The Hindu Business Line : Testimony or convention speech?

YES, I am aware that the US President, Mr George Bush, as the Republican Nominee, will deliver his convention speech in August. But reading the testimony of the Federal Reserve chairman, Mr Alan Greenspan, one might be excused for thinking that it was the speech of an incumbent President standing for re-election.

There was a liberal sprinkling of plaudits for the Fed's economic management and optimism on growth. Barring a casual reference to risks to growth, there was no mention of the structural deficiencies: the unusually low US household savings rate, the high current deficit, risks to the US dollar and the high fiscal deficit.

In reaction to the testimony, the euro declined against the dollar, and so did gold. The market's verdict appears to be that the Federal Reserve would push interest rates higher either gradually or rapidly. No countenance of the possibility that the Fed would either be forced to stay put or even consider lowering rates, in extreme circumstances.

The Chairman's speech and the market reaction suggest that they are ignoring long-term risks to the US economy. The same forces that caused the Fed to overestimate growth in 2001 and 2002 would now belie their forecasts of a strong acceleration in growth. Those forces have not dissipated, but are simply masked by easy credit and low bond yields. Contrary to market expectations, the Fed would raise rates far more cautiously while employing verbal tightening from time to time, as the Chairman did on July 20.

Is Mr Greenspan's upbeat growth testimony in line with the ground reality? He dismissed the softness in consumer spending in June as short-lived. Nor did he pay any heed to the tepid employment report for June. He said the labour market had turned around and has created an average 200,000 jobs in the last six months compared to 60,000 jobs per month in 2003. As averages go, the Chairman was right. But the average of 200,000 jobs was due to the creation only in three of those six months (March-May).

The Fed Chairman certified that the US households have rebuilt their balance-sheets, as did the US corporations. He is right about the latter and not the former. Two charts would show that he was taking some liberties with truth.

The first chart reflects charge on the income of the household. There is no sign, despite low interest rates, that households are using less of their disposable income to service debt. Compared to history, they are spending more and not less on servicing debt. The answer to why that is so is revealed in the second chart, which shows a parabolic rise in the outstanding debt burden of the households, particularly in the 1990s. To be sure, perceptive readers would argue that a rise in debt, if offset by a rise in net worth, is not a sign of trouble. It would simply mean that households have borrowed not to finance consumption but to accumulate assets. Partially, that is so in the US.

The problem with this logic is that while assets could drop in value, especially when bought at high prices, liabilities do not shrink in nominal terms. In the last few years, with US financial and real assets remaining fully valued, there is greater risk of a decline in the household net worth when asset values fall faster than liabilities can shrink. Indeed, owners' equity as a percentage of real estate is the lowest in 30 years. In 1973, it was 68.1 per cent and in 2003, it stood at 55.2 per cent, sliding further to 54.6 per cent in the first quarter of this year.

Given such huge risks to household net worth, it is hard to fathom the basis of Mr Greenspan's claim that households have rebuilt their balance-sheets. The fragile health of their balance-sheets only makes it imperative that more jobs are created and that they pay as well as those the employed used to hold before. Available evidence suggests that more jobs are being created in lower income categories. Hence, labour income support to consumption is far from assured. Given all of the above risks to household spending, it is hard to agree with Mr Greenspan that the slowdown in consumer spending will be short-lived. Hence, the conclusion that the Fed funds rate would peak at less than 2 per cent and not above.

Even if Mr Greenspan were right, for the Fed's real growth forecast of 4.5-4.75 per cent to be achieved would require that real GDP growth accelerates to 5.3-5.8 per cent in the second half.

If this happens, the Fed would be required to up the funds rate to 2.5 per cent by the end of the year. That would push the 10-year Treasury yield to a high 5.5 per cent. The US trade deficit would explode if the real growth rate accelerates close to 6 per cent in the second half.

Further, this large trade deficit would have to be financed at higher interest rates, leading to a double blow on the current account deficit. The consequence would be a significant depreciation of the dollar.

Therefore, whether or not we believe in Mr Greenspan's testimony and the Fed's economic forecasts, the investment verdict on US assets is clear: Stay clear of them.

(The author is an economist based in Singapore. The views are personal. Feedback may be sent to nageswar@singnet.com.sg)