The picture doesn't seem that awful: Very low unemployment. Modest price increases. A seemingly stable dollar. Millions of Americans more affluent than they were a year ago. An economic recovery soon to celebrate its fifth birthday.
Yet, last week, investors glanced at the picture and--faster than an army of frenzied brokers can shout "sell!"--proceeded to drive the stock market into one of the deepest canyons in years. On Friday alone, U.S. stocks lost $145 billion in value, according to Wilshire Associates, investment managers in Santa Monica. The market value of all stocks has been slashed by $486 billion since late August.
Why, considering all the good things going on in the economy, is everyone so nervous? Is it all irrational? Or, is there something real to worry about?
Dollar, Inflation Worries
Economists say there are very real things to worry about: the persistently vast trade deficit, along with the budget deficit, raises the specter that the U.S. dollar will go lower and that inflation will go higher. The American economy already has grown dependent on cash from foreign investors, with the Japanese owning billions of dollars in U.S. Treasury bonds. If inflation rises, interest rates will have to go still higher to keep the Japanese and others willing to buy U.S. bonds in the future.
And if rates rise sharply, the economy could dive into a recession. "There's nervousness that the whole house of cards is going to crumble--that the combination of large budget deficits and trade deficits isn't going to work forever," said Robert H. Chandross, chief North American economist for Lloyds Bank in New York.
Confusion about whether the economic picture is positive or negative is understandable--the economy is an endless jumble of good and bad news about employment, inflation, trade and deficits. Earlier this year, many experts predicted a lackluster performance with little inflation through 1988. The worrisome trade and budget deficits were expected to shrink slowly. Manufacturing, battered by foreign competition, was expected to recover somewhat. And unemployment, which had clung stubbornly in the 7% range, was decreasing.
By comparison with most economic recoveries, the current one has reached senior citizen status in its fifth year. It seemed unlikely that other countries such as Japan and West Germany were going to implement economic policies that would energize the U.S. economy still further.
This environment of low inflation and low interest rates made stocks attractive relative to bonds. Money flooded into the stock market.
By last summer, however, there were growing signs that the U.S. economy was healthier than the experts had projected. These signs included a lower-than-expected unemployment rate, growing demand for basic commodities and clear improvement in the trade picture during the early months of 1987.
And, perversely perhaps, that spawned the fears that became rampant in the markets last week. This seemingly favorable outlook provoked a skittishness in the financial community. As unemployment fell and labor markets tightened, fears grew that wages would exert added inflationary pressures. In particular, holders of bonds worried that the policies of the Reagan Administration and the Federal Reserve Board would unleash inflation, cutting into the value of their investments.
All the while concerns were growing about the U.S. trade deficit, which in 1986 meant that the country spent $166 billion more on foreign goods than foreign consumers spent here. Despite improvement in the first few months of this year, progress has slowed. And this has led to concerns in the financial community that go beyond the problem itself and to a possibly painful cure.
Encourages Lower Dollar
To combat the deficit, the Reagan Administration has encouraged a lower value for the dollar, an action that tends to force the price of imports upward, giving American producers a badly needed cost advantage. This contributes to inflation, however.
Meanwhile, the U.S. government continues to run a huge budget deficit, estimated at more than $150 billion for this year. Thus, the United States is enormously dependent on foreign investors, such as Japanese financial interests, to buy the bonds that finance these imbalances.
That is why the Wednesday release of the August trade figures, showing a $15.7-billion deficit, sent the markets into an uproar. The number suggested that the U.S. government might encourage a further decline in the dollar's value, raising the price of imports. Because that would drive up inflation, the U.S. government would have to offer higher interest rates to keep its bonds attractive to investors.
And that is what is happening. As rates have gone up, bonds look better than stocks as a place to invest. "That (soaring stock market) was a bubble that was ready to burst the minute interest rates started to rise," said John Hagens, an economist with the WEFA Group, economic forecasters in Bala Cynwyd, Pa.