WHY THE STOCK MARKET IS BOOMING
The lead essay on the editorial page of The Wall Street Journal this morning runs under the above headline. The piece, by David Gressel of Teleos Asset Management, is worth reading. Most Wall Street forecasters missed the boat, he argues, because they didn’t realize the U.S. economy is now in “an Austrian, or supply-side, business cycle,” which is driven by “an exogenous increase in the rate of return on capital.” The key, he thinks, is invention, “dramatic enhancements in computer chips and software,” with costs dropping for all economic activity that can be computerized. The argument is fundamentally flawed, though, because it could just as easily have been made in the summer of 1929. The market is not booming because new technology is available. The same new technology available here is available in Tokyo, and the Tokyo market is not booming. The same new technology is available in Mexico City, yet there is no boom on the Bolsa. When Gressel tells us that all this new invention will fuel a boom on Wall Street in the next few years, no matter what Congress and the President do on monetary, tax and regulatory reform, he reveals the deficiency of his Austrian supply model. It obviously does not incorporate either the concept of risk-taking as the source of real economic growth or the concept of expectations about the success of risks taken as the source of paper booms.
The American supply model was originally hatched by Francis Walker of MIT in the late 19th century and by Frank Knight of the University of Chicago in the first half of this century. They argued the dynamics of combining existing technology and financial capital in ways that had never been considered by the European economists, including Adam Smith, David Ricardo and Karl Marx. Andrew Carnegie was in this American supply model as he ploughed under steel mills that seemed perfectly good to his competitors, when better technology surfaced. Henry Ford was in this American supply model when, one day in 1914, he decided to raise the daily wage of his work force to $5 from $2. All existing economic theory in Europe at the time told him he was throwing his money away. Not only did productivity boom and margins climb as workers came from far and wide to compete for this big money. The men making the cars could also now afford to buy them, and the dynamic fed on itself.
The stock market boom now underway is certainly based on the availability of potential efficiencies in computer chips and software. The potential could not be realized, though, without capital, and capital does not increase in availability unless there is either a reduced risk or an increased reward to it. Wall Street is advancing smartly and confidently because of the market assessment of those risks and rewards -- an assessment that has more to do with Washington, D.C., Newt Gingrich, and the political earthquake on November 8 than with computer chips. Every day that goes by, the market sees in the debates between Democrats and Republicans, President and Congress, a shift in the potential risk/reward ratio to capital. The real economy is declining, because of the combination of tax and interest-rate increases that were imposed upon it in 1994. These increased the risk to capital and reduced rewards for successful risk-taking. The value of paper assets is climbing because of expectations that tax and interest rates will soon be falling. When at year’s end we saw the possibility of a DJIA of 5000 in ‘95, there were only two elements we cited: the likelihood that the Fed would decide to reverse its interest rate increases and the chances that the 104th Congress would produce a capital gains cut the President could sign. Nearly midway through the year, the market has steamed ahead primarily on the monetary leg of this equation. It is now beginning to discount the possibility of the tax leg.
Two weeks ago, a capital gains tax cut was still a long shot. It might work its way through Congress, but there was still a high likelihood the President would veto it if it arrived on his desk. Those Democrats who recommend a continuing strategy of class warfare as the only antidote to the Republican advance were still in control, but had to contend with reports that the President was seriously listening to the opposite view. As we reported April 21: “The President clearly has adjusted to the lessons of his first two years and the results of November 8. Coming into office, Clinton deferred to Hillary and the political strategists James Carville and Paul Begala in interpreting the mandate. This led to gays in the military, national health insurance, and class warfare on taxes and spending. Carville and Begala have been retired and the script at home calls for Hillary making the beds instead of the decisions. The White House is letting it be known that Clinton is now consulting old pal Dickie Morris for political advice. He’s a Connecticut pollster who normally works for Republicans -- including Newt’s amigo in the Senate, Majority Whip Trent Lott. Clinton’s only hopes for re-election are if the Republicans nominate a slash-and-burn ideologue like Phil Gramm, who will scare the women and children with no help from the Democrats, or that he demonstrates that a Democrat in the White House is necessary to keep the congressional Republicans from overplaying their hand. This latter strategy is Clinton’s best option, which requires that he veto as little as possible, but that with each bill he signs into law, he claims that he has sanded its rough edges down. The more of these results he achieves, the more ground he will close in the polls against the GOP frontrunner, Bob Dole.”
Two months later, Dickie Morris is the man of the hour, celebrated this morning by William Safire, in his New York Times column, as the new White House Svengali. It is Morris, we are told, who has transformed Clinton the class warrior into a kinder and gentler budget-balancer. Wall Street’s assessment of budget gridlock is melting away. The prospect of a capital gains tax cut is in ascendance. In today’s “Outlook” column on page one of The Wall Street Journal, David Wessel reminds us that when Candidate Clinton was promising everything to everyone back in ‘92, he was giving the old wink and nod on capital gains to his new friends in Silicon Valley: “...[H]e has always been more willing than most of his advisers to go along with a capital-gains tax break. Scale it back somehow and trim a few corporate tax breaks to ‘share the pain,’ and he may go along.” At the rate the President has progressed in his Zelig-like search for identity -- from FDR to Truman to Eisenhower to Kennedy -- it may not be long before he fills the Reagan void in the GOP. This could be why Wall Street is booming.
The bond market is rallying again today on renewed hope of a federal funds rate cut at the July 5-6 FOMC meeting. The Fed’s fine-tuning faction, led by Vice Chairman Alan Blinder, appears to have decided that the economy has suffered sufficiently to begin reversing course. We certainly agree that the real economy is crying out for some Fed relief. The May decline in industrial production -- at a 2.9% annual rate -- marks the first time since the 1990-91 recession that the index has dropped for three consecutive months. The price of gold, on the other hand, is injecting a note of caution. August futures today are up $1.50 to more than $394 on the same news that the bond market is cheering. This is telling Fed Chairman Alan Greenspan that his margin of error is extremely thin. Standing pat, he risks recession by year-end. Easing aggressively, he risks a significant inflation uptick, particularly if the demand for money does not rebound quickly in response to lower rates. It bears noting that much of this problem appears to be self-inflicted. From first quarter ‘93 to first quarter ‘94, demand for money was still growing at a brisk pace, with M1 velocity falling by more than 4%. Since early ‘94 (the Fed began “tightening” in February) velocity has risen by about 6%. Fed officials have to be concerned that if velocity doesn’t stabilize, any additional liquidity resulting from lower rates will merely fuel nominal, rather than real, GDP growth. We may get further clues on Greenspan’s thinking in his speech tomorrow night before the New York Economic Club.