couple years."

These comments by the world's senior central banker are remarkable. But they are totally understandable if one studies the history of how badly investment-led recoveries usually end. The century's two investment-led recoveries--in the United States in the late 1920s and in Japan in the late 1980s--ended with collapses of the equity market. These crashes resulted from overinvestment, which resulted from the paradox of thrift. Ironically, the rapidly increasing excess capacity in Asia, by channeling more investment funds to the United States while reducing the global demand for output, could exacerbate the tendency of overinvestment in the U.S. economy and could increase exuberance in financial markets. That buoyancy would ultimately be unjustified should the surge of investment in the United States become unprofitable. The underlying deflationary tendency in Asia with its already extant stock of excess capital increases the risk of earnings disappointments from U.S. excess capacity that could cause a sharp drop in the stock market.

Market Misinterpretation

Financial markets appear to have misinterpreted Greenspan's comments, which, arguably, were directed more to financial markets than to the performance of the real economy. U.S. and European financial markets are struggling to form a clear picture of how and when the favorable economic conditions in the United States might end. The traditional view, which the Fed chairman in his latest public pronouncement has articulated as a warning, is simply that a growth rate of over 3 percent will eventually put heavy pressure on the supply of labor. Wages will rise, and the higher wage costs will be passed forward so that the prices of goods rise as well.

Since the Fed needs to keep prices stable, it will be forced to raise interest rates, and the higher interest rates will slow economic activity. Eventually, with the return on bonds at a high enough level to draw money out of the equity market, stock prices will fall. In short, the recovery will end with economic overheating followed by a typical recession that lasts about a year, until the excesses of demand are worked off and prices begin to come down again. Greenspan is hoping to lower the level from which equity prices might have to fall by reminding markets that those prices are high when measured by conventional yardsticks. But, given his warning to markets about inflation as a trigger for higher rates, stock prices will rise even further if inflation does not appear.

The alternative way to end an investment-led expansion is more troublesome. This expansion continues to produce sufficient goods and services so that supply and demand growth are balanced and inflation does not materialize. The probability of this outcome in the United States is increased by three things: a continued high level of investment that reflects a continued high level of investment opportunities; the preoccupation of European policy makers with a hard euro, which causes them to follow restrictive monetary and fiscal policies; and the already emergent deflationary pressure in Asia.

In an investment-led expansion, continued growth without inflation excites financial market participants, who expect a longer stream of uninterrupted earnings growth and thereby pay higher and higher multiples for stock prices. The Fed, like many others, has developed a valuation model that suggests that stock prices are about 17-20 percent above normal, given the current earnings outlook and level of interest rates. The reason for such overvaluation is the continued good performance of the economy, which increases the time over which investors expect uninterrupted earnings growth to persist.

Verbal Preemptives

Clearly, Greenspan has begun to engage in a verbal preemptive monetary policy: he hopes to frighten market participants into believing that this expansion will end like any other, with higher interest rates necessary to control rising inflation pressure. Given the alternative--an investment-led recovery ending in an asset market bubble that eventually must collapse and create far more economic dislocation than a conventional Fed tightening would--Greenspan and other policy makers, along with some market participants, probably wish for a more conventional end to this expansion.

Having hinted at the overheating scenario in a traditional demand-led expansion, the Federal Reserve chairman will need some help from U.S. economic data to reinforce the picture of an overheating economy. The day after he spoke, the September producer price index recorded a 0.5 percent increase, seeming to underscore his inflation concerns. But close examination of the data suggested that--as often the case in September--the jump in the producer price index reflected a failure to adjust auto prices for seasonal factors and a one-time jump in tobacco prices echoing the tobacco settlement. In other words, measurement problems and a negative supply shock created most of the inflation pressure in the September producer price index. Core intermediate inflation remained locked at a 0.4 percent rate, while core crude goods inflation actually decelerated, from a 1.7 percent rate over the past year to a minus 2.8 percent annualized rate over the past three months.

Several days later, the consumer price index for September was reported up 0.2 percent, thereby allaying fears that the producer price index suggested pervasive higher inflation. The year-over-year increase in the consumer price index has been locked at 2.2 percent for the past several months, while core consumer price inflation, excluding more volatile food and energy items, is still decelerating, from a 2.2 percent rate over the past twelve months to a 1.7 percent annualized rate over the past three months.

The inflation data so far are not helping to underscore Greenspan's fears about a traditional reflationary end to a demand-led recovery. This probably results because this supply-led recovery is supported by strong investment behavior with price pressures tempered by deflationary impulses in Asia and tightening monetary policies in Europe.

A Stronger Dollar?

With too much capital already in place in Asia, and with Europe relying on a tepid export-led recovery to sustain itself during an essentially deflationary path toward monetary union, the danger is that the rapid capital formation still underway in the United States will become unsustainable. In an environment where the U.S. recovery does not generate inflationary pressure, the market mechanism that will adjust to shift weakening global demand toward Europe's expensive productive capacity and Asia's excessive productive capacity is a sharp appreciation of the U.S. dollar. The deflationary pressure in Asia and the disinflationary pressure in Europe would be exported to the United States in the form of a stronger U.S. currency.

The United States and Japan are engaged in a currency standoff that attempts to maintain the dollar-yen exchange rate at about 120 while Japan slips into a recession. U.S. policy makers will soon have to decide whether they would rather see a sharper and more dangerous Japanese recession that could threaten the global economy or allow the yen to depreciate by another 10-20 percent to shift some demand away from U.S. producers and onto Japanese producers. Surely, if Greenspan believes that inflation is about to break out in the United States because of too much demand pressure, then shifting that demand pressure abroad and helping to relieve deflationary pressure in Japan and Asia would be logical. Greenspan should be calling for a stronger dollar.

Policy makers are hindered in this course because they intuitively believe that, according to the American trade deficit and the Japanese trade surplus, the Japanese currency ought to be stronger and the U.S. currency ought to be weaker. This wrongheaded thinking goes back to the old twin-deficits bugaboo: if Japan is saving more than it is investing while the United States is investing more than it is saving, then Japan's virtue ought to be rewarded with a stronger currency.

This theory overlooks the glaring fact that Japan's and Asia's large excess of savings must go abroad to finance profitable investments in the Western Hemisphere or, alternatively, must finance a spending boom in Asia. To create a spending boom in Asia, however, would require central banks to print enough money to convince people that inflation is coming back and they should convert their money into goods, out of idle cash balances. This action is not likely in the current global policy environment that views inflationary policies as akin to the ultimate sin. The corollary is that deflation becomes more likely. Asia could use some inflationary policies to speed up the depreciation of its currencies and thereby accommodate a reallocation of demand away from producers in the Western Hemisphere, where policy makers see a threat of incipient inflation.

Greenspan and Robert Rubin should have a serious discussion about the policy implications of America's investment-led recovery in a world of global excess capacity. Surely it is time for some dollar appreciation to relieve some excess capacity and to slow some of the investment growth that will eventually become excessive in the United States. Surely the Fed chairman would like to see a stronger dollar causing U.S. bonds to outperform U.S. equities for a time. It would be far better to have U.S. bonds outperform U.S. equities because of a rise in bond prices and stable equity prices instead of an eventual collapse in equity prices that would result if the U.S. investment juggernaut causes the United States to join the world's growing excess capacity club.

John H. Makin is a resident scholar at the American Enterprise Institute.