Superspan faces his toughest test

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The Independent Online
ALAN GREENSPAN - Superspan to his admirers - delivered another of his Humphrey Hawkins testimonies to the Congressional banking committee on Thursday, and was Delphic even by his own oracular standards. He promised that he would act "promptly and forcefully" if evidence emerged of accelerating US prices, a remark which duly helped the Dow to lower ground and knocked some more of the gloss off the dollar.

Given that he could hardly have been more non-committal, this was pretty silly stuff. A good test of whether a proposition contains any content is to look at its opposite. Can you imagine any central banker promising to deal with accelerating inflation in a "dilatory and feeble" manner? If not, then you should be unsurprised at Mr Greenspan's commitment to doing his job.

The Fed Chairman's caution is understandable. The next few months may prove more testing for his reputation than many of the roller-coaster rides through which he has already guided the US and world economies. Even the most robust defenders of the view that computers are delivering a new American paradigm, under which growth can be sustainably stronger for longer, are beginning to recognise that the imbalances in the US economy just cannot go on.

Certainly, US productivity growth may have accelerated to some 2.1 per cent a year in the late-Nineties rather than the 1.1 per cent a year which was the economy's lot in the Seventies, Eighties and early- Nineties. And that does justify higher overall growth rates without raising inflation, and also higher profits growth which underpins Wall Street.

But the earnings growth from US corporates is not just due to a change in the productivity trend. If it was, unemployment would not have been falling: the definition of higher productivity is more output for a given amount of labour. Unemployment has in fact been falling quite quickly during the recent US upswing: from a peak of 7.2 per cent in 1992 on the standardised international measures, US unemployment is now down to 4.3 per cent.

This is, of course, good news. The US economy is proving able to operate at a lower level of unemployment without stirring up much in the way of inflationary pay pressures which would then feed through into prices. But it also means that much of the growth in the US economy - and the profits growth which is delighting Wall Street - is the usual one-off upswing due to the business cycle rather than a change in the long-run underlying trend. And that means that it must come to an end at some point, because you cannot have negative unemployment.

Another perspective on the "bubble versus new paradigm" debate is given by the chart, which shows a long run of share price to earnings (profits) ratios for the US market (S&P 500) going back to the mid-1920s. The most striking thing about the recent heights of the market is that it is in a region never explored before, even during similar periods of enthusiasm for new technology - whether the radio boom in the late-Twenties, or the electronics boom in the late-Sixties.

Enthusiastic US stock operators might do well to dust off the International Monetary Fund's (IMF's) calculations of the implied US profits growth which would underpin Wall Street. It examined the 20 per cent rise in the market over the year from Mr Greenspan's warning of "irrational exuberance" in the stock market to December 1998, and decided that the rise implied no change in the expectations of profits. Instead, it was explained by the fall in the attractiveness to investors (yield) on the competing securities (government bonds).

If bond yields had not fallen, making shares look more of a bargain, the IMF argued that expectations of profits growth would have had to be nearly 1 percentage point a year higher, or the S&P 500 some 20 per cent lower.

In the half-year since that study, US government bond yields are now back up to where they were at the end of 1997. But share prices, far from being correspondingly lower, are another 12 per cent higher than end-1998 despite the week's wobbles. That is either discounting profits growth of some 1.5 percentage points a year more than seemed plausible at end 1997 - or US share prices are about a third too high. Assume a bit of both, and you are still looking at a big stock market correction.

When stock markets move, they rarely deflate gently (Japan is an exception here) but go with a crash. Even if Mr Greenspan were then to react quickly to the fall, as he did last year, the odds are that the US consumer would begin to react by slowing consumption growth. Personal savings, on the official measures, are now virtually zero, having fallen from more than 8 per cent in 1985 and nearly 6 per cent in 1992. Even allowing for the growth of tax-allowable pension plans, which are not included in the measure, the US savings rate has halved since the early Nineties. A small bounceback would hit consumption hard.

And then the other big risk for the US kicks in: the level of the dollar (or of the yen and the euro, if you prefer it that way round). The strength of the greenback is dependent on the market view that the US will continue to offer better rates of return than competing markets, which has driven substantial repatriation of US funds and continued foreign purchases on Wall Street. This in turn has funded the widening US current account deficit, which amounted to $246bn in the year to the first quarter.

But will foreigners go on adding dollars to their portfolios at this rate? For the dollar to turn sharply, all foreigners have to do is to stop adding to their US assets. They do not even have to sell. And the consensus expectation for the US current account deficit this year is that it will reach 3.4 per cent of GDP. This is larger than the 3 per cent deficit in 1985 which sent the dollar into a three-year bear market, halving its value against the German mark. Moreover, a sharp fall in the dollar would almost certainly be associated with a corresponding fall in Wall Street. But by removing an important anti-inflationary prop from the US economy - the strong dollar has kept import prices down - a fall would limit the Fed Chairman's ability to cut interest rates to underpin equity valuations.

If Mr Greenspan, using all the wisdom of his 72 years, can resolve the dilemmas ahead while keeping US growth on track, he will deserve to have his tenure renewed by acclamation when his third term at the Fed runs out next June. A soft landing for the US economy, with the current account imbalance reduced by higher growth in Japan and Europe, is devoutly to be wished. The longer the problem is deferred, and the stronger is European growth, the smaller the risks. A hard landing would hit the rest of world - particularly recovering emerging market countries in Asia - particularly badly. Keep your fingers crossed.

Christopher Huhne is a Liberal Democrat MEP on the European Parliament's Economic and Monetary Affairs Committee.

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