You’ll Lose a Bundle Selling America’s Economy Short

Federal Reserve Chairman Alan Greenspan’s recent testimony before Congress on the Fed’s goals and hopes for the economy made two points. First, the Fed is through raising interest rates and is even lowering them a bit. And second, Greenspan admitted (so subtly that congressman sitting right in front of him, distracted by the S&L; bailout, missed it) that we may, in fact, already be in a mild recession that will last six to nine months.

What is important to remember is that a mild recession this year is the most attractive of the alternative economic scenarios confronting Greenspan and Federal Reserve colleagues. Preoccupation with the “hard landing” (recession)-”soft landing” (no recession) question on the outlook for the U.S. economy is causing pundits to overlook the fundamentally sound prospects for investment in the United States.

The bright side of a recession would be a smaller-than-expected 1989 trade deficit of about $90 billion and a stronger-than-expected dollar, especially against the Japanese yen, British sterling and the German mark. A strong dollar means lower inflation and won’t, contrary to the popular view, swell the trade deficit. Economic growth has more to do with imports than exchange rates. When the economy slows, American spending on imports drops sharply while American producers expand production of exports to make up for the loss of sales at home. The trade deficit falls and the dollar grows stronger as lower inflation makes investment in the United States more attractive.

There are more, largely political, sources of future dollar strength brewing abroad. While the U.S. economy is slowing and “profligate” Americans are spending less, as finance ministers from Western Europe and Japan have urged with metronomic regularity, central banks in Japan, Britain and West Germany will likely be holding to a slightly easier stance on monetary policy. All, especially Japan, will do so against a background of political problems that could push up medium-term inflation expectations and push down stock prices. Japan faces a general election to the lower house of Parliament--all seats up for grabs--in November with a strong chance that the long-ruling Liberal Democratic Party will be forced into a coalition government with the Socialist Party and its agenda for budget-busting social programs.

Labor unrest in Britain is growing as is unhappiness with high interest rates. It looks as if British inflation won’t becoming down soon. Meanwhile, concern is rising over the survivability of Margaret Thatcher’s Conservative government.

West Germany faces the prospect of a “red-green” coalition winning next year’s elections. That, and the possibility of currency controls that would be aimed at trapping capital in a leftward-swinging Germany, is already pushing German capital into the United States.

Despite a near-term slowdown, the longer-run fundamentals favor the dollar and U.S. investments. More and more, as the postwar system breaks down and the atrophying Soviet military threat reduces political discipline in Europe and Japan, the United States emerges as a uniquely stable and predictable political-economic environment, still possessing great natural advantages, especially in terms of investment opportunities. Over the next year, more of the $1.5 trillion in annual gross saving of Western Europe and Japan is likely to flow toward America. This will come just as America’s economy slows (temporarily, for the sake of inflation control), thereby cutting the supply of dollars generated by the external deficit. The result, a smaller supply of dollars flowing out of the United States coupled with a larger demand for dollars coming in, will be a stronger dollar and--especially if dollar appreciation is resisted by heavy central bank intervention--still lower U.S. interest rates and still higher prices of U.S. bonds and stocks. An overvalued dollar collapsed the U.S. stock market in 1987. An undervalued dollar is pushing it up in 1989.

There is some chance, about one in three, that an additional event like a major U.S. budget agreement this fall--coupled with favorable fundamentals in monetary and real economic conditions--will create a rush into dollars that will push the dollar up by another 25% to 35% against other major currencies.

These fundamental dollar-strengthening moves will encounter little resistance from central banks that have been wasting huge chunks of their taxpayers’ money by indulging themselves in a collective fantasy about target exchange rates. In the face of a powerful international surge into the dollar, Greenspan would find it possible to ease money and tilt investors even more toward purchases of U.S. stocks--a fitting reward for having taken the right course on monetary policy.

Naturally, this upbeat scenario will be doubted by the “sell America short” crowd that has warned ad nauseam about America’s profligate spending and loss of competitiveness. But the real risk is being assumed by investors who believe the “America in decline” view in a world where everyone loves to complain about American profligacy while continuing to discover that America can well afford it.