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Europe The European – July 17, 1996

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July 17, 1996

Why Growth is a Dirty World on Wall Street

When a fall in US unemployment figures causes a slump in share values, something is wrong, writes Economics Editor Thierry Naudin

Good news for the economy is bad news for finance. Last Friday, a fall in America’s unemployment figures once again caused a dramatic dip in Wall Street’s bond and stock markets. But, beyond financial arithmetic and demagoguery, events across the Atlantic offer good lessons for Europe.

With the unemployment rate at its lowest in six years, the current vitality of the US economy is beyond doubt. Jobs are regained faster than they were downsized. The economy grew four percent in the second quarter, or at about double the rate of the first quarter.

This is enviable compared with the 1.5 percent rate expected in Europe this year. So why the gloom in the markets? Because good news raises the specter of inflation, which in turn affects both bond and share prices.

Inflation is best fought with a rise in the cost of credit. When a central bank tightens its monetary stance, elementary arithmetic requires a proportional adjustment in the yield of fixed-rate bonds, which causes their prices to fall. But many of these bonds were bought on the assumption that they could be resold at a higher price. So portfolio managers prefer to sell now, in order to protect the value of their clients’ savings.

This causes long-term interest rates to rise even if the central bank does not move, as happened last week. The Federal Reserve decided that the current performance of the US economy did not warrant a rate rise, but better-than-expected news form the labor market suggested otherwise. As Wall Street veterans say: “The bond market raised rates for the Fed.”

The prospect of higher interest rates can also hurt the stock market. The squeeze on liquidity could reduce investor interest in shares and corporate profits, causing massive sales. And, indirectly, higher wages, such as those disclosed last Friday, may erode profit margins if companies cannot pass them on to consumers.

But regardless of the autumn slowdown projected by several economists, there is reason to believe that Friday’s sudden fall in the Dow Jones Industrial average index was overdone. Because the US economy is a relatively closed one, higher wages do not affect America’s international competitiveness to the same degree as Europe’s.

Moreover, some of the painful downsizing of the past few years is resulting in productivity gains. This makes the Federal Reserve confident that US growth can be allowed to grow more quickly without overheating. Should things go the way the fed hopes, it would invalidate the market’s fears that inflation is bound to reappear whenever growth runs faster than 2.5 percent in real terms. This, in turn, might persuade more managers to seek profitability through corporate growth strategies, which call for vision, rather than macho-style downsizing.

That its two pillars—private enterprise and the markets—are so fearful of growth is one of the shocking aspects of today’s capitalism. It looks as though everyone is on the defensive, trying to preserve market share rather than create new riches. When watching last Friday’s events in Wall Street, the public rightly sensed a problem of wealth distribution.

US share prices have risen 50 percent over the past 18 months as America’s post-war generation kept investing in equity to secure retirement income. They have a good incentive: taxation of Treasury debt income is high, and the government’s Medicare and pension programs may face bankruptcy earlier than official projections allow. This would suggest that current share prices are not as excessive as analysts think.

The government sought to alleviate the burden of interest payments by borrowing short-term. “But as a result, short-term interest rates doubled in two years,” notes Martin Armstrong, chairman of the Princeton Economics Institute.

This is a lesson for Europe. US short-term interest rates, used to be determined by the Federal Reserve, now they come under the influence of market forces. This short-term palliative to welfare funding problems causes uncertainty and instability. Italy is too familiar with this, and Germany should avoid it as its government prepares for its first short-term debt issues. The public is also aware that financial markets fret over a few cents’ rise in hourly earnings but do not blink at the million-dollar bonuses corporate managers allocate themselves.

Taxation has a mitigating role to play here#151;Europeans are keen on a fair distribution of riches.

With elections looming in many European countries, there is a scope for a debate, which should include trade unions and shareholders, about how best to make capitalism work, not just for a few, but for all.