Amid Gloomy News, Economy is Mending
THIS is the winter of discontent for George Bush. The economy is stagnant. The federal budget is out of control. The administration's policy process is in disarray. The Washington wolf pack, the White House press corps, smells blood.The president can thank Federal Reserve chairman Alan Greenspan for some of his current difficulties. In his 1988 election campaign, Mr. Bush promised to create 30 million jobs over the next eight years. However, the Fed had no intention of financing the rapid expansion required for this plan. The economy has added under 800,000 jobs since January 1989, less than 10 percent of the 10.3 million implied by Bush's promise. In 1991, the administration's options are limited. The Federal Reserve is pumping fresh cash into the economy. Monetary policy works with a lag. Meanwhile, the inflationary potential in the Fed's easy money policy is making bond traders nervous. An aggressive move to even easier money could send long-term interest rates sharply higher. Tax incentives to boost investment in capital equipment are in order. However, fiscal action would also risk a backlash. The US deficit may top $400 billion in the year that ends Sept. 30. With Democrats desperate to buy votes with middle-income tax cuts, the president is disinclined to hand his opponents the key to that Pandora's Box. Investors have retreated in the face of the onslaught of negative news. While the case for caution is clear, it would be wrong to wander off to the sidelines. Despite the gloomy business news (in fact, because of it), there are plenty of attractive investment opportunities. The most exciting opportunities in 1992 will be in the shares of capital goods companies - particularly producers of productivity enhancing capital equipment. IBM Corporation, the world's largest capital goods company, is an excellent metaphor for this kind of firm. At the same time, bond prices appear vulnerable to the risk of higher rates of inflation. In reality, the economy is in better shape than the attack journalists would have you think. Costs are down. Productivity is up. Even with modest, sub-par rates of growth, domestic profits from current operations are going up. As profits rise, so will business investment. Private service firms, which accounted for 96 percent of the gain in jobs over the past decade, hired almost 400,000 new workers from April through October. Real wages and salaries rose $24.5 billion during this period. That was about average for the initial stage of an expansion. Since April, housing starts have risen at a 28 percent rate from their cyclical low. Home values are bouncing back. And there was a pickup in retail sales in late October and early November. The strength in merchandise imports is another sign of an impending improvement in consumer demand. This summer, they averaged $473 billion at an annual rate, up at an 18.8 percent pace from the $431 billion rate posted in the January-March period. Imports subtract from the nation's output of goods and services. Even with this drag, gross domestic product (in constant, 1987 dollars) rose at a rate of 1.2 percent in the second quarter and 2.3 percent in the third. A further advance at a rate of 1.5 to 2 percent is likely during the fourth quarter. By flooding the economy with unwanted funds in 1985 and 1986 and then subsequently cutting off the flow of fresh cash, the Fed set off a series of shock waves. The initial result was the stock market meltdown in October 1987. Over the next two years, the economy seemed to ignore the pressure from the Fed. In the end, however, the monetary authorities got their way. They always do. Echoes from the Fed's monetary crackdown are still reverberating through the economy. That is why activity is so sluggish at present. This is only temporary. Over time, the new round of easy money will give a powerful boost to business. Investors should (1) be patient, and (2) keep a weather eye out for resurgent inflationary pressures that are already in the pipeline.