Despite the consternation about the collapse of the dollar against the deutsche mark and the yen, 1995 has so far emerged as a golden age for the U.S. economy and financial markets. Growth has slowed obligingly to a sustainable pace of around 2.5 percent, down from the 5.1 percent growth rate at the end of the past year. Inflation has remained moderate. Even more noticeable, stock and bond markets have rallied powerfully, with stock prices on average up more than 10 percent since the beginning of the year and interest rates between 1 percentage point and 1.5 percentage points lower than they were late last year.
Positive Economic Factors
The good news for U.S. financial markets is more than just a moderation of growth to a sustainable level with steady inflation. Combined federal, state, and local government deficits are at their lowest levels in years, requiring only about $120 billion a year, or about 1.5 percent of the gross domestic product, to finance. The supply of equities--based on data available through the end of the past year--is actually falling at a rate of about $100 billion per year. America's corporations are generating so much cash that they can afford to finance a high level of capital acquisition while buying back outstanding stock.
The recent takeover bid for Chrysler Corporation underscored the healthy liquidity situation of large U.S. corporations and investors. Chrysler's earnings have risen so rapidly relative to its capital outlays that the firm has accumulated a large pool of about $7.5 billion in cash. According to Chrysler management, the amount was to see the corporation through the coming slowdown of the U.S. economy. If, however, that slowdown is not close at hand, then Chrysler becomes an attractive takeover candidate for financial engineers, who could reconfigure Chrysler to take advantage of an unusually long economic recovery.
Just as surprising as the remarkable performance of U.S. financial markets over the past several months is the aid to the market from an increasingly accommodative policy stance of the world's three leading central banks. The Federal Reserve has stopped raising interest rates while providing ample liquidity for the U.S. banking system, which in turn has been making loans available to American households and corporations.
More surprisingly, the Fed's steady policy stance, even in the face of a sharply weaker dollar against other major currencies, has forced an end to the disinflation policies of Germany's Bundesbank, which cut interest rates by 1/2 percent at the end of March. More significantly, Fed policy has forced the Bank of Japan, which has been risking a dangerous accelerating deflation, to cut interest rates by seventy-five basis points on April 14.
Dangerous Instability from the BOJ
The Bank of Japan's policy of supporting the dollar with dollar purchases approaching $15 billion per month creates a dangerously unstable potential disturbance to the golden age scenario. The BOJ has been purchasing U.S. government securities, mostly two-year and five-year notes, with the dollars that it has acquired while trying to stem the yen's rise. This extra buying, especially given the light supply pressure, has tended to depress U.S. interest rates further, with two-year yields down to a level of just forty-two basis points above the federal funds rate. That narrow spread usually portends a further Fed easing, a move that does not seem likely right now.
The unstable aspect of the BOJ's dollar support policy, resulting in lower U.S. interest rates, is its tendency to push the dollar still lower by reducing the attraction of dollar assets and by stimulating U.S. spending; such activity in turn raises the U.S. external deficit. The unstable sequence--weaker dollar, more BOJ dollar and U.S. note buying, lower U.S. interest rates, weaker dollar, and so on--has become quite clearly defined.
When Tokyo markets reopened on April 17 after the tepid Japanese package to stabilize the U.S. dollar was announced--including a seventy-five basis point reduction to 1 percent in the official discount rate--continued dollar weakness against the yen was accompanied by eight-to-ten basis point falls in yields on U.S. two- and five-year notes. The BOJ had obviously hoped that the seventy-five basis point cut would stop the dollar weakness and break the unstable cycle.
The other way to break the unstable dollar support cycle would be for the BOJ to stop buying U.S. Treasury notes with the dollars it accumulates. The BOJ could buy gold or could simply hold the dollars in cash. The resulting higher U.S. interest rates would help to support the dollar. But then a higher U.S. inflation rate or a stronger U.S. economy could accentuate upward pressure on U.S. interest rates and force a rapid inversion of the U.S. yield curve and a quick return to the "hard landing" scenario. The deflationary pressure already evident in Japan and Germany would be accentuated, the outlook for global exporters would worsen, and fragile emerging markets could collapse further. We could be looking at a dark age instead of a golden age.
A Golden Recovery?
Barring the emergence of a dark age, the more parochial argument about the path of the U.S. economy continues. That debate has been conducted in terms of the "hard landing" scenario versus the "soft landing" scenario. The hard landing scenario, which marks the end of a typical demand-led recovery with a sharply inverted yield curve and a weak stock market, has been decisively rejected by markets in favor of the soft landing scenario, whereby the economy drifts down to a sustainable growth path of about 2.5 percent and inflation pressures remain in check. How much of the apparent soft landing scenario is really tied to the BOJ's dollar policy and the U.S. fixed income support policy remains to be seen.
Despite the risks of a near-term dark age, a possibility far more intriguing than the choice between a hard landing and a soft landing is beginning to emerge from a closer examination of market behavior. Underlying the likely oscillation of analysts' views from hard landing to soft landing and back again is the possibility that the U.S. economy is, over the long run, in a golden age.
The economy in a golden age grows for a longer time at a higher rate with lower inflation than anyone expects from typical historical experience. A golden age recovery is supply-led rather than demand-led. A rise in the real return on investment causes increased capital formation with an attendant increase in aggregate supply that outstrips the rise in aggregate demand. Underlying price pressures are held well below pressures that usually emerge during a sustained economic expansion.
Historically, golden age recoveries have been called investment-led recoveries because they are characterized by unusually high levels of investment. The reason for the high level of investment is often a major technological breakthrough that, when widely adopted, increases the return on investment. The improved accuracy and timeliness of information flows associated with the rapid development of computers may be related to the jump in the productivity of capital. But whatever the cause, there is strong evidence that the real return on investment is unusually high during the current business cycle expansion.
An alternative, much simpler version of the golden age scenario could be called the "eternal youth" scenario. Instead of the usual V-shaped trough that has been dated at March 1991 for this cycle, the economy may actually have experienced a long U-shaped trough that lasted from March 1991 to March 1993, with the recovery only beginning in earnest thereafter. Certainly, setting the trough for this expansion at March 1993 makes the path of personal income, consumption, and inflation much more similar to past business cycle recoveries than does setting the trough at March 1991.
More specifically, on the supply side the trough of the recovery may have fallen in March 1991, while on the demand side the trough actually came two years later, in March 1993. That timing would give the supply side a distinct lead over the demand side so that the economy would look like, and for most purposes would be indistinguishable from, one in a golden age, at least until demand growth catches up with supply growth. In a golden age, closure of the demand-supply gap would come much later than expected.
Misstating the trough on demand growth in this recovery is like marveling at the performance of a forty-year-old athlete who is really only twenty years old. Miscalculating by two years the spring 1993 birthday of the recovery of demand growth would produce large surprises for investors who think that they are looking at a tired five-year-old supply-constrained expansion when really a three-year-old demand expansion has been superimposed on a five-year-old supply expansion.
Many years of economic data and the benefit of hindsight will be necessary to discover whether this recovery is a golden age or just one with a misidentified birthdate. But for the next two years the difference really does not matter. Either a golden age or a recovery that began in March 1993 instead of March 1991 will produce extraordinary behavior in the financial markets. We shall call both versions of the alternative to the hard landing-soft landing scenario a golden age.
Differentiating between a Soft Landing and a Golden Age
How can we distinguish between a soft landing and a golden age? In a soft landing, stocks are supported largely by lower interest rates instead of higher earnings: defensive stocks, which perform well in a weak economic environment, improve relative to cyclical stocks, which perform better in a strong economic environment. In the bond market, the yield curve should flatten, and real yields may fall as the economy comes in for a soft landing and may even anticipate rate cuts by the Federal Reserve. In the currency market, the dollar should be weaker because of a prospective fall in real interest rates, lower growth, and moderating increases in asset prices. In the commodity markets, raw materials prices should fall relative to finished goods prices while precious metals prices should be weak relative to both.
The contrast between a soft landing and a golden age would become clear from the different behavior of financial and commodity markets. In a golden age, earnings continue to rise for a longer time than expected in a soft landing. As markets begin to sense extended earnings growth, cyclical stocks should begin to outperform defensive stocks. The higher level of interest in Chrysler shares and other cyclical companies over the past month hints at this possibility.
If a soft landing scenario gives way to a golden age, bond yields may actually rise, largely because of higher expected real returns on alternative investments rather than a sharp rise in expected inflation. The composition of inflation is important in trying to identify a golden age. Prices of raw materials ought to rise relative to prices of finished goods, as suppliers bid aggressively for inputs while productivity gains moderate the pass-through of cost pressures. Prices of precious metals ought to fall relative to raw materials prices because, while the demand for raw materials to produce more goods is rising, high real-interest rates increase the opportunity cost of holding precious metals, as does the lower-than-expected inflation that accompanies a golden age recovery.
Currency markets would provide one of the most dramatic clues to the emergence of a golden age. In a true golden age recovery, the dollar would strengthen for two reasons. First, the current account deficit should fall as superior U.S. productivity growth encourages higher exports and lower imports. Second, while a falling current account deficit would reduce the supply of dollars to global financial markets, sharp increases in equity prices that would accompany the golden age scenario of higher earnings of U.S. companies would begin to attract a high level of foreign capital inflows from countries without the golden age scenario. Neither Germany with its tepid demand-led recovery nor Japan with its deflationary weakness looks anything like a country in a golden age.
Of the two forces--the increasing demand for dollars accompanying higher foreign capital inflows and the possible reduction in the current account deficit--the capital flows factor should dominate in the short run. The U.S. recovery could become powerful enough to require a higher level of imported inputs, while generating a high enough level of income growth to push up imports for consumption so that the current account deficit might remain steady or even rise. At the same time the dollar would strengthen, as foreign capital sought the attractive returns in U.S. equity markets. But ultimately a supply-led recovery should have less need to rely on foreign production, and therefore the current account deficit should be lower.
Leading to a Hard Landing
Should the soft landing give way to a hard landing instead of a golden age, the differences would be readily apparent from prices of financial assets and commodities. In a hard landing, stock prices would fall, with cyclicals hardest hit as expected earnings collapsed and interest rates rose. In fixed-income markets, short-term rates would rise rapidly until the Federal Funds Rate was pushed up to a level one or two percentage points above rising bond yields. The dollar would weaken or strengthen depending on the pace of Fed tightening relative to the pace at which the hard landing scenario emerged.
Commodity prices would provide one of the most useful clues of the emergence of a hard landing over a golden age scenario. Prices of precious metals would rise relative to prices of raw materials. The hard landing would bring on a rapid increase in expected inflation while the sharp slowdown engineered by the Fed would cause the demand for raw materials to collapse.
Without the benefit of hindsight, neither a hard landing nor a soft landing nor a golden age will emerge with shining clarity. Rather, we will probably continue to oscillate between the hard landing and the soft landing scenarios while, if the golden age remains the underlying reality, investors in U.S. equities will continue to be pleasantly surprised, and dollar bears will be in for a rude shock.
Decisive evidence of a golden age is unfortunately not only retrospective but painful. As the economy, driven by the reality of a golden age, continues to outperform expectations and equity prices continue to rise, the public becomes convinced of eternal prosperity. (That conviction emerged in 1929 in the United States and in 1989 in Japan.) The stock market bubble--inadvertently fed by a central bank that believes that it is performing well by keeping inflation moderate although prices actually ought to be falling in a supply-led recovery--begins to expand so rapidly that the increase in wealth from that bubble causes demand to run away. Demand growth quickly comes to dominate supply growth, and the central bank is forced to collapse the bubble to avoid a runaway inflation.
In short, once the golden age gives rise to the myth of eternal prosperity and eternally rising stock prices, that age will be over. But because few analysts are even thinking about a golden age now, but rather are preoccupied with the hard landing-soft landing dichotomy, a golden age, if one is underlying this recovery, probably has several years to run.
John H. Makin is a resident scholar at the American Enterprise Institute.