Trading Places and Fear in the Market Place
Louis Ross (Global Emerging Technology Institute)
Accounting scandals, weak earnings and fear of new terrorist attacks hit the U.S. market hard this week. U.S. Federal Reserve Chairman Richard Greenspan, in his semi-annual monetary policy report to Congress, provided the markets with a relatively positive talk on the current and potential future state of the U.S. economy earlier this week. Chairman Greenspan mentioned an "infectious greed" gripping U.S. institutions and business executives, which included the liberal use of stock options and the pumping up of bogus earnings figures. Managing earnings led to numerous conflicts of interest. This did not bode well for the financial system, as the Dow continues to nervously bunji-jump in defiance of a call to arms and more dutiful confidence in the market. The market will continue to be over-valued until the complete story of just how managed where those earnings, and all the spin in the world will not instill confidence in investors until that happens. It will take a little more time. A new Senate bill that would implement sweeping reforms, including ones that directly punish corporate executives, including the liberal use of jail time for those found guilty of fraud and thievery. Besides what is happening in the markets, though not unrelated, the U.S. federal budget deficit, unlike the market, is registered solid gains. In New York City, the old "debt clock", which was shut off for a while during the economic boom, lit up the Avenue of the Americas in midtown Manhattan as the U.S. debt load began to head North again.
There was also talk concerning Japan. According to Chairman Greenspan, Japan needs to resolve structural problems in its financial system, including those related to the disposal of bad loans by banks. He also emphasized the importance of boosting economic activity by Japanese authorities through monetary policy. Though Japan certainly needs to make a move in terms of its finances and the restructuring of its economy, such calls for reform are falling on increasingly confused and deaf ears, and not only in Japan. This reminded me of an episode at a recent central European investment banking conference that I attended. An American confidently asked whether or not if Poland and the other central European economies have developed open and reliable accounting standards over the past few years so that they could be relied upon by investors. The audience reply was a unified chorus of incredulous laughter. There is confusion in the market place in the U.S., where people are questioning a lot of the methods used over the past 10 years which led to the situation we are experiencing today. The U.S. regained the admiration for its economic system which was arguably lost a decade ago, only to have it crash and burn at the inception of the 21st Century. The world, not only the U.S., should be concerned and be careful not to gloat too much.
These are nervous times in the global financial markets, especially in the United States and Japan. The U.S. economic model, as was the case a little over 10 years ago, has been put on the executioner's chopping block once again, with the exception that this time there is a lot more public, private and consumer sector debt on the books and a lot more scandals to deal with than during the early 1990s. Also, the circumstances make it very difficult for the economy to experience a revival the type of which occurred during the early 1980s. In 1982 the economy was held back by high interest rates and there was a great deal of room for pent up demand to be released in the housing market and an excess capacity of consumers to spend more. The boom in the 1990s was lead by rampant IT spending. In 2001 the economy slowed because businesses had invested too much, consumers had spent themselves into unprecedented levels of debt, and the housing market, by some analyst accounts, is at least half-way toward the end yet another bubble imploding.
The U.S. slump will continue at least well into next year. The fragile Japanese recovery is present, riding on the back of relatively strong exports and a weak yen. However, problems in the financial sector still serve to occasionally chill investor sentiment, leaving the Nikkei in a state of apprehension. As was the case for years, the U.S. and other foreign markets support Japanese export growth. For sure, an increase in foreign investment in the Japanese market found its way there due to the sad prospects in the U.S., so only time will tell whether or not the alleged recovery in Japan is sustainable.
Unlike Japan, the U.S. relies a great deal on foreign investment flows to help subsidize its deficits, which has racked up impressive gains over the past two years. After years of pumping billions of dollars into the United States because it seemed the land of opportunity, foreign investor started a marked retreat during the beginning of the year. A strong consensus was formed and foreign investors honestly felt that the U.S. market was not worth investing in. After years massive investment into the U.S., foreign investors started to retreat in droves, leading the dollar to decline significantly since March. The rest of the world believed in the revival of the U.S. and the value of its "new economy" and felt cheated after being caught in its precipitous decline. They did not expect the U.S. to be compared to banana republics, but neither did the Japanese expect to be compared to Argentina.
In 1993, Japan was still being portrayed in the U.S. as an economic threat. The U.S. model, in terms of popularity, was on the wane. Several years later, in 1995, the U.S. began a strong run of impressive economic growth spurred by massive investment in the IT and related sector that lasted a solid five years. During this time, the Japanese economy stagnated, a number of economic stimulus measures failed and Japanese domestic demand remained passive. Japan then suddenly was in the same league as Argentina and, during the beginning of the year, many American analysts were predicting financial collapse in Tokyo while maintaining a strong level of confidence in the revival of the U.S. market, which fell off of a cliff, especially after the September 11 terrorist attacks. Now foreign analysts are comparing Russian and American "corruption" in the same breath. Needless to say, we may be in for a few more unpleasant surprises over the next several months, with no one country being able to defend its policies or course of action.
One thing that many analysts failed to consider is the inter-dependence of both economies and the fact that both, since at least 1990, had serious structural problems. The internet bubble in the U.S. was a child of the promotion of the "service economy", and was supported by "sophisticated" accounting and inflated earnings that are only now being seriously questioned. Its financial system infrastructure developed the ability to construct "complex" solutions, which led to equally complex problems and room for manipulation. For example, accounting fraud was explained during the boom time in terms of "new paradigms" and the like. The pressure to report growing earnings results led to this and then, consequently, to over-inflated investor expectations. First manufacturing was outsourced, then those high-value added services (to placed like India), including R&D. Management, which by the way increased the outsourcing of management decision making as well as all of the above, became too engrossed in managing their earnings, and an untenable and (unable to maintain) system gelled around it. In Japan, the problem was the opposite. Financial markets were too "primitive" and the bureaucracy managed too many policies, which should have been developed and implemented by the private sector. Markets were not permitted to "clear" in a timelier manner. Corporate governance in Japan and other select continental European economies was seen as a serious problem, as management shielded itself from shareholder demands, maintained medieval cross-shareholding arrangements and capital structures that served to entrench management and arm them with a variety of defenses. Interestingly enough, the U.S. system apparently proved no more efficient or deserving of kudos as it also served to entrench the wrong type of management, but differed significantly in that U.S. entrenched management, just as self-serving as those in Japan, made off with a lot more money. It set the globalization of the U.S. system back many, many years in the eyes of foreign onlookers. The system did an incredible job of justifying its existence until the bubble burst.
In hindsight, it was clear that each system had its strengths and weaknesses, and its adherents had problems with identifying the weaknesses before it was too late, leading to a massive amount of wasted resources. Reluctance to change will lead to more waste. The accumulation of debt in the U.S. was portrayed as a virtue rather than a vice, as is still the case today. The accumulation of debt in Japan was viewed in the U.S. as more of a waste of resources, which, arguably, much of it was. However, the objectives of policy makers in each economy were very different. Japan's choices are irrational unless you realize that Japan sought to maintain a system that made it rich, subsidizing the status quo. The reluctance to change in some quarters of the private sector and financial system in the U.S. can also be observed.
The U.S. government had a surplus that disappeared overnight. This includes both federal and state/prefecture shortfalls, and this happened to Japan as well. Much is publicized in the U.S. about Japan's problem, but it's hard to argue that the U.S. is so much better off. Few people in the U.S. would say that the structure of the economy would be able to maintain pitiful Japanese-like economic growth rates for over the next 10 years if no change is implemented. Failure to recover quickly in the U.S. would have a much more serious impact domestically, and would set the global economy back several notches. The competitors of Rome did not always support the Empire, but after it crumbled what happened? The global economy cannot afford a modern version of the Dark Ages at this point in time.
Now, both economies have considerable amounts of public and private sector debt, with the exception that Japanese consumers have, on average, higher net worth. Both economies are experiencing difficult times in terms of investor confidence and companies are being forced to restructure, clean balance sheets and re-evaluate business strategy. For now, cost-cutting efforts are taking place on a grand scale through the use of what is now and will be for the foreseeable future an export platform, China.
Financial markets are suffering, that is for sure, but what are the two largest economies doing in terms of investing in the future and planting the seeds of the next bull market? Both economies are now banking on the next wave of technological innovation which would lead to an across the board revival in economic activity. This will occur after financial and political markets "clear." After all of the restructuring, reform, cost cutting and re-deployment of assets, it will come down to the creation of new technologies and new commercial markets for those technologies. Both economies will survive and both will maintain their positions as the two strongest economies in the world for some time to come. They will maintain their positions as the largest investors in R&D and serve as the key source of basic and applied research and market demand. If anything, both will maintain their positions since, simply, there are no other economies that will challenge them in the near future. China will function as a key, short-term contributor to the restructuring and retooling of the largest industrialized countries, including those in Europe. Europe, for sure, will increase its own competitiveness as it strategically positions itself to take advantage of the next wave of innovation, playing to its strengths. The same goes for several countries in Asia.
One thing that should be considered by both the U.S. and Japan, however, is that a number of new key technologies will provide a much more even playing field in terms of the ability to come up with ground-breaking results. For example, political indecisiveness and other concerns in the U.S. could significantly reduce the lead of U.S. companies in the biotech area. Intellectual capital and expertise is much more dispersed throughout the globe than was the case during most of the post-war years. Therefore, the challenge to reform and restructure will go hand in hand with the challenge confronting both economies in terms of creating new technologies and new markets.