Global Policy Forum

By James Grant

War has enough to answer for without being blamed for problems not of its own making. Last week the Federal Reserve excused itself from venturing any forecast about the United States economy pending the abatement of "geopolitical uncertainties."

But it isn't the fog of war that has shortened the vision of our monetary policymakers. It's rather the fog of finance, particularly the long legacy of America's greatest stock-market bubble. The truth about the three-year decline in stock prices and the hot-and-cold-running economy is that they have their roots in prosperity, not in war.

The paradox is easily explained. High stock prices invite capital investment. Ultrahigh stock prices invite redundant capital investment. Stock prices higher even than those on the eve of the 1929 crash invite titanically redundant capital investment. No wonder, then, that business spending on new plant and equipment has been so weak for so long: The sky-scraping stock market of the late 1990's (which indeed commanded valuations higher than those of 1929) induced enough corporate spending to sate demand and cause a recession.

That recession, which began in March 2001, is probably over by now (the official cyclical timekeeper, the National Bureau of Economic Research, continues to weigh the evidence). But the recovery is heavy-footed and faint-hearted. High energy prices and stay-at-home travelers haven't helped. Nor has worry about a new terrorist attack. But the source of America's persistent financial aches and pains is something more basic: the preceding mispricing of capital.

In the manic phase of the bull market, capital was essentially free. The frittering away of American savings wasn't intentional. It happened inadvertently, through investing: in telecommunications equipment, semiconductor manufacturing plants, computer servers, power generators, office furniture, Internet initiatives, etc. We invested more than we should have — in fact, more than we had. We borrowed to invest, from creditors both domestic and foreign.

And because the law of supply and demand is everything it's cracked up to be, the bull market ended. More productive capacity spurred higher output, which led to more intense competition and — no surprise — to lower profit margins. And those things led to lower stock prices, which, in turn, led to a crash in capital investment.

There was no "new economy" after all. Now almost one-quarter of corporate productive capacity is lying idle. All too many job seekers find themselves in the same predicament.

The war is not to blame for this sequence of events, which was set in motion years before 9/11. But the cost of the war (and future wars, pacifications and occupations) may prove burdensome in ways that Americans have been privileged not to have to worry about.

The United States at the millennium is an historical oddity, not only a great power but also a great debtor. It consumes much more than it produces. It imports much more than it exports. And it owns much less of foreign assets than foreigners do of American assets ($2.3 trillion less, as of the end of 2001). In 2002, Americans imported about $500 billion more than they exported — that being the size of the current account deficit, a comprehensive measure of the net flow of goods and services between the United States and the rest of the world. It is useful to think about this deficit in terms of the current defense budget: it is 35 percent bigger.

Most countries would jump at the chance to get into this kind of fix. But they can't. And if they did get into the habit of consuming more than they produce, they would quickly have to earn their way out — by consuming less and producing more. No such imperative is yet felt in this country, however. We conveniently finance our deficit with dollars.

Up until now, the rest of the world — America's creditors — has been more than happy to exchange its merchandise for our currency, a currency they have coveted both as a medium of exchange and a store of value. So the dollars have made fast round trips, from American consumers to foreign producers and back as investments in America.

The collapse of the American bubble has spurred the Federal Reserve to action. Since Jan. 3, 2001, it has cut the interest rate it directly controls, the federal funds rate, no fewer than 12 times.

And because desperate debts and falling stock prices conjure up the fear of a general decline in wages and prices, the Fed has pledged radical additional action. It has promised, if necessary, to make dollars superabundant — in effect reducing their purchasing power on purpose. In so many words, it has promised that there will not be no inflation.

In a Nov. 21 speech, Ben S. Bernanke, a Federal Reserve Board governor, tried rhetorical shock therapy. Using a device called a "printing press," he carefully explained, the government can "produce as many U.S. dollars as it wishes at essentially no cost."

Many central bankers have had the same thought. Few have dared to say it out loud. Another who did, a month after the Bernanke speech, was none other than Alan Greenspan, chairman of the Federal Reserve Board. If need be, said Mr. Greenspan, the Fed could hammer down long-term bond yields just as it has repeatedly cut short-term interest rates. It did so, in fact, the chairman reminded his audience, between 1942 to 1951, years of war, price controls and national mobilization.

Unilateralism" in military affairs may be necessary and expedient. But the relationship of a debtor nation to its creditors is necessarily multilateral. This is especially true in the case of a debtor that prints the money with which to service its debts.

Now the debtor, putting the needs of its own economy and financial system first, has promised to do what, pre-bubble, few self-respecting nations did: it has promised to crank up price inflation just a little bit. To reach this goal, the Fed is running the printing presses, buying Treasury securities with credit it creates out of thin air.

The stock market has apparently noticed. Buoyed by war news and easy money, it has strung together eight days of gains, the most since June 1997. But the bond market, too, has noticed. Interest rates have climbed, with the 10-year Treasury note now above 4 percent, up from a low of 3.56 percent only a few days ago. Mortgage rates have followed suit, a shift that imperils the glorious mortgage refinancing boom.

The war didn't cause America's financial and economic problems. But it's not so far-fetched to speculate that it may soon worsen them. Rising interest rates and a rising inflation rate may soothe the anxieties, and the consciences, of the governors of the Federal Reserve Bank. It is unlikely, however, that they will deepen the reservoir of confidence among the legions of America's foreign creditors.

James Grant is editor of Grant's Interest Rate Observer.

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