[A-List] New economy bull

["Annewilliamson" <Annewilliamson@xxxxxxx>]

POMPOUS CLAIMS V. POOR REALITY
By Kurt Richebächer

Considering the horrible backdrop of accounting scandals,
crashing stock prices, plunging profits, a yawning budget
deficit and even an unprecedented negative interest-rate
differential against the euro, the dollar has certainly
been performing astoundingly well. Yet let's not overlook
that against the euro, it is down almost 20%.

Inertia of exchange rate expectations is a familiar
experience. Basic to the dollar's relative strength is
obviously a general perception that the U.S. economy will
continue to outperform the economies in Europe and Asia.

Somehow in the past few years a perception has taken hold
in the currency markets that exchange rates are mainly
determined by differences in economic growth. There have,
indeed, been striking examples of this kind, but more often
it has not been vindicated. All the lessons of history say
that in the long run, it is the state of the balance of
payments that determines the strength of a currency.

Recent 90s history in the U.S. is reminiscent of the 1980s
'Reagan' era. Then, too, the dollar astounded the world by
soaring against the European currencies in flat defiance of
an exploding U.S. trade deficit. It was a completely new
experience for the currency markets.

While the U.S. current account between 1981-85 went from a
small surplus of $5,000 billion to a deficit of $121
billion, the dollar skyrocketed against the D-Mark from DM
1.74 to DM 3.42. From then on, however, the dollar fell
sharply, although the growth of the deficit slowed sharply
as well. The dollar's slump ended in 1995 at DM 1.25.

Let us peruse the figures of the recent past for
comparison: since 1997, the rise in the U.S. current-
account deficit has grown exponentially from $128 billion
to almost $500 billion. But this time, in addition to the
mammoth deficit, there looms a negative interest rate
differential of 2% against the dollar at the short end.
During its bull run in the first half of the 1980s, the
dollar enjoyed a big interest advantage against the other
major currencies.

Currency strength under such extremely negative conditions
is definitely unprecedented in history. There is only one
possible explanation for this extraordinary experience, and
that is phenomenal faith in the U.S. economy's inherent
strength and health.

Apparently, it was mainly two influences that drove the
dollar's bull run of 1981-85. Probably the most important
one was worldwide admiration for America's new "supply-
side" Reaganomics, against pronounced pessimism about the
European economies. (Eurosclerosis became the catchword of
the time.) A big interest-rate advantage for the dollar was
the other influence. The dollar's long decline began in
1985 when, in the face of a weakening economy, the Fed
accelerated its interest rate cuts.

It is still widely believed that Reagan's supply-side
strategies worked, although nothing could be further from
the truth.

Looking only at the increases in aggregate real GDP and
employment, they were indeed a great success. Economic
growth, which had stumbled in the early 1980s, began to
surge in 1983, compiling a more durable recovery than at
any time since the 1960s. For more than five years, real
GDP kept growing at an annual rate of more than 3%.
America's unemployment rate fell from 11% to 6%.

But looking at the pattern of economic growth and the
changes in the allocation of resources, Reaganomics has
been a total flop. The crux of economic policy is always
its impact on capital formation and profits. What happened
to the U.S. economy in the 1980s, in actual fact, was the
precise opposite of what the supply-siders had expected and
predicted. Soaring government and consumer borrowing
ravaged capital formation to unprecedented lows, and
business profits showed no improvement as a share of
national income or GDP.

The net national savings rate - the average rate of
business and consumer saving minus the government deficit -
virtually collapsed from about 6.5% from 1968-82 to 2% of
GDP, due both to sharply higher government and consumer
borrowing. Net capital investment as a ratio of GDP fell to
5% of GDP, nearly two percentage points below the post-war
average. Manufacturing net investment was flat for years.

Ultimately, "supply-side" Reaganomics grossly failed by all
accounts. Three bull years for the dollar were followed by
10 bear years.

We have recalled this experience of the 1980s because of
its stunning resemblance in virtually every detail to what
has happened in the past few years.

It begins with the bogus New Era. In the 1980s, it was
newly fashioned supply-side policies that would work
miracles for the economy. In the 1990s, it was a new
paradigm economy with miraculous efficiency gains through
massive investments in the new information technology and a
revolutionary improvement in corporate governance, guided
by the goal of increasing shareholder value.

What's more, in both periods, there was exactly the same
American derision of Europe's inflexible economies, and on
the part of the Europeans, there was exactly the same
inferiority complex. Even more stunning are the parallels
on the domestic side. In both periods, the pompous claims
of superior, new government and corporate strategies
contrasted grotesquely with the miserable economic reality.

Looking at what effectively happened to resource allocation
between capital formation and consumption, as well as to
profits - the policies in both periods were an outright
disaster. However, the macroeconomic damages of the 1990s
are worse...and have yet to be reckoned with.